OThe key metric for evaluating bank stocks is the efficiency ratio, which measures a bank’s total expenses as a percentage of its total revenue. For example, if a bank has an efficiency ratio of 60%, it means that for every $0.60 the bank spends, it generates $1 in revenue. This ultimately means that strong banks have lower efficiency ratios because they spend less to generate more revenue.
The efficiency rate is important when it comes to Wells Fargo (NYSE: WFC) as the bank continues its recovery. I believe Wells Fargo can still improve its efficiency ratio, which will translate into better profitability and returns in the future. Here’s why.
Past efficiency performance
If you look at Wells Fargo’s efficiency ratio over the past five years, you can see how the number has deteriorated and improved. Large banks like Wells Fargo generally seek to have an efficiency ratio below 60%.
|Year||Wells Fargo Efficiency Ratio|
Wells Fargo hasn’t had a good efficiency ratio for some time. The main culprit is the fake bank account scandal, in which employees opened millions of deposit and credit card accounts without customers’ consent. The scandal broke in 2016, and since then the bank has been hit with regulatory fines and consent orders. This forced the bank to spend more on regulatory checks to avoid another scandal like this.
Additionally, the Federal Reserve in early 2018 placed an asset cap on the bank, which prevented Wells Fargo from growing its balance sheet and in turn hurt its earnings over the years. Thus, expenses, the numerator of the efficiency ratio, increased, while revenues, the denominator of the equation, stagnated or decreased, putting pressure on the efficiency ratio and overall profitability.
Fall below peer group
As expected, Wells Fargo’s efficiency ratio increased more than that of its peers, as JPMorgan Chase, Bank of Americaand Citigroup.
|Bank of America||60.2%||64.6%||67%|
In most cases, having a consistently lower efficiency ratio can be a good indicator of a bank’s stock price and valuation performance. As you would expect, JPMorgan is trading at the highest valuation of this peer group.
But a lot has happened in the past two years. The COVID-19 pandemic has impacted all banks’ efficiency ratios, so you can’t see them exactly in a straight line. While Citigroup has historically had a better efficiency ratio, the bank has come under regulatory pressure and faced higher expenses as a result. Meanwhile, Bank of America and Wells Fargo are rebounding, which can be seen if we look at the evolution of the efficiency ratio at these three banks over the past few quarters.
|Bank||Q1 2021||Q2 2021||Q3 2021||Q4 2021|
|Bank of America||68%||70%||63.4%||66.8%|
Bank of America’s efficiency ratio rebounded a bit, but the bank also advised to keep spending flat in 2022, which would be a huge achievement given the high level of inflation. Wells Fargo’s stock has done extremely well over the past year as investors see the bank implementing a plan to dramatically improve its efficiency ratio and eventually push it down in years. 50. In early 2021, Wells Fargo CEO Charlie Scharf embarked on an ambitious plan to eliminate $8 billion in gross spending over three to four years. The bank has made progress on this, and recently Scharf said the bank would raise its target to $10 billion in gross savings.
Track the Efficiency Ratio at Wells Fargo
It’s not a good idea to buy or sell a stock based on just one metric, but the efficiency ratio gives a good overview of how expenses and income are changing. One of the reasons I know Wells Fargo can do better than profitability is because I see a clear path for management to reduce expenses, as well as a clear path for revenue growth with higher interest rates and a possible removal of the asset ceiling. .
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Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Citigroup is an advertising partner of The Ascent, a Motley Fool company. Bank of America is an advertising partner of The Ascent, a Motley Fool company. Bram Berkowitz owns Citigroup and has the following options: January 2024 long calls at $90 on Citigroup. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
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