Figuring Bank Results

The bank profit season has been and gone. How did banks fare, and how much profit did they make? If you read newspaper and other media reports on bank profits, it's easy to get confused.

Take the profit for National Australia Bank as an example (NAB reported its full year profit on Wednesday, November 9.) The Australian, the Australian Financial Review and the Herald Sun all reported that the full year net profit was $4.1 billion. The Age reported that the profit was $4.7 billion. And the Sydney Morning Herald thought the correct measure of NAB?s profit was $3.3 billion. The day before, Bloomberg and Dow Jones all opted to highlight the $4.1 billion figure.

The Sheet (my own independent banking newsletter) reported that NAB?s profit for 2005 was $3.5 billion.

It's hardly surprising there is wide variation; the accountancy group KPMG, in its bank results report, offers no less than 15 measures of bank profitability. All these measures are correct, depending on your point of reference.

The diverse profit figures used in media reports over the past couple of days highlights a wider issue that even a diligent student of banks must resolve.
Banks these days disclose so much data '” mostly in response to investor demand '” that there's a smorgasbord of alternative profit measures and qualifications and adjustments to profit, all designed to cater to the evolving taste of investors.

Take Commonwealth Bank as a second example. CBA publishes six different measures of net profit in its financial statements each half-year. There are three in the profit and loss statement (most companies would report two), and then a couple of variants the bank uses to guide the hand of analysts at investment banks and fund managers.

Just to help make the point, here are CBA's six alternative measures of net profit. The terminology for each variant is that used by CBA:

• Net profit on a statutory basis: $3.99 billion.
• Operating profit after tax: $3.36 billion.
• NPAT (cash): $3.54 billion.
• Underlying NPAT (cash): $3.47 billion.
• Adjusted profit for ROE and EPS calculation: $3.41 billion.
• Adjusted profit for ROE calculation (underlying basis): $3.34 billion.

And did CBA's profit this year rise by 12%, 13%, 31%t or 55%? The better answer is one of the lower answers. Some analysts like to use cash earnings, but this figure is also creates difficulties. According to this year's NAB accounts, cash earnings "does not refer to, or in any way purport to represent the cash flows, funding or liquidity" and "does not refer to any amount represented on a cash flow statement". To make that point differently '” cash earnings are not, in fact, cash earnings.

Michael Ullmer, executive general manager, risk management, at National Australia Bank, said in an interview this week cash earnings "is not cash, as it's still got depreciation in there, but it's still profit from a sensible point of view". Ullmer says the history of bank use of cash earnings as a profit measure dates to Commonwealth Bank's takeover of Colonial (a life insurance and funds management group) in 2000 and NAB's purchase of MLC (another money manager) in 2002.

NAB explains the process of adjusting its reported net profit to produce cash earnings as the exclusion of minority interests; payments on hybrid securities such as the National Income Securities and Trust Preferred Securities (which most people would regard as debt and should be treated as an interest expense in the first place); the revaluation of investments in life insurance subsidiaries, and goodwill.

Most of these adjustments will disappear from the profit and loss statement from next year anyway, now that Australian companies report using international accounting standards.

Hyrbid securities can make reading the net profit off the basic financial statements of some banks a challenge. Take St George Bank: the "bottom line" (operating profit after tax as reported in the financial statements) at St George is $898 million. Yet as the bank?s detailed commentary in its result packs makes clear, the bank's actual net profit is $828 million. The $70 million difference in the case of St George reflects what amounts to interest payments on quasi-equity securities.

A retail investor reseaching the long-term pattern of St George's profits '” using the financial performance figures outlined in the bank's annual report '” would come away with a misleading measure of the bank's profitability. Earnings per share can also easily mislead the non-professional investor; the term is useful as far as it goes, but that's not very far.

If all you care about is earnings per share (EPS), in order to slap some of price/earnings multiple on that number and thus determine whether a share price in expensive or cheap, then EPS is a useful measure of profit. But bear in mind, what measure of "earnings" went into the numerator, and is it the most appropriate? (EPS is the portion of the profit made by a company to which each share is entitled.) If earnings can vary widely then the 'E' in the EPS figure can also be variable.

EPS can also be subject to the influence of the number of shares on issues, as affected by buy-backs, dividend reinvestment plans and the like. The boards and management of banks put tremendous effort into coaxing the most of the reported rate of growth in EPS.

St George Bank reported EPS growth of 11% this year, well in excess of the rate of EPS growth of other banks, but that doesn't mean the bank reported a superior profit. To get to the bottom of which bank is really making the best profits you have to look at Return on Equity (RoE) '” a measure of how well a company used reinvested earnings to generate additional earnings. St George had a very strong RoE this year at 22.6%, but Westpac, despite a more modest EPS growth, was able to match the smaller bank with an RoE of 21.4%. The average for the bank sector was 18.5%, up from 17.7% last year.

Return on assets and return on risk-weighted assets (which takes into account the method used by regulators to weight loans for their risk, with housing loans getting a concessional weight) are also very useful indicators of genuine bank profitablity; but these figures are rarely highlighted and difficult to dig out of bank accounts. Fortunately, return on equity is a widely published standardised figure.

On this basis, Westpac is the most profitable of the four largest banks, with an RoE of 21.4%, followed by ANZ (17.5%), CBA (16%) and NAB (15%). The RoE figures from KPMG and PricewaterhouseCoopers are identical.

Any one bank may not agree with this choice of numerator and denominator for their calculation. As discussed above, net profit is a slippery concept in bank financial statements, and analysts don't always agree on how to work out the equity.

Ian Rogers is editor of the banking newsletter The Sheet at www.thesheet.com.