Navigating bank stocks: a complete guide to investment

Bank stocks have been a favorite of legendary investor Warren Buffett for a good reason. As of January 2023, he has invested over $80 billion in the industry. With some bank stocks trading at a bargain, it’s a great time to consider investing in this sector.

In this guide, we’ll break down the basics of bank stock investing. Whether you’re an experienced investor or new to the game, this guide will provide you with all the information you need to make informed investment decisions in the exciting world of bank stocks.

The three types of bank stocks

Bank stocks can be grouped into three primary categories, each with unique characteristics:

1. Commercial Bank Stocks: These stocks represent banks that focus on providing traditional banking services, such as accepting deposits and lending money to borrowers. Examples of commercial bank stocks include Wells Fargo and U.S. Bancorp;
2. Investment Bank Stocks: These stocks represent banks that specialize in providing financial services to corporations, companies, and governments. Investment banks, such as Goldman Sachs and Morgan Stanley, offer a range of services, including advisory services, asset management, stock trading, and facilitating complex financial transactions. They also guide companies through their initial public offerings (IPOs);
3. Universal Bank Stocks: These stocks represent banks that offer a combination of commercial banking and investment banking services. They include banks such as Bank of America, Citigroup, and JPMorgan Chase. Universal banks benefit from a diversified revenue stream and international scale. But they also come with the risks associated with both commercial and investment banking. These banks are more complex businesses to understand.

When considering investing in bank stocks, it’s essential to understand the differences between these types of banks and how their business models affect their performance. Additionally, investors should consider their investment goals and risk tolerance when choosing which type of bank stock to invest in.

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The top three bank stocks by market cap

The following are the three top bank stock by market cap:

JPMorgan Chase

With assets of nearly $4 trillion, JPMorgan is the largest U.S. bank by assets. Its core business is focused on community banking, investment banking, and wealth management. Despite the global financial crisis and the COVID-19 pandemic, JPMorgan has emerged as a strong performer in the industry.

Bank of America (BOA)

BOA is the second-largest bank in the U.S., with assets of over $3.2 trillion. After experiencing significant setbacks during the financial crisis, CEO Brian Moynihan led a remarkable turnaround that positioned the bank for success during the COVID-19 pandemic. With a cleaned-up balance sheet and excellent management, BOA is considered one of the best-run of the biggest banks.

Wells Fargo

Wells Fargo has a strong track record of lending results across economic cycles. This makes it one of the best banks at managing crises. However, the bank’s reputation was tarnished by a fake accounts scandal that led to significant regulatory restrictions and the ouster of its CEO. Despite this setback, Wells Fargo remains a significant player in the banking industry.

Investors considering investing in bank stocks should research each bank thoroughly and weigh the potential risks and rewards before making any investment decisions.

How to calculate a bank’s profitability ratios

Calculating profitability ratios for a bank is crucial in determining how profitable it is, given that many banks generate profits from lending activities. Here are four key profitability metrics to analyze traditional bank stocks:

1. Return on Equity (ROE): Calculated by dividing net income by total shareholder equity and multiplying the result by 100. An ideal benchmark for ROE is at least 10%. The higher the Return on Equity (ROE), the more efficiently a bank is putting shareholder equity to work;
2. Return on Assets (ROA): Calculated by dividing net income by total assets and multiplying the result by 100. An ideal benchmark for ROA is at least 1%. ROA measures the percentage of overall profit a bank makes relative to its total assets;
3. Net Interest Margin (NIM): Calculated by dividing net interest by total interest-generating assets and multiplying the result by 100. Look for an ideal benchmark for NIM is at least 3%. Net interest margin (NIM) refers to the proportion of interest that a bank generates on its loans after subtracting the interest paid on deposits and other capital sources. This critical metric plays an integral role in determining a bank’s profitability. Its movements are typically influenced by fluctuations in interest rates;
4. Efficiency Ratio: Calculated by dividing non-interest expenses by net revenue and multiplying the result by 100, an ideal benchmark for the efficiency ratio is 60% or lower. A lower efficiency ratio is better since it means more money left to lend or invest, leading to higher returns and profitability.

Investors should not rely on a single metric when analyzing a bank’s profitability but instead, consider a combination of these metrics to gain a comprehensive understanding of the bank’s financial health.

How to assess a bank’s risk

Assessing a bank’s risk is crucial for investors, given that banks are heavily leveraged businesses that lend out a significant portion of the deposits they receive from customers. To assess a bank’s risk, here are two important metrics to consider:

1. Nonperforming Loan Ratio: This ratio represents the percentage of loans that are at least 90 days past due and approaching default. A lower percentage of bad loans is better, and a nonperforming loan ratio above 2% can be a cause for concern;
2. Net Charge-offs: This metric measures the percentage of total loans that are unlikely to be paid back. During times of economic downturns, it’s crucial to keep an eye on banks that have significant amounts of unsecured debt, including credit card debt. Focusing on these banks can provide valuable insight into the potential risks associated with investing in them.

When considering a bank stock’s value, the price-to-earnings (P/E), ratio is crucial, but for banks, the price-to-tangible book value (P/TBV) ratio is also useful. By focusing on tangible assets, P/TBV measures how much a bank is trading relative to its property, cash, and loans.

To minimize risk, investors should focus on high-quality banks, investing in them when shares are discounted compared to historical valuations. Additionally, comparing banks to similar peers is key, as different banking services, operating models, and profitability metrics can cause banks to consistently trade at higher or lower valuations than peers.

Bank stocks, it is crucial to make informed decisions

Investing in bank stocks can be a lucrative opportunity for investors. However, understanding the different types of banks and how to assess their profitability and risk is crucial to making informed investment decisions. By considering key profitability ratios such as return on equity, return on assets, net interest margin, and efficiency ratio; investors can gauge a bank’s financial health.

Assessing a bank’s risk through metrics like the nonperforming loan ratio and net charge-offs is also important for making informed investment decisions. Ultimately, investing in high-quality banks at a discount on their historical valuations can lead to profitable returns for investors.

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