How do normal investors like you and I invest in a bank? According to Warren Buffett, the answer is pretty simple. Look to the bank’s return on assets or ROA.
“Well, a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it’s earning 0.6% or 0.5% on the asset, it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you’re required to hold a certain amount of tangible equity compared to the assets you have. But you’ve got banks like Wells Fargo and USB that earn very high returns on assets, and they at a good price to tangible book. You’ve got other banks … that are earning lower returns on tangible assets, and they’re going to sell — they’re going to sell [for less].”
The attraction of return on assets is its simplicity. It captures so much of the essence of a bank, without getting caught up in the complexity of the big bank accounting mess.
In our continuing series of discovering the formulas and ideas to value a bank or financial institution, we will discuss the return on assets or ROA.
Definition of Return on Assets
So what is a return on assets?
According to Investopedia.
“Return on assets (ROA) is an indicator of how profitable a company is about its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.”
This term is often referred to as return on investments or ROI.
Return on assets tells you what earnings were created from invested capital or assets. Return on assets can vary from the company and will be very dependent on the industry the company is in.
This is why when using return on assets as a comparative measure, it is best to compare it to companies previous ROA or the ROA of a similar company.
The assets comprise of debt and equity of a company, both of these types of financing are used to fund the operations of the company.
The return on assets figure gives the investors an idea of how effectively the company is converting the money it has to invest in income.
Obviously, the higher, the better because the company is earning more money on fewer invested dollars.
Management’s most important job is to make good choices when allocating its resources and the best managers are great capital allocators.
These allocators can create more assets from the assets they already have and create more income for the company from those assets.
How it impacts valuations of banks
When calculating return on assets for a bank, we need to remember that banks are highly leveraged, so a 1% ROA indicates huge profits.
The discrepancy catches a lot of investors off guard; you need to remember that this numbers should be used to compare itself to other banks, not a tech company.
That comparison is not apples, to apples.
The major assets of a bank are it’s loans to individuals, businesses, and other organizations and the securities that it holds. It’s liabilities are it’s deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market.
Banks can increase their profitability by using leverage and profits can be measured by return on equity or return on assets.
Because of leverage, banks earn a much higher return on equity than they do on assets.
“In the 1st quarter of 2016, all financial institutions insured by the FDIC, which includes most banks, earned an average return on assets equal to 0.97%, whereas the return on equity was 8.62%.”
This chart from the St. Louis Fed Reserve website will help illustrate the return on assets across the banking industry for the last 33 years.
As you can see after dipping down during the financial crisis, it has returned to be fairly flat for the last six years. Before the crisis, the ratio was higher, but the banks were using leverage at dangerous levels, which helped fuel the crisis.
The return on equity is what the bank’s owners are primarily interested in because that is the return that they earn on their investment, and depends not only on the return of assets but also on the total value of the assets that earn income.
However, to purchase more assets, a bank needs to pay for it either with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities rather than their capital because this greatly increases their return.
When a bank increases its liabilities to pay for assets, it is using leverage—otherwise, a limit to bank’s profit would be the fees that it can charge and its interest rate spread.
Now on to the formula.
Formula for Return on Assets
The formula is a fairly easy and straightforward to calculate.
The numbers come from two different places, the income statement and the balance sheet.
They are easy to find and plug into our formula to find the return on assets for our financial companies.
Return on Assets = Net Income / Total Average Assets
Let’s lay that out a little bit, so we understand what these terms mean.
- Net income is the total companies profit, calculated by taking revenues minus the costs of doing business such as depreciation, interest, taxes, and other expenses.
- For banks, the income comes from interest income, or loans, securities, and such. Add to this the non-interest income such as fees and you arrive at the income portion.
- The expenses for banks are interest expenses from deposits and loans, and the more normal expenses like salaries, benefits, equipment and so on.
- Breaking down bank net income can be more complicated than non-banking companies, but it is all laid out in the income statement for you to decipher.
- Also is referred to as the bottom line, to help give you some context.
Total Average Assets:
- The bank’s total assets comprise of shareholder’s equity plus liabilities.
- These are the tools the bank uses to generate more equity for the business.
- We take the average of the assets from the fiscal year, by using the assets from the current year and the previous year. Both found on the balance sheet.
- The total assets can be a little confusing because this number can come from either the asset side or the liability side. But with banks, the shareholder’s equity and liabilities are what drive the creation of more assets. However, they need the cash, loans from other banks to make these assets.
Something to be aware of about return on assets. Like return on equity, you calculate return on assets with only one year’s data. It can lead to fluctuations in the ratio, drastically if there are any upheavals in the business, such as earnings or business cycles.
Let’s take a look at some examples of this formula in action.