This study investigates the efficacy of a fundamental analysis-based approach to screen U.S. bank stocks. We construct an index (BSCORE) based on fourteen bank–specific valuation signals. We document a positive association between BSCORE and future profitability changes, as well as current and oneyear-ahead stock returns, implying that BSCORE captures forward looking information that the markets are yet to impound. A hedge strategy based on BSCORE yields positive hedge returns for all but two years during our 1994–۲۰۱۴ sample period. Results are robust to partitions of size, analyst following, and exchange listing, and persist after adjusting for risk factors. We further document a positive relation between BSCORE and future analyst forecast surprises as well as earnings announcement period returns, and a negative relation between BSCORE and future performance-based delistings. Overall, our results show that a fundamental analysis-based approach can provide useful insights for analyzing banks.

Introduction

This study examines the efficacy of a financial statement–driven fundamental analysis strategy for screening bank stocks. According to some estimates, the size of the U.S. banking sector as measured by total banking assets is as large as the annual GDP.1 Despite the importance of the banking sector to the wider economy, most valuation research in accounting and finance excludes bank stocks. The exclusion of bank stocks may be partially justified, as the financial statement–based value drivers are substantially different for banks as compared to other industries. For example, while working capital accruals are important for firms in manufacturing and retail, specific accruals such as loan loss provisions are more important for banks. The recent crisis has also brought to the fore criticisms concerning excessive fixation of bank managers and market participants on Return on Equity (ROE) as a key bank performance evaluation metric. Many observers (ECB 2010; Admati 2011; Admati et al. 2013; Moussu and Petit-Romec 2013) have suggested that ROE enhanced by risk and leverage may not reflect sustainable profits and may have contributed to value destruction during the recent financial crisis. Accordingly, we explore whether investors can improve upon a simple ROE-based investment strategy by incorporating additional fundamental signals. We build upon prior studies in accounting that document the usefulness of signals constructed using historical financial statement data in predicting future accounting and stock return performance (e.g., Lev and Thiagarajan 1993; Bernard and Thomas 1989, 1990; Sloan 1996; among others). Our approach in this paper is similar to that of Piotroski (2000), who documents the efficacy of financial statement analysis in ex-ante identification of winners and losers among value stocks. Further, we are motivated by Mohanram (2005), who contextualizes fundamental analysis for growth stocks. In this paper, we attempt to contextualize fundamental analysis for bank stocks. We combine fourteen bank-specific valuation signals to create a bank fundamentals index (BSCORE). We motivate our signals from the residual income valuation model developed in Ohlson (1995), Feltham and Ohlson (1995), and other papers. The value of a stock should depend on three factors—the ability to generate profitability in excess of the cost of equity (+), risk (−), and growth prospects (+). Our choice of specific signals is motivated by the guidance in Calomiris and Nissim (2007) and Koller et al. (2010), who analyze valuation of bank stocks. We combine signals pertaining to: (i) overall measures of profitability (return on equity and return on assets), (ii) components of profitability (spread, operating expense ratio, non-interest income, earning assets, and loans-to-deposits ratio), (iii) prudent banking activities (loan loss provisions, non-performing loans, loan loss allowance adequacy, and tangible common equity ratio), and (iv) measures of growth (growth in revenues, total loans, and trading assets). We first examine the mechanism through which BSCORE affects future returns.