Sunday, September 28, 2008

Finding Value In The Financial Sector

It goes without saying that the stocks in the financial sector have seen their fair share of difficulties. At some point, bargains will certainly surface in this sector as beaten down stocks provide investors with attractive purchase entry points.

As an investor, one will want to analyze these investment opportunities in order to determine the attractiveness of these investments. Following are some of the key metrics one should review when analyzing financial firms.

Profitability Ratios

* Return on Assets (ROA):
  • ROA = Net Income ÷ Total Assets
  • ROAs of 1% or greater are considered strong.
* Return on Equity (ROE)
  • ROE = Net Income ÷ Shareholder’s Equity
  • ROEs of 12% or higher are considered good.
* Net Interest Margin (NIM)
  • NIM = Net Interest Income ÷ Average Earnings Assets
  • Higher margins are better; margins above 4% for banks and above 3% for thrifts are impressive.
* Fee Income/Average Assets
  • Fee income is less volatile than net interest income, and is highly prized.
* Efficiency Ratio (ER)
  • ER = Non-Interest Expense ÷ (Net Interest Income + Fee Income)
  • Lower ratios are usually better, but reducing expenses too much might cause service to slip. An ER below 50% is very good.
Loan Quality Ratios

* Loan Loss Reserves to Total Loans
  • Loss reserves are found on the balance sheet as a reduction of gross loans (gross loans – reserve = net loans).
  • Ratio should be 1.3% or higher.
* Non-Performing Assets/Total Loans
  • Non-performing assets are non-performing loans plus other real estate owned.
  • Provides an indication of how much of the loan portfolio might be impaired; should be as low as possible (greater than 4% to 5% isn’t good, and above 8% to 10% can be life threatening).
* Loan Loss Provision/Net Charge-Offs
  • Loan loss provisions should be at least 100% of the net charge-offs.
  • Loan loss provisions consistently exceeding net charge-offs is very conservative.
* Loan Loss Reserve/Non-Performing Assets
  • Should be at least 100% (the value of every bad asset is covered by a reserve); higher is always better. But a lower ratio is not bad if bank’s management has good workout-teams capable of collecting on non-performers.
Capital Ratios

* Common Equity/Total Assets
  • The key capital ratio, and it should be at least 8% or better.
Non-Qualitative Factors
  • Insider ownership and insider buying: The more insider ownership, the better; insider buying is bullish.
  • Acquirer or acquiree? You can make money with either a well-managed growth-by-acquisition strategy, or a strategy of investing in small well-run banks likely to be acquired.
  • Deposit growth: 8% to 10% annually is good.
  • Dividend payout ratio: Many banks offer attractive yields, but if dividends per share consistently exceed earnings per share, a dividend cut may be coming.
By utilizing the above metrics to evaluate financial firms, one may uncover some attractive investment opportunities in this beaten down sector.


Money in the Bank: How to Find Opportunities in a Fallen Sector (PDF)
AAII Journal
By: John Deysher, CFA
Pinnacle Value Fund
July 2008

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