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It can be tricky for the average investor to evaluate an investment bank but the general rules of stock-picking apply: Profitability is good, rising dividends are better, and cash flow should be sustainable. There are also some additional metrics with particular relevance for investment banks, however. They include shareholders’ equity metrics, the composition of liabilities, debt to total capital, return on capital employed (ROCE), and return on assets (ROA).
Key Takeaways
- Successful investment banks identify opportunities to assist promising companies to grow and to create liquidity in the stock market.
- These banks are often substantial financial institutions with solid ties to Wall Street.
- Measurements of an investment bank’s viability include its price-to-earnings ratio, returns on assets and equity, and return on capital employed.
- Understanding how efficiently a bank can acquire assets, make investments, manage risk, and turn a profit for shareholders will help you analyze it.
Successful Investment Banks
The investment banking industry makes up a large part of the overall financial sector of the economy particularly when it comes to the capital and credit markets. Successful investment banks identify opportunities to assist promising companies to grow even faster and to create liquidity in the stock market.
Investment banks work with larger organizations or institutional investors at a basic level. They offer advice and investment services, help with raising or managing new capital, and sometimes act as principals.
These tend to be substantial financial institutions with solid ties to Wall Street. Investment banks earn much of their revenue through fees or commissions. They also have their portfolios and they can profit from their holdings.
You have to understand how efficiently it can acquire assets, make investments, manage risk, and subsequently turn a profit for shareholders to analyze an investment, retail, or commercial bank.
The Price-to-Earnings Ratio
Think of the price-to-earnings (P/E) ratio as the price you have to pay to get access to company earnings. The P/E ratio is calculated by dividing price per share by earnings per share (EPS). This information should be available in every major investing website or publication.
Return on Assets
The return on assets (ROA) metric reveals the earning capacity of profit by an investment bank to its total assets. It can help you gauge how effectively management uses the bank’s existing asset base to make profits for shareholders. Calculate ROA by dividing the investment bank’s net income by its average total assets. Income is in the numerator so higher ROA figures are better.
Return on Equity
The return on equity (ROE) ratio is probably second in popularity only to the P/E ratio. It helps express how effectively a company rewards its shareholders for their investment.
Consider a company that earns $500,000 in net income and has an average stockholders’ equity of $10 million. You can calculate ROE by dividing $500,000 from $10 million to get 0.05 or 5%. Every $1 of shareholders’ equity turns into 5 cents in profit. Higher numbers are preferred for ROE as well.
Debt to Total Capital
The debt to total capital ratio describes how much debt is being used to hold the investment bank together. The ratio is calculated by dividing total debt by total capital. A higher figure means that there’s a higher level of risk built into the company’s financial structure. Analysts use this ratio similarly to the debt/equity ratio.
Return on Capital Employed
Return on capital employed (ROCE) is another ratio that emphasizes efficiency but it’s particularly suitable for an investment bank. These banks bring in a lot of service revenue but they often hold substantial assets and tie themselves to substantial liabilities. ROCE is calculated as earnings before interest and tax divided by total capital employed. Higher figures reflect a capital strategy that’s profitable and efficient.
The Current Ratio
Think of the current ratio as a modifier of the debt to total capital ratio. Even a highly leveraged investment bank could be secure if it has strong, consistent cash flow for financing its obligations. The current ratio is equal to current assets divided by current liabilities. This directly measures the ability of the company to pay back short-term debts and payables with its liquid assets.
What Is a Good Price-to-Earnings (P/E) Ratio?
A P/E ratio is measured against the average ratio of the applicable industry or sector. A bank with a P/E ratio that’s above the average is considered a growth investment and could potentially cost more than its earnings. A P/E ratio that’s below the average indicates a value investment. It can be held less expensively.
What Is a Good Return on Assets (ROA)?
A good ROA is typically at least 5% but this also depends on the industry or sector of the bank or firm. An ROA of 20% or more is considered excellent. It’s not quite this black and white, however. The number should be compared to other banks or firms.
What Are the Typical Fees Charged by an Investment Bank?
Investment banks and firms typically publish their fees and commissions so there should be no surprises. Commissions are considered to be transaction costs when the bank handles the purchase or sale of assets for you. Advisory fees can be charged for advice or management of your portfolio. You’ll most likely have to pay operating expenses as well. The exact percentages and costs will depend on the bank.
The Bottom Line
It’s critical to understand the operations of any bank you’re thinking of investing with. These ratios and tools can help you identify danger signs and weigh the bank’s processes for acquiring assets, managing risk and investments, and earning you a profit. Don’t part with your dollars until you’re
very sure of the relationship you’re getting into. Ask questions and always request an explanation for anything you don’t understand.
Remember: Profitability is good, rising dividends are better, and cash flow should be sustainable.
