You need to tread carefully when using a price earnings ratio (P/E) and dividend yield to gauge how attractive bank stocks might be. That’s because bad debts or one-off items can compromise the sustainability of bank dividends.
So it’s important to understand that banks require some peculiar evaluation criteria when it comes to assessing their intrinsic value and business performance. If you do want to call on the price earnings ratio to help value and compare one bank stock against another, then it must be used alongside some bank-specific financial ratios.
Whilst some valuation principles are equally applicable to all companies, there are a number of complications specific to banks such as determining leverage – due to being both borrower and lender - regulatory impact, capital expenditure and interest margins.
The key financial ratios you need to look at when evaluating banks and estimating their intrinsic value are net interest margin, cost to income ratio, bad debts, return on assets, Tier 1 capital ratio and the price to book ratio.