Chapter Six

Measuring and Evaluating the Performance of Banks and Their Principal Competitors

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Key Topics
Stock Values and Profitability Ratios Measuring Operating Efficiency Performance of Competing Financial Firms

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Long-Range Bank Objective

Profit Maximization Vs Wealth Maximization

Maximizing the value of the Firm: A key objective for Nearly All Financial-Service Institutions Basic goal of Financial Management: Maximizing Shareholders Wealth All financial firm's should purse this goal Stockholders expectation counts
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Value of the Banks Stock

Value of Banks Stock Expected stream of future

E(D t) P0 t t 0 (1 r)
The risk free rate of return The equity risk premium
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stockholders dividend Discount Factor

Cost of capital (r) has two components:

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Value of a Banks Stock Rises When:

Expected Dividends Increase: Recent growth>Profitable acquisition Risk of the Bank Falls: Rise in equity capital>Decrease in loan losses Market interest rate decreases Combination of Expected Dividend Increase and Risk Decline

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Value of Banks Stock if Earnings Growth is Constant

D1 P0 r-g
Where, D1= expected dividend on stock r = rate of discount g = expected constant growth rate

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Key Profitability Ratios in Banking

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Net Income After Taxes Return on Equity Capital (ROE) Total Equity Capital

Net IncomeAfter Taxes Return on Assets (ROA) Total Assets

Net Interest Income Net Interest Margin Total Assets

Net Noninterest Income Net Noninterest Margin Total Assets

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Key Profitability Ratios in Banking (cont.)

Total Operating Revenues Total Operating Expenses Net Bank Operating Margin Total Assets

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Net Income After Taxes Earnings Per Share (EPS) Common Equity Shares Outstanding

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Name of the Ratio 1. Return on equity capital

Calculation
Net income after taxes/ Total equity capital

Description/comments

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Rate of return flowing to the shareholders Net benefit that the stockholders have received by investing their capital The performance of the bank in converting assets into net earnings The ability of the management to increase the spread between interest revenue and interest costs The ability of the management to increase spread between noninterest income and cost For most banks this is negative Operating profitability compared to total assets

2. Return on assets (ROA) 3. Net interest margin 4. Net noninterest margin

Net income after taxes/ Total assets Net interest income/ Total assets Net noninterest income/ Total assets

5. Net operating margin 6. Earnings per share (EPS)

Total operating revenue Total operating expense/ Total assets Net income after taxes/ Common equity shares outstanding

Earnings generated for shares outstanding

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Breaking Down ROE

ROE = Net Income/ Total Equity Capital

ROA = Net Income/Total Assets

Equity Multiplier = Total Assets/Equity Capital

Net Profit Margin = Asset Utilization = x Net Income/Total Operating Revenue Total Operating Revenue/Total Assets

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ROE Depends On:

Equity Multiplier Net Profit Margin Asset Utilization

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Leverage or Financing Policies: Debt vs Equity Effectiveness of Expense Management: Cost Control Portfolio Management Policies: Mix and Yield on assets

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2008 The McGraw-Hill Companies, Inc., All Rights Reserved.