Assessing the value of equities generally relies on estimating the cash flows a company will generate in the years ahead and comparing that with the share price.
The cash flows that banks generate may be steady when economic conditions are steady, but banks often swing into making losses during recessions, while most other businesses just make smaller profits. For this reason, the, say, 10-year future cash flow model that you might use to value an industrial company cannot be used for a bank, unless you think you can predict there will be no recession in any of the next 10 years.
Therefore, price/earnings ratios and even dividend yields are not solid bases for valuing bank shares.
Indeed, some would say that when a bank has a low PE ratio, its earnings are having a boom and so the shares should be sold, and that you should only buy a bank during a bust when the PE ratio will be infinite as it has losses – negative earnings.
In those dark times, even the very brave investor would want to check that the bank would survive. This requires the analyst to assess how much regulatory capital – so-called Tier 1 capital – will be left after bad debts have been written off.
If the bank does not have sufficient capital it might well need to issue more shares, often at a hefty discount to the market share price and these share issues can be a good moment to buy into bank shares, knowing that they are being given extra liquidity.
Discount to ‘book value’
At these low points bank shares often trade at a discount to their “book value”. Using book value to assess bank shares forms a more solid basis than using earnings or dividends.
Book value, or per-share shareholders’ funds, is a figure found on the balance sheet, which represents accumulated past profits that have not been distributed to shareholders.
It acts as a rough estimate for how much cash the company could give back to shareholders were it to start to wind down its operations. However, this is only a rough proxy as: book shareholders’ funds include goodwill from historic acquisitions and any company in wind down would have to settle various contracts, including substantial staff compensation.
Also, in most competitive banking markets, banks average a return of around 12 per cent on their book assets over the cycle, which helps estimate sustainable earnings for the core lending business.
If a brave investor had waited for the most scary point in the 2008 banking crisis and had bought, say, Lloyds Bank shares, they might have picked up some at just below 29p. The Lloyds price today is just over 51p – hardly a great return given the risk.
