Before I decide whether to buy a bank’s shares, I always like to look at its return on equity and its core tier 1 capital ratio.
These core financial ratios provide an indication of how successful a bank is at generating profits using shareholders’ funds, and of how strong its finances are. As a result, both ratios can have a strong influence on dividend payments and share price growth.
Today, I’m going to take a look at Barclays (LSE: BARC) (NYSE: BCS.US), to see how attractive it looks on these two measures.
Return on equity
The return a company generates on its shareholders’ funds is known as return on equity, or ROE. Return on equity can be calculated by dividing a company’s annual profit by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
The fallout from the financial crisis and the PPI scandal have meant that Barclays share price has risen by just 9% over the last five years, while its dividend has been slashed from 11.5p (2008) to 6.5p (2012). This weak performance is reflected in its return on equity, too:
| Barclays | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 12.7% | 6.3% | 7.3% | 5.6% | -1.9% | 6.0% |
Value vs. risk
Like Royal Bank of Scotland, Barclays currently trades at a discount to its tangible asset value per share, making it a potential value opportunity for long-term investors. However, these discounted valuations imply above-average levels of risk — in this case, the risk that the banks’ assets will suffer further write-downs.
One way of assessing this risk is with a bank’s core tier 1 capital ratio, which compares the value of the bank’s retained profits and equity with its loan book.
In the table below, I’ve listed Barclays’ core tier 1 capital ratio, ROE and discount to book value, alongside those of its UK-focused peers, Lloyds Banking Group and RBS.
| Company | Discount to tangible asset value |
Core Tier 1 Capital Ratio |
5-year average ROE |
|---|---|---|---|
| RBS | 38% | 10.8% | -7.8% |
| Lloyds | -20% | 12.5% | 1.6% |
| Barclays | 16% | 11.0% | 6.0% |
The figures above suggest to me that while RBS is offers the biggest value opportunity, it is also the highest risk. Safer Lloyds already looks fully priced, but Barclays offers an attractive discount to book value and a prospective 2.5% dividend yield. It also has the highest five-year average ROE.
Buy Barclays
I believe that Barclays remains a firm buy at current prices, providing an attractive balance between risk and reward.
Analysts expect the bank to deliver earnings of around 36p per share this year, and to raise its dividend by more than 10%, which could prompt further growth in its share price. However, if you already hold Barclays stock, then you might be interested in learning about five star shares that have been identified by the Fool’s team of analysts as “5 Shares To Retire On“.
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> Roland does not own shares in any of the companies mentioned in this article.
