How do you determine which bank is a good buy or not?

Question

Calling all Bank investors! How do you choose a bank?

I am looking for thoughtful responses here and put some opportunity to pump up your holdings.

I own USB, WFC, and BAC bank shares. While I have been losing value with them lately, I have been shorting Lehman and doing well on them because they needed capital investments (Sign of weakness to me) and everything has been negative in the news. So I am guessing that LEH has a higher risk of going under.

I don't want to short unless I am completely positive about who I am shorting.

This morning on the radio, they mentioned that www.bankrate.com has a risk rating of all banks about their probability of going under with 5 as riskiest to go under and 1 as very little chance.

http://www.bankrate.com/brm/safesound/ss...

BAC has a 3 rating, WFC and USB are a 2. I was expecting LEH to be a 4 or 5 but they are rated as a 1.

So I am surprised to see that. So maybe my reasoning is off but what is the smart way of valuing a bank?

Answer 1

The intrinsic value of a company is based on the equity on the balance sheet, the return that the company has proven it can generate from that equity, how much of that return it distributes as dividends, and what the required rate of return is.

Don't get too upset if the company does not pay high dividends.  If that company is making a high return on equity, whatever doesn't get paid as dividends is reinvested in the company.  If the companys return on equity after tax is higher than what you could get on a dividend in the bank, then they're better off retaining the earnings rather than distributing them.

The price of the company on the market will fluctuate with sentiment in the short term, but in the long term, the price will follow the intrinsic value of the company.

Brian McNiven in his book "Value Invesdting" states the valuation formula as:

Value = (APC / RR * Reinvestment + Dividends) / RR * EPS

where

APC = "Adopted Performance Criteria" - A percentage which is usually the Internal Rate of Return on the investment, the Net Return on Equity of the company for the last year, or some other measure of how you expect the company to perform

RR = "Required Rate of Return" - A percentage.

Reinvestment = the part of the earnings that is not paid by the company as dividends, expressed as a percentage

Dividends  = the part of the earnings that is paid as a dividend expressed as a percentage.

EPS = "Equity per Share" or "Book Value" in dollars.