The DIY Investing Podcast - 79 - How Banks Make Money

79 - How Banks Make Money

06/08/20 • 39 min

The DIY Investing Podcast

Mental Models discussed in this podcast:

Leverage
Fractional Reserve Banking
Margin
Economies of Scale
Operational Leverage

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Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

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You can find out more information by listening to episode 11 of this podcast.

Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode79

Banking Business Model - Key Concepts

As some of you may remember, one of my goals for this year is to improve my understanding of bank stocks. Today’s podcast will focus on the basic business model that banks use to make money.

Key Concepts:

Deposits
Cost of Deposits
- Direct Cost: Interest Rates paid on Deposits
- Indirect Cost: Overhead (Employees, Rent, etc...)
Loan Yields
Loan Losses
Fractional Reserve Banking -> Leverage Rate
- ROE = ROA * Leverage
Banking Profits = Loan Yields - Loan Losses - Cost of Deposits - Overhead

A recent movie I enjoyed about Banking

Recently watched: The Banker on Apple TV+
Two black entrepreneurs in the 1960s buy two Texas banks.
Samuel L. Jackson
Anthony Mackie

The movie follows their journey and the ensuing blowback by Jim Crow.

One of the things the movie did very well was to explain the basic banking business model. Banks are easiest to understand when you focus on single branch banks instead of large money center banks like JP Morgan or Wells Fargo.

Summary:

Banking is the business of bringing in deposits and lending them out.

Banking is a perfect example of a capital intensive business. A bank cannot grow unless it receives capital in the form of deposits. Deposits are the lifeblood of a bank and only through healthy deposit growth can a bank sustainably grow loans and therefore profits.

Mental Models discussed in this podcast:

Leverage
Fractional Reserve Banking
Margin
Economies of Scale
Operational Leverage

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.

Follow me on Twitter and YouTube

Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

Support the Podcast on Patreon

You can find out more information by listening to episode 11 of this podcast.

Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode79

Banking Business Model - Key Concepts

As some of you may remember, one of my goals for this year is to improve my understanding of bank stocks. Today’s podcast will focus on the basic business model that banks use to make money.

Key Concepts:

Deposits
Cost of Deposits
- Direct Cost: Interest Rates paid on Deposits
- Indirect Cost: Overhead (Employees, Rent, etc...)
Loan Yields
Loan Losses
Fractional Reserve Banking -> Leverage Rate
- ROE = ROA * Leverage
Banking Profits = Loan Yields - Loan Losses - Cost of Deposits - Overhead

A recent movie I enjoyed about Banking

Recently watched: The Banker on Apple TV+
Two black entrepreneurs in the 1960s buy two Texas banks.
Samuel L. Jackson
Anthony Mackie

The movie follows their journey and the ensuing blowback by Jim Crow.

Summary:

Banking is the business of bringing in deposits and lending them out.

Previous Episode

78 - Earnings Yield on Cost: A valuation rule of thumb

Mental Models discussed in this podcast:

Earnings Yield
Discount Rate

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.

Follow me on Twitter and YouTube

Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

Support the Podcast on Patreon

You can find out more information by listening to episode 11 of this podcast.

Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode78

Earnings Yield on Cost

In our last episode, we discussed the source of investment returns. In this episode, we’ll dive deeper into the nuance of stock valuation.
A rule of thumb is a simple reference point method to quickly determine whether a stock is overvalued or undervalued. A rule of thumb for valuation is not a substitute for valuation, but simply a starting point to allow you to focus and prioritize your time on ideas that appear to be good values.
Earnings Yield - Current Earnings / Stock Price
Earnings Yield on Cost: Possible Future Earnings / Original Stock Purchase Price
Rule of thumb: Earnings yield on cost must eventually exceed 10% in order to earn a 10% rate of return on your investment (due to business performance) versus speculation.

Investing Rule - Earnings Yield and Discount Rate

Stocks must eventually trade at an earnings yield on cost equal to your discount rate in order to earn your required return on capital for you as an investor.

Stock Investing Examples

Amazon
- $1.22T Market Cap
- 2019 Earnings: $11.5B
- Earnings Yield: 0.9%
Apple
- $1.38T Market Cap
- 2019 Earnings: $55B
- Earnings Yield: 3.9%
Discover Financial
- $14.5B Market Cap:
- 2019 Earnings: $2.9B
- Earnings Yield: 20%
NACCO
- $184m Market Cap
- 2019 Earnings: $39m
- Earnings Yield: 21.2%

Next Episode

80 - Zero Interest Rates should not reduce your Discount Rate

Mental Models discussed in this podcast:

Discount Rate
Equity Risk Premium
Second-Order Effects

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.

Follow me on Twitter and YouTube

Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

Support the Podcast on Patreon

You can find out more information by listening to episode 11 of this podcast.

Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode80

Interest Rates

I discuss The Fed and their recent actions to lower interest rates to zero using the overnight lending rate.

I also cover the equity risk premium and second-order effects of zero interest rates.

Discount Rates

Your Required Rate of Return
Your need to save and invest can increase as rates fall

Summary:

When the Fed reduces interest rates to zero the first-order effect is a disincentive to save. Yet, zero interest rates should not reduce your discount rate because the second-order effect is because lower returns would increase your need to save money.