Measuring and Evaluating the
Performance of Banks
Performance:
Performance
refers to how adequately a bank or other financial firm meets the objectives of
its stockholders, employees, depositors and other creditors, borrowers and all
stakeholders.
Measuring the Value of a
Firm:
Banks are simply businesses organized
to maximize the value of the shareholders’ wealth invested in the firm at an
acceptable level of risk.
Dividend expected to be paid in future periods E (Dt)
Value of the Bank’s
Stock (Po) = = ∑
Minimum acceptable rate of return tied to
bank’s (1+r)t
perceived level of risk
(r = risk free rate of
interest + equity risk premium)
·
Risk free rate of
interest = current yield on government bond
·
Equity risk
premium = to compensate an investor for accepting the risk of investment in a
bank rather than in risk free securities
Factors affecting the value of Stock:
From the above-mentioned equation, we
can identify the factors that may lead to raise the value of a bank’s stock:
1.
The value of the
stream of future dividend is expected to increase, E (Dt)
2.
If the bank’s
perceived level of risk falls (lower rate of ‘r’ by lowering equity risk
premium)
3.
Market interest
rate decrease (lower rate of ‘r’ by lowering risk free rate of interest)
4.
Expected dividend
increases are combined with declining risk perceived by the investors
Research evidence has found that the
stock value of banks is specially sensitive to market interest rate, currency
exchange rate, and the strength and weakness of the economy that it serves.
Management can work to adopt policies that increase future earnings, reduce
risks, or pursue a combination of both in order to raise company’s stock price.
Profitability Ratios: Proxy/Surrogates for Stock Values
Theoretically, the best indicator of a
firm’s performance is its stock price. This indicator often fails to truly reflect
the firm itself because of inefficiency of markets where the stocks traded
over. This fact forces analysts to fall back on surrogates for market value
indicators in the form of various profitability ratios.
·
Return on Assets (ROA): ROA is is primarily a ‘managerial efficiency’
indicator. It indicates how capably the management of the bank has been
converting the assets of the firm into net earnings.
Net income
after tax
ROA =
Total
assets
·
Return on Equity (ROE): ROE is a measure of the rate of return flowing to the
bank’s shareholders.
Net income
after tax
ROE =
Total
equity
·
Net Interest Margin (NIM): NIM is an efficiency as well as profitability-measuring
ratio that measures how large a spread between interest revenues and interest
costs management has been able to achieve by close control over earning assets
and the pursuit (search/hunt/quest) of the cheapest sources of funding.
(Interest
income from loan _ (Interest expense on deposits
and
security investment) and on other debt issued)
NIM =
Total earning assets
·
Net Noninterest Margin: This ratio measures the amount of noninterest revenues
relative to noninterest cost incurred. Noninterest revenues are mainly various
service charges and income. Noninterest costs include salaries and wages, loan
loss expenses, repair and maintenance costs etc.
Noninterest
revenues – Noninterest expenses
NIM
=
Total
earning assets
·
Net Operating Margin:
Total operating revenues – Total
operating expenses
NOM =
Total
assets
·
Earnings per share of stock (EPS):
Net Income after Tax
EPS
=
Total
common equity shares
·
Earnings Spread: ES measures the effectiveness of a bank’s intermediation function in
borrowing and lending money and the intensity of competition in the market of
the firm.
Total interest income
Total interest expense
EPS
=
Total earning assets
Total interest bearing
liabilities
Relation between ROE and ROA:
The Tradeoff between Risk & Return
Even with a poor ROA a financial
institution can achieve a relatively high ROE through heavy use of debt and
minimal use of owner’s capital. This relationship can be explained with the
analysis of ROE & ROA blending.
Both ROE and ROA has the same
numerator: net income. These two profit indicators can be linked directly as,
Total assets
ROE = ROA ×
Total equity
If we elaborately split them,
Net income after tax Net income after tax Total assets
Total
equity = Total assets ×
Total equity
Total revenues – Total operating expenses – taxes Total assets
ROE = Total
assets × Total
equity
The above two equations says that ROE
or shareholders’ return is highly sensitive to how its assets are financed. If
the leverage is greater, ROE tends to be greater. That means with a poor ROA, a
financial institution can achieve a relatively high ROE through heavy use of
debt and minimal use of owner’s capital.
If a bank’s projected ROA is 1% for
this year will need BDT 10 in
assets for each BDT 1 capital to achieve a 10% ROE. If ROA is expected to fall
0.5%, a 10% ROE is achievable only if BDT 1 capital supports BDT 20 in assets.
It also clear from the equations that if
ROA is expected to decline, a firm must take more risk in the form of higher
leverage to achieve desired ROE.
