Bank Stocks and the SSG – Notes from an ICL Workshop

1.         Because banks borrow, buy and sell money, we cannot use conventional methods to figure revenues.  The annual revenues must be deciphered from several figures on the S&P and Value Line reports, and quarterly revenues must come from the 10K and 10Q reports.  You cannot obtain quarterly revenues from S&P or VL.

2.         There are four values that determine bank revenues:

a)         Net Interest Income.  This is the difference between the money the bank makes on loans, and the interest it pays on fed loans and depositor accounts.

b)         Non-Interest Income.  This is the money they make from non-lending activities, like trust services, bank fees, safety deposit boxes, and credit card fees, etc.

c)         Loan Loss Provision.  Banks are required to set aside a certain amount of money to cover bad debt.  It’s usually a percentage of their loan portfolio.  This must be deducted from the revenues.

d)         Tax Equivalent Adjustment.  Some of the bank’s interest income is tax-exempt.  This adjustment turns their tax-exempt dollars into pre-tax dollars so we can compare apples-to-apples.  This is for advanced study, so we do not have to take this into consideration.

e)         Therefore, the annual and quarterly revenue for the SSG will be Net Interest Income + Non-Interest Income - Loan Loss Provision.

(Information for those who want it:  S&P uses Gross Interest Income in their reports, which doesn’t account for changes in interest rates.  This skews the earnings, so we shouldn’t use it.  Value Line uses Loans in their reports, which doesn’t account for the other income sources, so we shouldn’t use it, either. VL’s Loan figures do already include the Loss Loan Provision, so they are “net”.)

  3.      The rest of the SSG information can be found on the S&P and Value Line reports.

  4.      It is suggested that we plot Book Value per share, by hand, on the front of the SSG.  It should
         be running parallel with Earnings.  If not, the bank’s fundamentals are deteriorating.  And, if Book
            Value is growing at a rate less than EPS, then EPS growth will eventually be limited.

  5.      Ralph Seger plots Revenues, EPS, PTP, Book Value and Dividends on the SSG.  He figures
            the average 5-year rate of growth for each, then he picks the lowest growth rate of these, and uses
         it as his forecast for future earnings.  So, if 5-year growth history has been:

            Revenues         19.4%          
         EPS                 18.1%
            PTP                 22.0%
            Book Value       13.2%
            Dividends         20.8%             

           Ralph would use 13.2% as his projection for future earnings; the lowest of the above.

  6.      In Section 2, we  also need to plot Return on Assets--a better gauge than ROE for a financial stock.                 It’s a measure of efficient use of the company’s assets, which includes the customer’s deposits.              
A value of 1% or more is good, and it should be trending up. 
           Net Profit (Net income) div. by Total Assets = ROA.  (Make this 2C)

  7.      On the completed SSG, we should look for the same criteria, as with any other company.

  8.       Our study should include an examination of the Balance Sheet.  In particular, the quality of assets, 
             or the types of loans held in their portfolio.  Mortgage loans are the safest, commercial loans
             and consumer loans and next safest, and construction loans are the riskiest.

  9.       The presence of large debt does not necessarily indicate an excessive amount of leverage. 
What does matter is its ability to earn income on those borrowed dollars.  We measure this with 
          (2C) Return on Assets.

  10.     Loan Loss Provisions should grow in line with Loans.  If it’s growing faster than Loans, it is often
         a sure sign of potential problems.  It could indicate a slowing economy or an aggressive lending strategy.

11.       Capital Ratio:  Banks grow by increasing deposits from new or existing customers.  This increases their asset base.  Banks are required by law to grow their Equity and Loan Loss Provision Reserves by an equal amount in order to maintain a “primary capital” ratio of 5.5% to 6%.  Therefore, Share Equity + Loan Loss Provision div. by Total Assets = Capital Ratio.  These can be found on the Value Line.  And we should avoid banks that are skirting the edge of permissible limits of primary      capital.  It’s nice to have a cushion in the case of unexpected events.

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