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Bank Stocks: Investing Through Fundamentals

The prospects of the banking industry have been clouded by near- or below-zero interest rates and this has dampened the economic outlook.

Yet with the right tools for analysis, investors can still find value in the fundamentals of select banks.

As the global markets have been on a roller-coaster ride through the first half of 2020, the banking industry is still feeling the pain.

Three months ago, investors were caught off-guard when HSBC Holdings plc (SEHK: 5) and Standard Chartered PLC (SEHK: 2888) announced decisions to slash or suspend dividend payments for the year.

As the economic woes of Covid-19 deepens, many global universal banks have also reported eye-watering credit losses in the first quarter and delayed, if not cancelled altogether, their dividends.

Investors may have enough reasons to doubt the profitability and growth prospects of the sector for a long time to come.

But for those who have bank stocks on their watchlist, this article intends to provide concrete guidelines to what really matters when investing in bank stocks.

The four KPIs

Whether it is global universal banks or local commercial banks, the key performance indicators (KPIs) to watch for when tracking its financial health are four-fold.

These are: assets under management (AUM), return on equity (ROE), return on assets (ROA), and price-to-book (PB) ratio.

AUM

A major source of banks’ income has long been the interest payments it receives and pays through loaning and borrowing activities with individuals, businesses and other banks.

The AUM number thus gives you a rough idea of the size of the bank’s business, or simply, how much money the bank is able to attract in the form of deposits or through investment services.

Another metric that derives from the concept of AUM is “net new assets”, which refers to the new money inflows into the bank under a given period.

And it is also helpful to take into account the net interest margin (NIM) that calculates the net profit of the banks’ interest-generating assets, including deposits and investments.

ROE and ROA

Though for a long while, interest payments have been the major source of banks’ income, this model has been gradually transformed into the sought-after greater profit margins.

Now many of the major banks also profit through, for example, investment services, brokerage business, and insurance. These sources of income have gained increased significance on banks’ income statements.

Return on equity and return on assets are metrics deployed to further examine the profitability and efficiency of a bank’s business; they also play a vital role in evaluating the stock’s worth.

ROE is calculated by dividing the net income of the bank by the amount of shareholders’ equity (which is equals to total assets minus total liabilities on the balance sheet).

It is a measure of management efficiency of the bank and how much income it can generate out of its assets (excluding debts).

Generally speaking, an ROE of under 10% is not ideal, and the S&P long-term average for ROE across all industries is 14%. This holds true for banks as well.

HSBC, for instance, stated as far back as in 2017 that it hopes to raise its ROE above 10%.  But to this day, it has not been realised – perhaps a red flag to anyone who is considering the stock.

Similarly, ROA calculates the income generated by the bank out of its total assets (including debts). An ROA above 1% is considered ideal. The larger the bank’s total assets, the more likely its ROA will be lower.

PB

The PB ratio is measured by dividing the market value per share by the book value (total tangible assets) per share. It is often used to determine if a stock is overvalued by the market or otherwise.

It is of great significance in valuing banks as it is relatively easier to come to an accurate valuation of the bank’s tangible assets (often in the form of cash).

Some could argue that PB works best for smaller banks with less complexity than for universal banks that hold assets across a diversity of asset classes.

When the PB falls below one, chances are the stock is trading with a discount and is potentially undervalued. On the contrary, a PB of over one means that investors tend to pay a premium in the market to own shares of the stock.

Foolish conclusion

In times of low (or, as we are currently seeing in some parts of Europe and in Japan, negative) interest rates, this does not bode well for banks’ profits and deposits.

Moreover, the ongoing economic downturn has led to increased default risks, exposing banks to heavier credit loss.

Fundamental analysis will prove more critical in the current period of depressed earnings, especially in identifying business resilience and sustainability in the face of a major crisis.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Lorretta Chen doesn’t own shares in any companies mentioned.