Motley Fool Hidden Gems Investing - A Language Guide for Financial Stocks

Episode Date: March 27, 2022

Looking to brush up your language skills when it comes to financial stocks? Motley Fool senior analyst Jason Moser and Matthew Frankel dive deep into the metrics they use to judge financial companies, and provide comparison guidelines for investors to watch. They discuss: - Why the P/E ratio is less important than you may think - The nuance of judging a bank’s efficiency - One metric to watch for any fintech company Additional resource - https://www.fool.com/investing/stock-market/market-sectors/financials/bank-stocks/how-banks-make-money/ Stocks: AXON, WFC, COF, PYPL, JPM, AFRM Host: Jason Moser Guest: Matthew Frankel Producer: Ricky Mulvey Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

The reason that these online banks, say Axos Financial, which is my bank, the reason they haven't taken over and people aren't willing to fully switch is because the customer service, not just the branches, the customer service really hasn't caught up because that adds expenses. I mean, half of the branch expenses is labor costs. I'm Chris Hill, and that was Motley Fool contributor Matt Frankel. If you've been looking for a deeper dive on financial stocks, this one's for you. Motley Fool senior analyst Jason Moser talks with Matt about the metrics they use to judge financial companies and why those numbers are just one part of the story. This one gets into

the nitty-gritty of valuing financials, looking at things like take rates, non-performing loans, and efficiency ratios. But they start with the fundamentals and why book value is so important. We'll focus, I think, primarily on things like banks and insurance to get started here because that's such a big universe. But this seems like it'd be a really fun show to dive into some of those nerdy metrics that we as analysts always focus on in order to gauge the health of all of these different financials-related companies. You've put together, I think a very impressive list here of metrics that we talk a lot about, that we follow, that we track. We want to dig into what these metrics are, explain what they are, what they mean,

and talk a little bit more about how we use them in our analysis of these financial-related businesses. First up, we want to talk about book value, something that we hear a lot about book value when we talk about insurance companies, but it's not limited to just insurance companies, but talk a little bit. What's book value? Think of book value in the same context as equity in your house. It's a balance sheet metric. If you buy your house, you put a down payment and you take a mortgage for the rest, the difference between your home's value and what you owe the bank is your equity. Same concept for book value. It's the difference between the assets a company owns and its liabilities. This is not a financial-specific metric. It's just most useful

for evaluating companies like financials, where traditional metrics like earnings don't make sense or the assets a company owns doesn't really match up to the actual value of the business. For example, banks are only required to keep something like 10% of capital on their books for all their loans. You might see a bank with $3 trillion of loans and a $300 billion market cap, but it doesn't really match up. Book value tells you really just the value of the business. Think of it as if, let's say, JPMorgan Chase decided to shut its doors and go out of business, sell off everything it owns, and pay off its debts. Book value would be what's left at the end of that. When we look at book value and we then try to convert that into

a metric that we can use to analyze a bank or an insurance company. What's the easiest way to translate that into a metric that we can follow? Price to book value is one of my favorite bank valuation metrics. I'll tell you why. Price to earnings is the most common metric we use to value stocks, the PE ratio. It doesn't work well with banks because their earnings aren't always reflective of what the business is doing. I'll give you an example. In 2020, when the COVID pandemic hit, what were all these banks doing? They were setting aside billions of dollars in reserves in anticipation of loan losses. Well, those billions of dollars in reserves counted against their earnings, even though they weren't really spending anything. The losses turned out

not to even really materialize. That counted against their earnings and made it look like they had bad quarters. I think Wells Fargo actually ran at a loss in the second quarter of 2020 because of this. Bank of America lost half of its earnings in the second quarter of 2020 because of a reserve issuance. Book value just cuts through that into more consistent, more one-to-one metric. It tells you how much a bank is trading for based on the actual value of its assets minus liabilities. I know that's also a metric we like to use for insurance companies. It's interesting you bring up that reserves issue with banks, because that's something we've really talked a lot about here over the last couple of years.

It was interesting to see how these banks really did put a lot of that money aside. And you're right, it counted against them. And then that was sort of a catalyst we knew was kind of like a coiled spring almost, right? I mean, we knew that if the situation improved and the banks didn't need all of that money they set aside, well, then they could release those reserves. and it really did play out on those earnings per share numbers. It's always something to keep in mind. The market is not dumb. We know the market is forward-looking. It is taking that into consideration though, don't you think? Sure. But when you see a bank trading at, say, Goldman Sachs right now trades at six times earnings, that's not exactly the case.

Bank of America is trading for a low double-digit multiple to earnings per share, but that includes a lot of those reserve releases that you were mentioning, so it doesn't really tell the whole story. So, price to book really levels the playing field along with that. Yeah. Now, tangible book value is something very similar, but it's a little bit different. Explain the difference between book value and tangible book value. So, book value includes everything a company owns, all of its assets. Tangible book value includes the assets that are fairly easy to sell or determine a price of. For example, banks can sell their loans to other banks, so that's a tangible asset.

If a bank owns its office building it operates in, that's a tangible asset. If it owns patents on designs, that's not a tangible asset because it's not something that's readily monetizable. Goodwill that comes from acquisitions, you're buying a brand name or something like that, those are not tangible assets. Bank of America bought Merrill Lynch's brand name during the financial crisis. That's an asset, but it's not a tangible asset. So, it excludes things like that and just focuses on the things that it could actually sell if it needed to or could monetize fairly easily. Okay. Now, next up, we've got return on equity and this is a metric. Return on equity is something, it makes me think of Berkshire

Hathaway and Warren Buffett. I know that's a metric that Buffett likes a lot. What is return on equity and why? Why does Buffett like return on equity so much? So, it's a profitability metric. It shows how efficiently a bank or any company is using its shareholders' equity to generate a profit. For example, if a bank's book value is, say, $300 billion and it's generating $30 billion in annual profit, that would be a 10% return on equity. So it's a measurement of how effectively they're using shareholders' money to make money. Gotcha. Gotcha. In return on assets, something similar, a little bit different. I've used return on assets personally in gauging the value of banks before, but return on assets, something similar, a little bit different

though than return on equity, right? Yeah. So return on assets doesn't incorporate leverage really. It just looks at the assets on a bank's balance sheet, say loans and things like that. So if a bank has $2 trillion of loans, it might want to produce 1% of that or $20 billion in a return. The general rule is return on assets, you want to see the benchmark be 10% or higher. That would be considered a profitable bank. Higher the better, obviously. Return on assets, you'd want to see a 1% or better, which is considered the industry benchmark. Higher is better. Most of the big four banks are in the 12 to 14 range for return on equity most of the time, and in the 1.1 to 1.4 range for return on assets. So that's kind of

where you want it to be. Now, with banks, we see in earnings calls, often they'll talk about the efficiency ratio. And I mean, with banks and insurance companies, I mean, efficiency really is kind of the name of the game. How is the efficiency ratio calculated and what does it tell us? First of all, with efficiency ratio, lower is better. Efficiency ratio is how much money a bank is spending to generate its revenue. If a bank is spending $0.70 for every dollar of revenue it's generating, its efficiency ratio would be 70%. If it's only spending $0.60 to generate each dollar of revenue, its efficiency ratio would be 60%, so that's better. It means it's costing less money to generate that revenue. Now, brick-and-mortar banks are at an inherent

disadvantage over fintechs and banks that don't have branches, say, Marcus by Goldman Sachs or SoFi or those kinds of banks. I'd roughly say about a 60% to 70% efficiency ratio is what you should expect from a branch-based bank, and something in the 50% ballpark would be more of a fintech bank efficiency ratio. Yeah, and it feels to me like, I know we've seen plenty of stories out there over the last several years about banks wanting to reduce that footprint, not rely on such a heavy physical infrastructure of banking centers. I mean, honestly, man, I live my life trying to figure out how to not go to a banking center, kind of like I don't want to go to the DMV, I don't really want to go

other bank either. Do you feel like going forward, because I feel like that physical presence is going to continue to come down over time. I mean, it just seems the only direction that it can go. Do you feel like that's an opportunity for banks when it comes to something like the efficiency ratio? Is that going to change the importance, I guess, or the weighting of how we look at that efficiency ratio? Oh, for sure. Efficiency ratios are going to trend downward, meaning in the positive direction for the foreseeable future. It's a fine line banks have to walk between providing customer service that people expect and be running an efficient operation. The reason that these online banks, say Axos Financial, which is my bank, the reason they

haven't taken over and people aren't willing to fully switch is because the customer service, not just the branches, the customer service really hasn't caught up because that adds expenses. I mean, half of the branch expenses is labor cost. So same if you have a customer service call center, that's a labor cost that you have to add in. So it's a fine line between balancing the customer service people expect, because on occasion, there is a reason to go into a bank. I mean, I was at a Bank of America branch last week for the first time in like a year, and it looks a lot different than it used to. They got rid of the drive-through in most of their branches. And there's one teller. There's not even like a counter. There's like one window with a teller

in it though. But it's not necessarily about reducing the branch count. It's about focusing on the branches that you need the most and that are closest to most of your customers and reducing waste and running them in an efficient manner as possible. Yeah, that makes a lot of sense. That definitely makes a lot of sense. Customer service is hard in any line of work. Certainly when it comes to banking, I mean, it's very understandable that folks get emotional about their money. I mean, that's something that we talk often with our members here at The Fool. Money is just an emotional thing. And sometimes you really do need that physical sort of presence, right? I mean, you need to be able to see the person that

you're speaking with and understand what they're telling you and trying to solve a problem. And That is something I feel like in the fintechs of the world where the customer service is just, you're right, it's not caught up yet and I guess at some point it'll have to. I'll say, last year when I bought my vacation house, I had to wire about $100,000 for a down payment. I don't want to do that through my computer. That's something I'm going to drive to the bank, I want to be sitting there, I want to verify the information on the teller's screen before it hits go, that's something I want to drive to the bank and do. Or I at least want to talk to a live person, which with some of these

online-based banks is a lot tougher than you think it would be. So there are some things you want to drive to the bank for. So like I said, it's going to be a balancing act by some of these big banks over the next couple of decades. So non-performing loans and charge-off ratio, When we talk about banks, banks, obviously, they make their money by lending. It feels like the charge-off ratio and non-performing loans are connected in that way, but explain the charge-off ratio and why it matters, particularly in the banking industry. Yes. I'm glad you actually lumped those two together because they're two degrees of the same thing. Non-performing loans are just loans that aren't doing what they're supposed to do. In other words, if a customer

agrees to pay you 5% interest and make monthly payments for 60 months, if those monthly payments stop coming for a few months, that's a non-performing loan. During the COVID pandemic, that became a really fluid metric because people got loan forgiveness, they asked the bank, can I postpone payments for three months, things like that. That would count as a non-performing loan in a lot of cases. But some banks break it down into 30-day non-performing loans, meaning loans that have missed one payment, 60-day non-performing loans, loans that have missed two payments. Kind of gives you an overall feel of how their loan book is doing. Charge-offs are loans that have been deemed uncollectible, that they're writing off.

Now, especially with big banks, this is a cost of doing business. Not everyone is going to pay their loans back. For one reason or another, people lose their jobs. Their expenses get out of whack. They get overloaded in debt, whatever the reason. You're not going to collect 100% of your loans, but you want that number to be as low as possible. Most major banks are in the 0.5% range, meaning that out of every million dollars of loans they make, they're charging off about $50,000, I think is how it works out. No, $5,000. About $5,000 out of every million they charge off. The non-performing loan rates are usually considerably higher because late payments happen more often than people just flat out not paying their loans. Those are two metrics that

you can use in conjunction to assess a bank's credit quality. The trend is really important there, because during, say, the financial crisis, you'll see the charge-off ratio shoot up. That didn't really happen during the COVID pandemic. You can get a feel for when they might release some reserves, like we mentioned earlier, or when they might need to up their reserves if things are getting bad. It tells you the trend in the industry as well. When I think of this charge-off ratio and the non-performing loans and that stereotypical bank, old stodgy bank metric. It also feels like these metrics really apply today to this burgeoning BNPL space, the buy now, pay later, where you're seeing companies actually built on that offering. Oftentimes,

they're providing the underlying technology and service and then they're partnering with banks on the backend there to be able to help fund those loans, because ultimately that's what buy now, pay later is. You're lending a consumer money to be able to purchase something now and pay it back in installments. I guess Affirm is probably the company that stands out as one of the better-known companies in this space, but that's something that they have to take into consideration too. They go into that knowing that consumers aren't going to pay back every one of those installment loans. Oh, for sure. I mentioned that 0.5% is typical for a big bank. That's not typical for,

say, a firm or a buy-now-pay-later company. They're expecting 5%-ish charge-off rates. That's just the nature of the business. It's the same with lenders that are credit card heavy, like Capital One, for example, which makes most of its money off credit cards, has a much higher charge-off rate than, say, Wells Fargo, where that's a much smaller part of its business. It depends on the mix of a bank's business. Like I said, credit card lenders expect to have to eat more debt, which is why they charge 18%, 19% interest on credit card loans, as opposed to companies that are primarily auto lenders, which charge 4% or 5% interest because they know they're not going to have to write off that much of that debt. If they do, they can

repossess the car because it's a secured lending product. It depends on the nature of the business and the mix of loans that they're dealing with. Now, we talk a lot about net interest margin during earnings season. That gives us a real good insight as to really how profitable a bank is, how much money they're making on those loans. It feels like it's been a drag here for a long time because the interest rate environment has been so low. Obviously, a big point of discussion here over the last several months, and I think we're going to be talking about it more here in 2022 and beyond, is the raising of interest rates. Talk about net interest margin, what it is and how it's connected to this interest rate conversation. Yes. Net interest margin,

think of that as the bank's profit margin. If a bank is collecting 5% interest on its loans, paying 1% on deposits. The difference between that's 4%, subtract whatever administrative costs are involved in those loans, and then you get your net interest margin. It's also called the spread, the interest spread between what they're paying and what they're collecting. There's a couple of reasons this is important. One, it's why rising interest rates can actually be good for banks. So far in 2022 especially, all of a sudden investors are seeing why bank stocks could be good to have in your portfolio during times like these. But it's also worth noting that bank revenue growth isn't always indicative of the growth of the business. The reason is because

interest rates fluctuate. For example, if a bank's loan book rises by 10%, they go from $1 trillion into $1.1 trillion in loans, but interest rates declined significantly, you could actually see their revenue fall, even though their business is actually growing nicely. So the net interest margin can kind of help put that into perspective. When you see, okay, their loan portfolio is actually growing, they're just a little less profitable because of interest rate conditions right now. It could kind of be an offset because banks are kind of a funny business in the sense that earnings don't always reflect its profitability. The growth metrics in terms of revenue and earnings don't really reflect the growth of the business necessarily because it's

so tied to these underlying conditions like interest rates that the banks have no real control over. They kind of do, but you can't just raise interest rates because then the other bank is going to get all the business. They're definitely dictated by the market and by what the Fed's doing and just prevailing conditions. Well, let's wrap up the conversation today with this final metric. This one's fascinating to me because I think it applies to a lot of these fintech companies that we talk about today, as opposed to maybe just your stereotypical bank. But take rate is a metric, which I think it's interesting because it goes well beyond even financials. You think about a company like Etsy, for example, and you'll see

Etsy talking about their take rate. What is take rate and why should we be paying attention to it? Think of take rate as a percentage fee for providing a service. How much they take from it, right? Right. In fintechs, this is usually used in context of payment processing. If, say, Square or PayPal processes payments, they might take 2%, 3% of the payment volume. That might get split up to a bunch of third parties, like Visa and MasterCard, whoever issued the card in the first place, the network operators, things like that. But take rate is generally, it's a percentage of gross payment volume or gross merchandise volume that represents a company's revenue. For Amazon or e-commerce

companies, you'll see this as a percentage of listing fees or things like that. It's not just financial-specific metric, but with fintechs especially, it's really very handy. Yeah. PayPal, another good example there. You see these companies talk about a take rate in that 2%-ish range, which seems like a pretty reasonable one. When you talk about changes in a mature company's take rate, you're not talking about something that's going from a 2% to a 4%. That's not really something that's going to happen. I mean, a material change in the take rate from PayPal would be going from like 2.1% to 2.4%. Really, it is something that matters. It seems like it's very connected to, like you mentioned, that total payment volume that's going through

that network. They are businesses that are really based on volume and that's why take rate is so important to those businesses. It's a metric that these companies really can't compete on as much as you might think. As I mentioned, a lot of the take rate with Square, PayPal and the others are passed on to third parties who want their money. The actual amount that is kept by these fintechs is usually paper thin, so there's really not that much wiggle room in the take rate. It's like interest rates with these big banks in that they're set by the market, they're not set by the companies. It is interesting when you see like Square processed $43 billion of payments last quarter. Okay, well, what does that mean

to the business? That's what take rate tells you. Yeah, that's a really good point. I'm glad you mentioned that because it's so easy to look at those massive numbers, right? PayPal pushing $1.25 trillion through all of its networks. And it's like, wow, I mean, that business has got to be killing it. Well, it's worth remembering that they're just getting a very, very minute little sliver of that $1.25 trillion. It really does matter for these businesses to grow that total payment volume because that's ultimately how they grow the business because that take rate is going to hang in there at a pretty steady rate. But that's why we focus on that total payment volume so much because it is really what can fuel the profitability of this business.

It's always nice talking with you. I really appreciate your insight here. Thanks so much for taking the time. Of course, anytime. Chris Hill. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.