Understanding Banks' Earnings:
An Evaluation & Forecasting Technique
Part 1
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Lee Humphries

The year-to-year change in a bank's earnings per share (EPS) is driven by the fluctuating values of nine critical ratios.  This paper defines those ratios and shows how to integrate them into a spreadsheet routine that will:

• isolate their respective dollar-and-cents contributions to annual changes in EPS,

• measure their relative power to improve EPS, and

• calculate future EPS based on their projected values.

This analytical technique is useful to both investors and managers.  It quantifies for investors the effect on EPS of past ratio changes, and it helps them evaluate the bank's capacity for future earnings increases.  It reveals to managers those operational areas where improvements will yield the greatest bottom line benefits, and it allows them to calculate the EPS effect of targeted ratio changes.

I. Nine Critical Ratios

Definitions

A bank's EPS is determined by the interaction of nine critical ratios, which we define in the following way.

Ratio 1: interest expense ÷ average liabilities—the average interest rate paid on total average liabilities.

Ratio 2: provision for loan losses ÷ interest income—the loan loss provision rate.

Ratio 3: interest income ÷ total revenue—the percent of revenue derived from interest income.

Ratio 4: non-interest expense ÷ total revenue less interest expense—commonly known as the efficiency ratio.  A bank with significant tax exempt interest income will sometimes increase the ratio's denominator, total revenue less interest expense, adding to it the tax benefit that results from exempt interest income.  This adjustment produces a lower—and, at first glance, better—efficiency ratio than the one calculated by the standard method.  We will avoid this needless complication.  Any tax benefit arising from exempt income will be readily apparent in the below-normal tax rate calculated by the next ratio.

Ratio 5: income tax ÷ pretax earnings—the effective tax rate.

Ratio 6: total revenue ÷ average assets—the rate of asset turnover.

Ratio 7: average common equity ÷ average assets—the common equity ratio.  Changes in the common equity ratio will always be examined in conjunction with changes in the preferred equity ratio (average preferred equity ÷ average assets).

Ratio 8: preferred charges ÷ average common equity—the reduction in return on common equity arising from the payment of preferred dividends and preferred stock retirement premiums.

Ratio 9: average common equity ÷ average common shares outstanding—the book value.

The Effect of Critical Ratio Value Changes on EPS

We shall now see how the values of these ratios shaped the EPS change of a $66 billion dollar bank holding company headquartered in the Midwest.  The bank's annual report shows that earnings for the latest fiscal year were thirty-one cents per share higher than earnings for the previous fiscal year.

Using the procedure explained below, we can trace those thirty-one cents back to specific increases and decreases in the year-to-year values of the nine critical ratios.  As Exhibit 1, Column D shows (see below):

Ratio 1.  The average interest rate paid on total liabilities increased, costing about 27 cents per share.

Ratio 2.  The loan loss provision rate increased, costing about 15 cents per share.

Ratio 3.  The percent of interest revenue to total revenue increased, costing about one cent per share.  (This is a roundabout way of saying that there was a decrease in the percent of non-interest revenue to total revenue.  For mathematical simplicity, we use the percent of interest revenue rather than non-interest revenue.)

Ratio 4.  The efficiency ratio decreased, adding about 31 cents per share.

Ratio 5.  The tax rate increased, costing about 2 cents per share.

Ratio 6.  The asset turnover increased, adding about 15 cents per share.

Ratio 7.  The common equity ratio decreased (partially offset by an increase in the preferred equity ratio), adding about 12 cents per share.

Ratio 8.  The preferred charge to common equity increased, costing about 2 cents per share.

Ratio 9.  The book value increased, adding about 20 cents per share.

When the positive and negative effects of these ratio changes are summed, the result is $0.31.  Adding this amount to the Previous Year's EPS of $2.45, we arrive at the Latest Year's EPS of $2.76.  Let's find out how the figures were derived.

Exhibit 1—EPS Effect of Year-to-year Changes in Critical Ratios

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