Bank Valuation & Quality Criteria
A practical checklist for assessing commercial banks
Commercial banks differ fundamentally from industrial companies: their “revenue” is mostly net interest income, their balance sheet is their product, and risk management is inseparable from value creation. The following eight metrics — split between earnings quality and self-financing ability — provide a robust framework for separating excellent banks from mediocre or dangerous ones.
Earnings Quality Metrics
| # | Metric | Formula | Good | Borderline | Poor / Red Flag |
|---|---|---|---|---|---|
| 1 | Net Interest Margin (NIM) | Net Int. Inc ÷ Avg Earning Assets | >2.5% | 2.0–2.5% | <2.0% |
| 2 | Efficiency Ratio | Non-Int. Exp ÷ Total Revenue | <50% | 50–60% | >60% |
| 3 | Provision for Loan Losses Ratio | Provisions ÷ Avg Gross Loans | <1.0% | 1.0–2.0% | >2.0% (credit issues) |
| 4 | Non-Performing Loans (NPL) Ratio | Allowance ÷ Gross Loans | <2.0% | 2.0–3.0% | >3.0% (high credit risk) |
| 5 | Return on Equity (ROE) | Net Income ÷ Avg Equity | >12% | 8–12% | <8% |
| 6 | Tier 1 Capital Ratio | Common Equity ÷ Total Assets | >14% | 10–14% | <10% (regulatory risk) |
| 7 | Loan-to-Deposit Ratio (LTD) | Gross Loans ÷ Total Deposits | <90% | 90–100% | >100% (wholesale funding) |
| 8 | Dividend Payout Ratio | Common Div ÷ Net Income | <50% | 50–70% | >70% (unsustainable) |
| 9 | Capital Generation Ratio (bonus) | (Net Inc − Div) ÷ Avg Equity | >6% | 3–6% | <3% (needs external capital) |
Quick Interpretation Guide
- Excellent banks → hit Good on ≥7 of the 9 metrics.
- Strong pass / avoid → two or more Poor readings.
Classic "Hallmarks of a truly superior bank" (the ones the author personally weights most heavily)
These are the non-negotiables that separate the compounders from the rest:
- NIM → >2.5%
- Efficiency Ratio → <50%
- ROE → >12%
- Tier 1 Capital → >14%
- LTD → <90%
- Payout Ratio → <50%
If a bank clears all six of the above, it is almost always a multi-decade compounder (JPM, HDFC Bank, CBA, Wells Fargo in its good years, Handelsbanken, etc.). Missing one is still fine; missing two or more and you are usually looking at a mediocre or dangerous bank, no matter how cheap it appears on P/B.
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