Q&A: How Do I Value Banks & Insurance 101

0:00In most businesses, you can get pretty far by looking at revenue growth, margins, and free cash flow. But banks and insurance companies, they're a different monster altogether. Their inventory or loans, their raw materials are risk, and their profits can look amazing right before they blow up. So today, Andrew's going to teach us how to break down and value banks and insurance companies the right way. What metrics actually matter, what shortcuts are okay, and what red flags scream value trap. so here we go okay so it's time for some real talk i have a serious problem with shoes like legitimate like my wife has opinions about a type of a problem so when i find a pair of shoes that i absolutely love and they're three or four hundred dollars i don't just buy them outright i always try to find them cheaper first you know to keep my wife happy that's exactly what dupe.com is for it's an ai powered shopping tool that finds cheaper alternatives to the expensive stuff that we want to buy.

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2:48That's Shopify.com slash beginners. You're tuned in to the Investing for Beginners podcast. The show for the long-term investor. We cut through the noise to focus on what works. Compounding, discipline, and the conviction to buy wonderful businesses and stick with him your path to financial freedom start now and welcome back to the investing for beginners podcast everybody my name is stephen morris and across from me is the banking expert and insurance expert andrew say there and i got to be honest with y 'all like when it comes to banks and insurance companies they typically go in the too hard pile because uh with our listener with our listeners question i'm right there with him i just i struggle with it but this is from one of our value spotlight members uh nate he said good morning andrew i've been looking into resources for valuing banks and insurance companies and i was hoping you had some better resources than what i've found i'm familiar with the bvps roe um and doing the same for insurance companies and multiplying by their active capital ratio.

4:07But any other advice or pointers would be great. So that is what we are going to do. And Andrew is going to take the time to teach me as well, because I need it also. So, Andrew, I guess just, well, okay, fine. I'll be nice. Hi, Andrew. How are you? I am good. Okay, good. I'm more excited. I'm kidding. What were you going to say? I'm more excited to talk about this than I should be. That is disturbing for some reason to me. I'm not entirely sure why, but that kind of scares me. Is there going to be like a quiz or a test at the end of this that's 80 % of my grade or something? All right, exactly.

4:54So the first question I have is what makes banks and insurance companies so intimidating? Why is it so hard? uh, for, for beginners and people like me who just aren't as well versed in it like you. I mean, it's a completely different business model. They do things in a completely different way. So there's several examples, but let's start with the biggest difference is these type of companies, these financial services companies, they are built by the balance sheet. So assets, its liabilities and equity, everything centers around that. And in the real world, I'll put that in air quotes, you talk about what is the building blocks of businesses, things like inventory, working capital, factories, data centers these days, right?

5:51All of these kind of different assets in the banking and insurance industry. it's um liabilities and assets so in the banking case there's deposits right like banks are taking deposit depositors cash and that becomes their quote working capital and that's how they build the business out and for insurance companies it's float they're collecting premiums to pay them out later. So that's the biggest difference is this balance sheet. And then the secondary effect to that is that the cashflow statement now is completely jacked up. And one of the big first steps we take as investors is you go from just an income statement, I'm just staring at headlines and looking at earnings per share.

6:45The next step to go deeper is cashflow statement. But if you try to do that with a bank or an insurance company, It's just not helpful in a lot of ways. And just while cash is just being thrown around everywhere and it doesn't doesn't equate like it like it does for a normal company. So those would be, I guess, two reasons. And there's a few others as well. But in my mind, those are the biggest that would trip people up. Is the cash getting thrown around? Because I guess for a bank and insurance company, cash is the product. So it's not, I guess, treated as, I don't know how to say this, it's not treated as the golden rule, if you will.

7:31It's more, it's the product. So we'll put some cash over here. Is that kind of why that's like that? Or is there a different reason they throw cash around the way they do? I love that. Yeah, I guess cash is the product. the way that they're going to make profits is off of the cash. So how do we try to make profits off of our cash? Well, we're listening to Investing for Beginners. We're looking for stocks. We're buying assets. So that's the same thing that banks and insurance companies will do. They will take the cash and invest it, buy assets. And so that difference between the liabilities, the cash that they bring in, and then the cash that they take out, that becomes profits.

8:16It's to your point, that is kind of the whole point of it all. And when you come to a regular company, cash is not the product. Cash is something that just you need to grease, keep things greased and rolling. So, yeah, I like that kind of mindset. Okay, awesome. Yeah, okay, cool. Understood a little bit. So let's keep going. No, I'm kidding. um so when it comes to to banks and insurance companies i know was it is it geico yeah geico was one of warren buffett's all-time favorite investments um historically speaking have banks and insurance companies been great solid investments for investors or have they been a double-edged sword like what what what do we look at historically when we look at investing in banks, Goldman Sachs, SoFi, stuff like that?

9:16That is a loaded question. That's what I'm here for, baby. Let's go. Yeah. It depends on what time period you're looking at. For insurance companies, there's been a few insurance companies that have just been ridiculously great investments. Berkshire Hathaway, Warren Buffett's Berkshire Hathaway, perfect example of that. GEICO, another great example. Progressive Insurance, another great example. They've returned so much for shareholders since IPO. So there's been a few insurance companies. I can't speak to the entire industry because I don't know for a fact, like historically how it's done. For banking, banks were all the rage in the 2000s.

10:03and a lot of that ended up being unsustainable. They were taking on way too much risk and then we all know what happened with the great financial crisis. So the banking industry of today is very different post great financial crisis. We just talked in an episode about regulation and how that can affect stocks and obviously we want to stay away from stocks that have too much on the regulation side. Just a stereotype, but the government tends to overdo things on the deregulation side and the regulation side. And I've heard investors say, who have studied this, they say that the government will often swing to extremes.

10:47So you have the deregulated banking, which turned into a giant mortgage mess. And so what does the government do? They swing the other way and completely over-regulate banks to the point where they've been a bad investment. You look at their price earnings for years and years, and they've been bad investments. And then you have a special class of banks, which are too big to fail, as everybody calls them. But what they are is so far away from a bank. They're really a conglomerate of financial companies. companies they have investment banking they have um the typical loans and deposits and they have trading houses and and all these sorts of things so um it's definitely been banking's definitely been interesting but i don't know if i would call it good or bad but the united states is weird man like like we just have a banking system that is one of one i would say yeah yeah that's and it's I mean, we talked about that last episode about, you know, the government.

11:54It has been my experience that they vastly overreact in one direction or another. Always. There's never a middle ground with the government. It's always one extreme or the other. And it's always super painful, whichever way they go. It's a soapbox for another day. Anyway. So when it comes to actually looking at a bank and trying to figure out. Actually, before I ask that, I want to ask, if you hear someone say a bank or an insurance company is cheap, because I know you like to take the skeptics view of things or the opposing view, what would your first question be? if I come to you and I say, Hey, this bank is a great investment and it's, it's, uh, it's pretty cheap right now.

12:44What would your skeptics brain instantly start to question? I instantly go to either. There's not much growth left. So what you think is cheap is cheap because it's not going to grow much. And most of the big banks are that way. And we can talk about why if we want to. The other thing that comes to mind is, all right, this is too good to be true. One of the things about both banks and insurance with cash being the product, you can kind of pull that lever. You can put pedal to the metal. You can grow very, very fast in these industries simply by taking on more risks than everybody else. So I think we all can figure out what happens with that.

13:27It works until it doesn't. And so to me, if you're saying ah, this is a very high fast grower, my mind instantly goes to, okay, it's probably risky. They're probably doing risky financial things like the banks did in the 2000s. Right. And I think that's, for me, that's a super, super huge knowledge point when it comes to looking at banks and insurance companies, but especially banks, is you have to be able to decipher the other I guess risk leverage or leveraged risk I don't know how you would say that but um how do you how do you even begin to go about trying to figure out how much risk a bank is taking on oh so we're diving in here the loan book the short answer is the loan book so um longer answer is tier one capital ratio we could go on and on and on um but basically there's two aspects to it there is um like the regulatory side because of the regulations that we've seen after the great financial crisis companies have to keep a certain amount of cash as reserve banks and the bigger you are actually the more you need in reserves.

14:54So you can look at that ratio and say, okay, one way to say that a bank is safer is because they have more in reserve. That's one way to think about it. Another way is the loan book. And the importance of this particular thing is going to depend on the company's business model, the bank's business model. So like I mentioned, some of the banks have a bunch of business units. Some are your typical bread and butter, like this is savings and loans, very simple. And in that case, you can just look at the loan book. And hopefully they're giving you enough disclosures where you can make those assumptions or those analyses.

15:33The other thing you can do is you can look at what's the track record of the loan book? How much have they had loans that default? and how does that compare to the industry and how have they done during times when things were tougher. And sometimes I can tell you as well. But just speaking general, very generalized, credit cards tend to be riskier than auto loans, which tend to be riskier than mortgages. just some big kind of examples. And then there's also like loans to commercial, you know, loans to businesses, working capital or lines of credit, things like that. And those have tended to be on the safer side, but it all depends.

16:26So it's hard. I mean, it's tough because I think you can't always get a good answer as easily because depending on how the company discloses it, it could be more black boxy than you might prefer. So you kind of have to just make a judgment call, and that makes it hard. And correct me if I'm wrong here. So a super huge risk then would be that it's all left up for interpretation. So I might find a way to apologize for why they're doing X when I'm looking at their loan book or whatever, rather than, and then you can take a different standpoint and not justify it. And does that make sense? Like, it's so left up for interpretation.

17:20You would have to be really careful that you're being honest with yourself on the level of risk they're taking on. Is that right? What if you could get a 25 % match on every dividend you earn? Well, now you can. When you earn dividends on the Plink app, you'll receive a 25 % cash boost up to$250 bonus per year. That means if you earn$1 ,000 in dividends, that's$250 more in your pocket. Your bonus can be taken as cash or reinvested, giving you potential to grow your earnings. No opt-in, no extra steps. As long as you own eligible dividend-paying stocks, ETFs, or funds on the Plink app, your dividends are automatically boosted each month.

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20:25Like that, that feels a lot more tangible than I've also seen other loan books where they say we score one, two, three, four, five, five is very safe. Four is pretty safe. And then you just have to trust that like all of our loans are fives, you know what I mean? Like, and it's like, what do you do with that? Right. So it is very, you have to pick and choose. But what's great about banking is there's like 3 ,000, 4 ,000. I don't know the exact number, but there's thousands of banks, bank stocks even that you could buy. Maybe not thousands of bank stocks, but there's thousands of banks and there's hundreds and hundreds of bank stocks you can buy.

21:08So you can afford to be picky if you're like absolutely dying to get into a bank stock.

21:17But knowing that, I think, I think it's worthwhile for most of us to say, you know, because I know there's so many fish in the sea in this case, don't just, don't reduce your standards because you're just like dying to get into a bank stock. Just trying to wrap my head around. Cause I mean, you know, so far with the stocks on my, my portfolio with, with my investing track record, it's pretty black and white. Like there, there's not a whole lot of room for interpretation, except for the things like, you know, pricing, power, moats, things like that, obviously you have to read into. But the numbers are pretty black and white always.

22:01And I feel like with banks, since numbers are their toys, not necessarily their metrics. I mean, it's still their metrics, but, you know, accounting is is a bank's bread and butter like per se and so it feels like that is where the interpretation comes into a lot like how does a bank even build a moat like what what is the moat of a bank exactly yeah that's a really really good question um i've heard i've heard people say like switching costs could be a moat for a bank because people are just so lazy they don't want to change their their banking accounts because it's such a hassle and then that being a moat um i've bought like i've bought bank of america that one did underperform the stock market i bought jp morgan chase that one outperformed the stock market and i looked at things like cost of capital advantages because they're bigger and because of just the way their customer deposit base was comprised they were not having to pay as much on deposits at the time as like smaller banks and more flighty deposits so like your deposit base could be a source of a moat people would argue jamie diamond is just an exceptional ceo and he is their moat and I've heard like fintech being a moat and I have a fintech bank that their moat is very much being digital in a world where so much of the other banking is just decades behind so I don't know it is one of those things that you can kind of slice and dice it so many different ways and I don't know if there's been enough winners to prove that one mo is necessarily better than the others it is a very commodity service right like you have a bank i have a bank everybody has a bank it's in most cases it's a pretty commoditized thing so it's a very true point um you can't live without without your bank especially you know you know it's funny back in back in the day when like mcdonald's started accepting debit cards i was like that's the dumbest thing in the world like get some cash man and now like i'll remember how old i was when i started maybe maybe 2021 and now it's like i i don't remember the last time i had cash in my wallet like yeah so i mean especially nowadays you know banks are you gotta have a bank you mentioned fintech real quick fintech for the most part in and of itself is not a bank correct most fintechs use other banks they're just the the go-between this isn't or or am i wrong on that yeah i would say i don't have any like hard facts on it but there are definitely so many fintechs that are not banks.

25:23And then that creates, that makes it hard too because then there's different rules for them as there would be for a bank. And people argue whether the fintechs and their ability to kind of act like a bank but not have to play by the bank rules, people argue that that will disrupt traditional banking. So it's a fascinating industry because it's definitely in flux and you gotta think there's going to be winners there's got there's going to be losers um so if you feel confident in this industry it could be a great place to fish definitely um well i just as you were talking i was thinking like paypal i know paypal has their own bank um they they issue loans credit cards all kinds of stuff um but then there are others i don't i don't think stripe like they're just a go-between they're a payment processor um they don't do any of the banking i don't think so i mean i was just wondering and so i guess when you're looking at it that's something else that you have to take into account is you know what you know what fintechs are banks doing business with um as well just another random thought layer i guess Anyway, so getting to Nate's question, first and foremost, will you explain what he's talking about with the BVPSROE?

26:59Yeah, thanks for writing in, Nate. This is a fascinating question. Obviously, we turned it into an entire episode, but he's definitely on the right track. Like BVPS is short for book value per share. And like I said at the beginning, when you look at banks, when you look at insurance companies, everything's centered around the balance sheet. And so book value per share times ROE, which is return on equity. That is a much better way to try to get a view of a company's profits. So here's another thing with, again, frustrating probably and confusing, but it is what it is. You know, you look at a cash flow statement for a normal company, you look at an income statement, straightforward.

27:48You know, okay, we know how much Nike made in profit. We know what that accounts to in earnings per share. With banks and insurance companies, because they have to take losses on their cash, right? They have defaults they have to deal with. They estimate how much they think they're going to have to pay or how much money they're going to lose from the bad loans or the bad investments they make. So they estimate it, and that goes into their earnings number. And then they adjust for their previous year's estimates, and that also goes into their earnings number. So you get these huge ups and downs in earnings, and so earnings per share gets completely out of whack.

28:28So that means price earnings is pretty useless, and that's why you want to stick to the balance sheet because the balance sheet for a good bank or a good insurance company, that balance sheet should be growing year after year after year. And it doesn't have to be perfect, but in a general rule, the balance sheet's getting bigger. And so because things will be so up and down with profits and earnings, what you want to do is look at a longer term view and that's where return on equity comes in. Usually people are looking at, let's say five years of return on equity or 10 years of return on equity and averaging that out.

29:05And so if you take that by the company's current size, what's their balance sheet today, and you can get a general and a pretty decent, I would argue, a pretty good estimate for this company's profitability. And that should give you a better idea of what a bank or an insurance company is worth. And that's what I use personally. I don't use this exact formula, but this is how I, I guess I use this formula and then I add on more, but basically this is how I substitute what would be a free cashflow number that you would just calculate simply on the cashflow statement. Instead of making it very easy like that, we have to go through a couple extra steps to look at a more accurate, longer term number, and then use that when we're trying to figure out, okay, this bank's worth$20 and this bank's worth 80.

30:01And like a big part of that is just because the banks, you know, especially we'll say a bank is heavy on the credit card. And you mentioned like credit cards are a lot more risky. I would assume that's because the process of getting a credit cards is a lot less scrutinized than it is if you're trying to get a mortgage. If you've never bought a home, like the biggest pain in the butt in the world. I mean, I know there are bigger, but good grief, buying a home, that was stressful. And like, I've bought three homes now and after every one, I'm like, I'm never doing this again. Then I forget how much it sucks and I do it again.

30:50but anyway so when when we're looking at banks say they're their credit card heavy all like a significant amount of their money can be tied up into those credit cards correct so that that's what you're talking about like it's hard to to just you can't just look at their their statements and be like okay they have this much money because in reality they don't even though it looks like they do am i getting that right um i think for a bank you have to look at risk and profits as two separate things like you have to look at both and they definitely feed into each other if a credit card loan is more risky they'll charge a higher interest rate to that riskier loan, which is why higher risk can mean higher growth and higher returns.

31:48But I would say like a bank's profitability, that's one of the things where you can get tripped up. Their profits and their risk are two completely separate things, even though they're intertwined. Like I would look at both differently. so i would i would figure out make sure that this this looks solid and then i would look at okay what kind of profits do i think they're going to make over a longer time period that's fair so to nate's question then what other ways are there to value a bank other than the uh bvps yeah i mean so first i would recommend check out oswald demother and he's got different full semesters on YouTube and look up his free cashflow to equity model specifically for what he does for banks and insurance companies, because that's what I use.

32:44And that is going to give you a much deeper dive than we can do on a podcast because it's actually what he taught in his course. I basically take... So other people have mentioned, you can do a dividend discount model, which is a very old fashioned valuation tool. Some people use that. I would argue it's conservative. What I do is you take this book value per share multiplied by return on equity. That gives you an estimate for this bank's long-term profits, profit generating ability, their profitability. And I will multiply it by like a 0.9. So basically, the banks will have different reserve requirements.

33:32But in general, it's somewhere close to like 90 % that they can reinvest in themselves. But like 10%, they have to keep back as reserves. Legally, they cannot. Like if I give$100 to a bank, the bank can't just give somebody$100 on the credit card loan. They have to keep some of that in reserve. And so a good ballpark benchmark is 10 % in reserve. And so when you're analyzing the free cash flow of a bank for valuation purposes, you would take this long-term estimate, you multiply it by 0.9 because we're going to say 0.1 is kept as reserve. 0.9 they can do to put in credit cards or mortgages or whatever loans they want to put them into.

34:19And then that number will create our discounted cash flow. So it's the same discounted cash flow model that we've talked about that you use for a normal company. But the free cash flow number that you get is based on this balance sheet focused metric rather than a cash flow statement metric. One of the things about Bitcoin that's really surprised me is how much easier it is to transact with these days. I was always under the impression that using Bitcoin as payment was inefficient, expensive, and risky. But Cash App has made it easy. It seems like Cash App is being accepted by more and more merchants everywhere I look.

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