Lecture No.

(6)
Measuring and Evaluating the
Performance of Banks and Their Principal
Competitors Part (1)

1- Introduction

What do we mean by the word perform when it comes to

banks and other financial firms?

Performance refers to how adequately a financial firm meets

the needs of its stockholders (owners), employees, depositors
and other creditors, and borrowing customers. At the same
time, financial firms must find a way to keep government
regulators satisfied that their operating policies, loans, and
investments are sound, protecting the public interest.

The lack of success of these institutions in meeting the

expectations of others is usually revealed by a careful study of
their financial statements.

Why are financial statements under such heavy auditing

today?

One key reason is that banks and other financial institutions

now depend heavily upon the open market to raise the funds
they need, selling stocks, bonds, and deposits.
We take a detailed look at the most widely used indicators of
the quality and quantity of bank performance and at some
performance indicators used to measure banking's principal
competitors.

Banks and other corporate financial firms focus on the most

important dimensions of performance profitability and risk.
After all, financial institutions are simply businesses organized
to maximize the value of the shareholders' wealth invested in
the firm at an acceptable level of risk.

2- Evaluating Performance

How can we use financial statements, particularly the Report of

Condition (balance sheet) and Report of Income (income
statement), to evaluate how well a financial firm is performing?

What do we look at to help decide if a financial institution is

facing serious problems that its management should deal with?

Determining long-Range Objectives

The first step in analyzing financial statements is to determine

the objectives. Performance must be directed toward specific
objectives. A fair evaluation of any financial firm's performance
should start by evaluating whether it has been able to achieve
the objectives its management and stockholders have chosen.
Many financial institutions have their own unique objectives.
Some wish to grow faster and achieve some long-range growth
objective. Others seem to prefer the quiet life, minimizing risk,
but with moderate incentives for their shareholders.

Maximizing the Value of the Firm: A Key Objective for Nearly

All Financial-Service Institutions
Larger financial-service corporations are finding they must pay
close attention to the value of their stock. Indeed, the basic
principles of financial management suggest strongly that trying
to maximize a corporation's stock value is the key objective
that should have priority over all others.

If the stock fails to rise in value according to stockholder

expectations, current investors may seek to unload their shares
and the financial institution will have difficulty raising new
capital to support its future growth.

What will cause a financial firm's stock to rise in value? Each

institution's stock price is a function of the

Expected stream of future

Value of stockholder dividends
E ( Dt )
stock = = (1 + r )
t =0
t
(6-1)
(PO) Discount factor (based on
the minimum required
market rate of return on
equity capital given each
financial firm's perceived
level of risk)

Where E(Dt) represents stockholder dividends expected to be

paid in future periods, discounted by a minimum acceptable
rate of return (r) tied to the financial firm's recognized level of
risk.

The minimum acceptable rate of return, (r), is sometimes

referred to as an institution's cost of capital and has two main
components:
(1) The risk-free rate of interest (often determined by the
current yield on government bonds) and

(2) The equity risk premium (which is designed to reward an

investor for accepting the risk of investing in a financial
firm's stock rather than in risk-free securities).

The value of the financial firm's stock will tend to rise in any of
the following situations:

The value of the stream of future stockholder dividends is

expected to increase, due perhaps to new growth in some
of the markets served or perhaps because of profitable
acquisitions the organization has made.

The financial organization's understand level of risk, due

perhaps to an increase in equity capital, a decrease in its
loan losses, or the perception of investors that the
institution is less risky overall (perhaps because it has
further diversified its service offerings and expanded the
number of markets it serves) and, therefore, has a lower
equity risk premium.

Market interest rates decrease, reducing shareholders'

acceptable rates of return through the risk-free rate of
interest component of all market interest rates.

Expected dividend increases are combined with declining

risk, as recognized by investors.
Research evidence over the years has found the stock values of
financial institutions to be especially sensitive to:
- Changes in market interest rates,
- Currency exchange rates, and
- The strength or weakness of the economy that each serves.
Clearly, management can work to achieve policies that increase
future earnings, reduce risk, or follow a combination of both
actions in order to raise its company's stock price.

The formula for the determinants of a financial firm's stock

price presented in Equa5on (6-1) assumes that the stock may
pay dividends of varying amounts over time. However, if the
dividends paid to stockholders are expected to grow at a
constant rate over time, perhaps reflecting steady growth in
earnings, the stock price equation can be greatly simplified into

PO = D1/(r g) (6-2)

Where:
(D1) is the expected dividend on stock in period 1,
(r) is the rate of discount reflecting the perceived level of
risk attached to investing in the stock,
g is the expected constant growth rate at which all future
stock dividends will grow each year, and
(r must be greater than g).

For example, suppose a bank is expected to pay a dividend of

$5 per share in period 1, dividends are expected to grow 6
percent a year for all future years, and the appropriate discount
rate to reect shareholder risk is 10 percent. Then the bank's
stock price must be valued at

PO = $5 / (0.10 0.06) = $125 per share

The two stock-price formulas discussed above assume the

financial firm will pay dividends forever into the future. Most
capital-market investors have a limited time horizon, however,
and plan to sell the stock at the end of their planned
investment horizon. In this case the current value of a
corporation's stock is determined from

D1 D2 Dn Pn
PO = + ++ + (6-3)
(1+r) 1 (1 + r) 2 (1 + r) n (1 + r) n

Where we assume an investor will hold the stock for (n) periods,
receiving the stream of dividends D1, D2, , Dn, and sell the
stock for price Pn at the end of the planned investment horizon.

For example, suppose investors expect a bank to pay a $5

dividend at the end of period 1, $10 at the end of period 2, and
then plan to sell the stock for a price of $150 per share. If the
relevant discount rate to appropriate risk is 10 percent, the
current value of the bank's stock should approach

$5 $10 $150
PO = + + = $ 140.91 per share
(1+0.10) 1 (1 + 0.10) 2 (1 + 0.10) 2

3- Profitability Ratios: An Alternative for Stock Values

While the behavior of a stock's price is, in theory, the best

indicator of a financial firm's performance because it reflects
the market's evaluation of that firm, this indicator is often not
available for smaller banks and other relatively small financial-
service corporations because the stock issued by smaller
institutions is frequently not actively traded in international or
national markets. This fact forces the financial analyst to fall
back on alternatives for market-value indicators in the form of
various profitability ratios.

Key Profitability Ratios

Among the most important ratio measures of profitability used

today are the following:

Return on Net income

equity capital = (6-4)
(ROE) Total equity capital

Net income
Return on
= (6-5)
assets (ROA) Total assets

(Net income Interest expense)

Net interest
= (6-6)
margin Total assets

(Noninterest revenues Provision for loan

and lease losses Noninterest expenses)
Net noninterest
= (6-7)
margin Total assets
 (Total operating revenues
Total operating expenses)
Net operating
=
margin Total assets
(6-8)
Pretax net operating income
=
Total assets

Earnings per Net income

share of stock = (6-9)
(EPS) Common equity shares outstanding

Like all financial ratios, each of these profitability measures

often varies significantly over time and from market to market.

Interpreting Profitability Ratios

Each of the previous ratios looks at a slightly different aspect of

profitability. Thus,
Return on assets (ROA) is primarily an indicator of
managerial efficiency; it indicates how capable
management has been in converting assets into net
earnings.

Return on equity (ROE). on the other hand, is a measure

of the rate of return flowing to shareholders. It
approximates the net benefit that the stockholders have
received from investing their capital in the financial firm
 (i.e., placing their funds at risk in the hope of earning a
suitable profit).

The net operating margin, net interest margin, and net

non interest margin are efficiency measures as well as
profitability measures, indicating how well management
and staff have been able to keep the growth of revenues
(which come primarily from loans, investments, and
service fees) ahead of rising costs (principally the interest
on deposits and other borrowings and employee salaries
and benefits).

The net interest margin measures how large a spread

between interest revenues and interest costs management
has been able to achieve by close control over earning
assets and use the cheapest sources of funding.

The net noninterest margin, measures the amount of

noninterest revenues resulting from service fees the
financial firm has been able to collect relative to the
amount of non interest costs incurred (including salaries
and wages, repair and maintenance of facilities, and loan
loss expenses).

Typically, the net non interest margin is negative:

Noninterest costs generally exceed fee income, though
fee income has been rising rapidly in recent years as a
percentage of all revenues.
Another traditional measure of earnings efficiency is the
earnings spread, or simply the spread, calculated as follows:
 Total interest income Total interest expense
Earnings - (6-10)
=
spread Total earning assets Total interest
bearing liabilities

The spread measures the effectiveness of a financial firm's

intermediation function in borrowing and lending money and
also the force of competition in the firm's market area.

Concept Check
1- Why should banks and other corporate financial firms be
concerned about their level of profitability and exposure
to risk?
2- What individuals or groups are likely to be interested in
these dimensions of performance for a financial
institution?
3- What factors influence the stock price of a financial-
service corporation?
4- What is return on equity capital, and what aspect of
performance is it supposed to measure?
5- What is the return on assets (ROA), and why is it
important?
6- Why do the managers of financial firms often pay close
attention today to the net interest margin and
noninterest margin?