Interest rate hikes should be good for banks since they collect income from higher interest rates on deposits and loans, right? Banks continue to report huge profits, and you may want in on the action. Let's go over the basics of investing in bank stocks and how to invest in bank stocks, so you can hit the ground running if you're looking for bank stocks to buy.
Types of Bank Stocks
Banks are among 11 different stock sectors in the S&P 500 benchmark index. While the core business model of banks is relatively easy to understand because they take customer deposits and make loans, different types of banks specialize in other areas.
Banks have expanded to include more financial products and services beyond providing loans, checking and savings accounts. Banks must have a federal and/or state charter to conduct banking services, which also provides Federal Deposit Insurance Corporation (FDIC) coverage for deposits up to $250,000 per account. The FDIC does not cover investments. While much of this information may seem familiar, some specifics apply when you invest in banks.
Commercial banks are the most recognized types of banks that fit the traditional operating model of taking deposits, providing checking and savings accounts and lending services to retail and business customers. They provide personal to commercial loans, from credit cards and mortgages to working capital for your business. The federal government charters these national banks, which are members of the Federal Reserve System.
These banks provide financial services like raising capital, introducing high-net-worth investors, debt and structured financial product offerings, underwriting IPOs, advising and facilitating mergers and acquisitions and other complex financial transactions to corporations and governments. They tend to have higher net-worth clients for their wealth and asset management and advisory services in addition to providing private banking functions.
These banks are a one-stop-shop providing services found in both commercial and investment banks. From providing rewards and cash-back credit cards, investment advisory and brokerage services, and mortgage, auto, college and refi loans to CDs and money market accounts. They tend to be the largest banks by assets with the most branches and ATM networks, often called money center banks, serving consumers and businesses nationally.
Learn more: Is Bank of America a Good Stock to Buy?
How to Value and Buy Bank Stocks
To analyze and quantitatively value a bank stock, you should use its latest earnings report data to apply specific standard financial metrics for profitability. Disregard book value and cash per share when it comes to analyzing bank stocks, as most screeners apply customer funds into the equation, which distorts the value and is technically not owned by the bank. Book value also considers intangibles, including brand names, patents and goodwill, which is subjective or easily inflated.
Step 1: Calculate the net interest margin (NIM).
This ratio is how much the bank makes on the interest it charges on loans minus the interest it pays out on savings accounts. Rising interest rates bump up this metric since it enables the bank to charge more for its loans. You can derive it by calculating net interest divided by total interest-generating assets multiplied by 100. A 3% margin or greater is attractive.
Step 2: Calculate the return on equity (ROE).
This ratio measures the profits as a percentage of shareholders' equity. In other words, how much would be left over to be returned to shareholders if the bank paid off all its debt and sold its assets? You can calculate this by dividing net income by total shareholder's equity times 100. A result greater than 10% is an attractive baseline.
Step 3: Calculate the return on assets (ROA).
The return on assets (ROA) ratio is the percentage of net income relative to its total assets, including cash, cash equivalents, securities, interest-bearing loans, property, etc. You can calculate it by dividing net income by total assets, multiplied by 100. A greater than 1% figure is attractive.
Step 4: Calculate the efficiency ratio (ER).
As the name implies, this ratio measures the efficiency of a bank's operations based on how much of its top line goes toward paying operating costs. You can calculate it by dividing noninterest expenses by net revenues times 100. An efficiency ratio under 60% is desirable.
Step 5: Calculate the price-to-earnings (P/E) ratio.
This ratio helps compare the valuation of stock to its industry peers. You can calculate it by dividing the stock's last trade price by its earnings per share (EPS). It's what an investor would pay for every $1 of profit, assuming the company will generate profits.
Companies that don't generate profits don't have a P/E ratio. You can use the P/E ratio of a specific bank to compare against the industry average or other peer banks. You can compare it to historical P/Es for the particular bank or industry to see if the bank stock is relatively cheap compared to peers. You can use it in comparison to benchmark indices like the S&P 500 and find undervalued stocks. For example, if the industry average P/E for commercial banks is a 10 and you see a bank stock for 6, it may be considered undervalued.
Ways to Buy Bank Stocks
There are many ways to buy bank stocks based on your risk profile, but how to buy bank stocks? A simple purchase through a registered online broker does the trick if you have researched and prepared for the highest-risk option to buy a specific bank stock — it can help you buy bank stocks quickly and efficiently.
However, if you want to spread your risk by investing in a broader number of bank stocks, you can purchase a mutual fund. If you prefer the diversification of a mutual fund combined with the execution of a trading stock, consider buying an exchange-traded fund (ETF) which can contain many different finance stocks. The best bank ETFs trade like stocks but track indexes like mutual funds — they are more liquid.
You can take a general S&P 500 financial sector ETF or invest in specific types of bank stocks or themes. The more liquid ETFs tend to include stocks widely traded and/or those that are components of major benchmark indices like the S&P 500 or Dow Jones Industrial Average.
Learn more: Are Bank Stocks a Good Buy Right Now?
How to Assess a Bank's Risk
You may think that banks are consistently profitable, low-risk investments, but that's not always the case. Banks are leveraged businesses. There are definite risks involved when investing with banks. To provide loans, banks leverage the money they take in. Banks try to hedge their risk as leverage grows.
It can become a game of Jenga, where a collapse in one business area can disrupt the whole operation. If banks lose too much money on leverage, they can become insolvent, as became terrifyingly apparent during the 2008 financial crisis. Since then, safeguards have been put in place by the Federal Reserve and Treasury Department to ensure banks are well-capitalized and run periodic stress tests under stringent capital requirements. You can also assess a bank's risk by watching two critical risk metrics based on lending practices: the nonperforming loan ratio and net charge-offs.
The nonperforming loan (NPL) ratio measures the percentage of nonperforming loans divided by the total amount of the bank's outstanding loans. Nonperforming loans at least 90 days delinquent on payments are subsequently at risk of default. The lower the NPL percentage, the better. Ideally, under 2% is attractive.
Net charge-offs (NCOs) are loans the bank can't completely recoup, as the borrower can't or won't pay back the debt. The bank loses on that loan, which becomes an uncollectable debt after six months of non-payment. The net charge-off is the dollar amount of the loan which the bank can't recoup or the gross loan amount minus any subsequent recovery of the delinquent debt, such as collections.
This is especially relevant with unsecured debt like credit cards versus secured loans like mortgages and auto loans. The NCO ratio is the annualized ratio of net charge-offs divided by the average outstanding loans times 100 and tracked by the Federal Reserve. Investors can track the history of net charge-off ratios, as a rising percentage can be a warning sign. For example, if a commercial bank had a net charge-off percentage of 2.41% in 2021 and rises to 2.61% in 2022, it's a 20-basis point jump, signaling weakening economic conditions and/or lax credit standards for the bank. An NCO rate of less than 1.5% is an ideal benchmark.
Bank Stock Dividends
Most banks pay stock dividends. There are extreme situations where they may cut or halt dividend payouts during a credit crisis, economic downturns and periods of losses. However, bank dividends tend to be stable, which makes them attractive income-generating investments. The annual percentage yield can fluctuate based on the underlying stock price. Therefore, a high dividend may not compensate for the loss absorbed by the decline in the stock price if you are an investor. Dividends often provide a cushion of safety for the underlying stock price volatility but can be irrelevant if the stock falls more than the annual dividend yield.
Monetary Policy Impact on Bank Stocks
Banks benefit from net interest income from consumer deposits during monetary tightening periods when the U.S. Federal Reserve (Fed) raises interest rates. However, loan demand also tends to drop. During economic expansion periods when the Fed cuts interest rates, banks make less on interest income but provide more loans as consumers take advantage of lower interest rates to finance or refinance large purchases.
Here are some common questions you might ask when investing in bank stocks.
Are bank stocks a good investment?
Are bank stocks a good buy? Bank stocks can be a good investment during economic growth periods, so you want to find the best banks to invest in stocks. A strong economy means more loans to provide and fewer defaults, despite making less net interest income. They can buffer their earnings with net interest margin growth in economic downturns as loan volumes decline. Investment banks tend to have more IPOs, and M&A deals boost the bottom line.
What are the benefits of buying bank shares?
Bank stocks provide a dividend and potential price appreciation. They are some high-dividend stocks for those who like receiving income on their investments. They are generally stable investments, more so during solid economic periods than weak ones. Instead of hating on the ongoing bank fees, you can appreciate them as shareholders benefitting from their contribution to the bottom line. Also, they are not as volatile with high betas, like the FAANG stocks.
How do you choose bank stocks?
How do you know which bank stocks to buy? You can choose which bank stock(s) to invest in by fundamentally analyzing them using the profitability mentioned above, valuation metrics, and technical analysis. The technical analysis involved reviewing the underlying stock price history, trends and price patterns to gauge support and resistance price levels to gauge entry and exit points.