Let's look at some key performance measures for banks, which take the balance sheet into account.
The key measures we're going to consider are return on assets, return on equity, and return on tangible equity.
For all of these measures, since we're comparing an income statement item, net income, on the top of the formula to a balance sheet value on the bottom, it's typical for the average of the opening and closing balance sheet values to be used.
Note that none of these measures are the best individually for analyzing the performance of the bank, but rather they all tell a slightly different story of how well the bank is doing at generating returns. Let's start with return on assets, or ROA. For non-financial companies, this measure can be used to measure the performance of the operations of the business independent of its capital structure by comparing EBIT or EBITDA to the company's total assets. However, since taking in deposits is part of the operations of a bank, EBIT and EBITDA don't reflect the performance of the operations of a bank because both are calculated before interest.
As a result, in analyzing the ROA of a bank, the recurring net income is used as the return figure on the top of the formula. The return on assets for banks tends to be relatively low, typically under 1%, due to the large asset base of banks. The factors that drive a bank's ROA include the returns from the loan portfolio, revenues from non-interest income streams, operational cost discipline, as well as the level of expected losses.
In essence, it tells us how well the bank is able to generate profits from its asset base. Return on equity, or ROE, measures the return generated for the owners, the shareholders, relative to the amount of equity they put into the business.
It's calculated by dividing the recurring net income by shareholders' equity.
A higher ROE means that the bank is generating a relatively high amount of profit for equity investors.
Given the low ROA, return on assets, for most banks, how do they generate sufficient return to satisfy the risk taken by equity investors? This relies on leverage, the significant levels of deposits and other debt financing in order to generate a sufficient return for shareholders.
A higher return on equity can be achieved by having more leverage and therefore a lower level of equity in the capital structure.
This is limited due to regulatory minimum equity levels, but higher ROEs due to lower equity levels may reflect a thinning buffer against losses, meaning the bank is at higher risk of bankruptcy. Another metric closely associated to ROE is return on tangible equity, or ROTE.
Tangible equity is calculated by taking a bank's shareholders' equity and deducting goodwill and intangible assets.
One of the benefits of using tangible equity rather than the total book value of equity from the balance sheet is that tangible equity is more closely aligned with a bank's regulatory capital, which also excludes goodwill and intangible assets, since these assets are unlikely to be able to be sold to cover any losses if the bank is close to bankruptcy.
Using tangible equity also allows for better comparability between banks. A bank that has grown through acquisitions rather than growing organically will have much higher levels of goodwill and intangible assets such as brands, intellectual property for internally generated IT systems, and customer lists on their balance sheet.
Finally, tangible equity is also widely used within bank valuation multiples in the form of price to tangible book value. So the return on tangible equity considers the returns of a bank relative to a key valuation metric.
