Analyzing Banks: Management and Investor Perspective

Abstract

This paper proposes a new framework to analyze both the profitability and stock returns of banks by decomposing a bank’s return on equity (ROE) in its components. The decomposition follows a simple model of a bank, and is directly related to specific management decisions. We validate the decomposition by predicting future profitability and stock returns for a global data set of banks covering 26 years. The empirical analysis shows that there are remarkable differences in the economic significance across the various ROE components to predict future profitability and stock returns of banks. These differences have important implications for management, regulators, and investors.

Keywords: Banks, Financial Analysis, ROE Decomposition, Stock Returns, Panel Regression

JEL Classification: G12, G21, M41