I like sports and often keep track of my performance. The other day I participated in an event that took me 4:20 hours to finish. Is this good ?
Of course you wouldn’t be able to answer because you don’t know what the distance was and if I was biking or running (or rowing) and what the conditions were. The result needs to be related to the effort, in this case the distance covered and means used.
About Profit And Profitability
When measuring the financial result, the principle is the same. We can’t make any statements about success -profitability- until we know what the financial effort, the investment was. Stating that someone who makes a profit of a thousand makes more profit than someone who makes one hundred is like saying that a biker is faster than a runner. If in first case the investment was 10.000 and in the second case 1.000, the profitability is the same. No one would claim that the first investor did a better job or obtained a better results.
Still, when I read about profits, it is predominantly about the net amounts of the profits. Not a word about profitability. Politicians and university professors complain about the giant profits banks make. This does not apply to banks alone, last week I saw similar comments on the profits of Petrom, Romania’s largest company, in Ziarul Financiar. Already some time ago there was an article in the Ziarul Financiar about the profits of the Romanian Banking system over the last 7 years (2004 – 2010). Based on BNR numbers, the conclusion was that the net profit in the total banking system over this period was 3,5 billion EUR.
What Makes A Big Profit
In order to form an opinion on how big a profit this is in terms of return we need to do two things. First we need to relate the profit to the effort made in order to obtain it, namely the investment. This gives us the return on investment. Once we have this we can compare with benchmarks or the return of investment in other sectors.
Computing the return on investment of a bank is a simple exercise and the data can easily be found on the BNR website. If we look at this we can see that the average return on equity (capital) for the Romanian banking system over the same period was 7,5 percent. If we were to add the results for the year 2011 to the picture, the overall result would be even lower.
So, now that we know what the return was we can form an opinion on how successful an investment really is. We could compare the outcome to the results in other sectors, telecom, cement, pharmaceuticals, oil and gas, retail. We could make a comparison to investments in other financial instruments. Would you put your money on a RON deposit for 5 years fixed at an interest of 7,5%?
Risk Is Important Too
The standard way of doing this is to compare against a “risk free” benchmark. Because investing in a bank is a long term commitment – you cannot just take the capital out after a year – we need to look at an alternative benchmark, the yield on government debt for a maturity of, say 5 years. Today this cannot really be considered to be totally risk free but a better benchmark doesn’t exist.
So, if the shareholder, instead of investing, say, 2 billion RON in a bank, had invested the same amount into treasury bonds, the “risk free” benchmark, his return over the same period would have been about 7,5 % Obviously, by investing in a bank, which carries a higher risk, he would like to see a higher return. So, despite the big number of 3,5 billion, it was not a very good investment if we look collectively at the sector. In reality some investors have been extremely successful and others have done poorly.
Whichever way we look at this, the conclusion is that 7,5% average return over 7 years in not very high, it is actually low. Still, shareholders in banks have decided to reinvest a major part of the obtained profit in the Romanian banks, showing a long term commitment. Of course there are big differences from bank to bank, meaning some are clearly more profitable than others -which is good, because if all banks were at about the same level op profitability and it would be low, then the environment would most likely be blamed. A few banks that show good profits demonstrate that the banks that are not successful have only themselves to blame.
By the way, the 4:20 was for running a marathon, so not very good, my personal best is 3:30.