Efficiency Ratio: How Profitable Is Your Bank? This ratio really helps you understand how banks earn income and from what sectors they earn it from. The ratio also helps price to book ratio investopedia forex the expenses that a bank can have and the impact they can have on the bottom line.
Banks are either hated or loved, depending on when you ask customers. If they’ve been approved for that loan or denied a refund of any fee, you will get different answers. As a value investor, banks and financial institutions can be a frustrating experience to try to value. They don’t fall into the same category that other companies do, so therefore they often get ignored.
In the end, banking is a very good business unless you do dumb things. The cool thing about learning to value banks is that once you learn how to analyze one, you pretty much can analyze all of them. There are about 500 banks that trade on the major exchanges, so this should give you plenty of options to choose. Now, don’t get me wrong they can be very complicated with all the financial instruments, heavy regulations, old account rules, macro factors, and the intentionally vague jargon to try to throw you off.
But at their core, all banks are similar in that they borrow money at one interest rate and then hopefully, lend it out at a higher interest rate, pocketing the spread between the two. Which is the main avenue that banks use to make money. You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. The Efficiency Ratio is calculated by dividing the bank’s Noninterest Expenses by their Net Income.
Banks strive for lower Efficiency Ratios since a lower Efficiency Ratio indicates that the bank is earning more than it is spending. Sounds and looks pretty simple, doesn’t it? And as ratios go it is pretty simple and straightforward. But there are some accounting terms I want to go over, so we understand what it is we are looking at, and what the terms mean so we comprehend the meaning behind this ratio. The nice thing about this ratio is that we don’t need a degree in finance to figure it out or years in banking to decipher the meaning behind it.