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In this case study, we
will use Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), and Bank of America (NYSE: BAC) to demonstrate what drives profitability.
First, let’s begin with Return
on Equity (ROE), the ratio of a bank’s earnings to its capital. ROE Equity Multiplier (Leverage) Return On Assets (ROA)
Comparing ROE for Bank of
America, Wells Fargo, and Citi: Q2 2013 ROE ROA Capital Ratio $BAC 6.55% 0.74% 11.30% $WFC 14.02% 1.55% 11.06% $C 8.8% 0.89% 10.11% All financial data sourced from Yahoo! Finance and company earnings presentations.
Wells’ outperformance in ROE is
clearly driven by higher ROA. So let’s now drill down into ROA. ROA Asset UtilizationProfit Margin Where asset utilization measures how productive the bank’s assets are (i.e., does $10 of assets yield $0.50 or $1?).
Comparing ROA for Bank of
America, Wells Fargo, and Citi: Q2 2013 ROA Profit Margin Asset Utilization $BAC 0.74% 13.73% 5.39% $WFC 1.55% 24.58% 6.29% $C 0.89% 16.97% 5.20% Profit margin defined here as total income (total interest income plus non interest income). Asset utilization calculated as annualized total income divided by average total assets.
Once again, the driving factor
behind Wells’ outperformance is quite clear – much better profit margins and slightly better asset utilization. The asset utilization ratios look similar in terms of the percentages; however, the 1% advantage for Wells across its $1.4 trillion in average total assets translates to a substantial advantage in raw dollars.
Let’s drill down one final
time into profit margin. For banks, expenses break down into two overarching categories: interest expense and non-interest expense.
To measure interest expense on
a relative basis, we will use the net interest margin. This is a measure of the difference the banks bring in from interest income on loans and interest paid out to depositors.
To gauge non-interest expense on
a relative basis, we will use the efficiency ratio. This is defined as the ratio of non- interest expenses to revenue. For this ratio, a lower ratio indicates fewer expenses per dollar of revenue. So, lower = better.
Q2 2013 Net Interest Margin
Efficiency Ratio $BAC 2.44% 76.62% $WFC 3.46% 57.3% $C 2.85% 59% Once again, it’s clear to see Wells’ advantage. However, it is only now coming into focus why Citi outperformed Bank of America …
Taking this systematic approach to
analyzing banks is a simple and fundamentally sound method to uncovering the driving factors in company performance. In this case, it highlights just how strongly Wells Fargo has performed recently, and it also points to the work remaining to be done at Bank of America.