How do normal investors like you and I invest in a bank? According to Warren Buffett, the answer is pretty simple. Look to the bank’s return on assets or ROA.
“Well, a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it’s earning 0.6% or 0.5% on the asset, it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you’re required to hold a certain amount of tangible equity compared to the assets you have. But you’ve got banks like Wells Fargo and USB that earn very high returns on assets, and they at a good price to tangible book. You’ve got other banks … that are earning lower returns on tangible assets, and they’re going to sell — they’re going to sell [for less].”
The attraction of return on assets is its simplicity. It captures so much of the essence of a bank, without getting caught up in the complexity of the big bank accounting mess.
In our continuing series of discovering the formulas and ideas to value a bank or financial institution, we will discuss the return on assets or ROA.
Definition of Return on Assets
So what is a return on assets?
According to Investopedia.
“Return on assets (ROA) is an indicator of how profitable a company is about its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.”
This term is often referred to as return on investments or ROI.