Bank Valuation V
In this article I will discuss metrics related to the price of a bank stock.
So far in this series we covered the following metrics:
– Net Interest Margin (NIM)
– Return On Assets (ROA)
– Loan Loss Reserve, and losses related to the loan portfolio
– Return On Equity (ROE)
– Profit Margin
What I present here are techniques that I have found useful in evaluating opportunities in bank stocks in particular. They will help you to become aware of certain risks & situations affecting banks that you will have to weigh, while helping to avoid problematic ones. There are many other techniques and methods out there as well.
You can think about the price of a stock in the same way as the price of anything else you decide to buy. Only when you are interested in an item do you really start looking at and tracking the price. If there is something you aren’t interested in, you might look just to compare, but would stop there. If the price on a used toilet seat declined, you probably won’t care. If a stock passes the valuation criteria of all the previous metrics we’ve discussed, and we think its a good investment to purchase, only then should price come into the picture. A common mistake people make, is that they automatically assume a large price decline means a stock is selling at a discount to its fair value, or has become undervalued. Such an assumption is untrue, as we will see. Price & value are two different things.
The price listed on the stock exchange represents one share of the company’s total shares outstanding. Most public companies have hundreds of millions of shares outstanding. A board lot is usually 100 shares. It is true that if you purchase less than full board lots (i.e. not in multiples of 100 shares) you may pay a price premium or experience more difficulty obtaining the number of shares requested. However, I never found it to be a problem.
Price/Earnings (P/E) – The Price To Earnings ratio compares the current market price (of one share) of a stock as a multiple of its earnings (per share). Its generally used to weigh the price attractiveness of a stock. For example if the P/E of one company is higher than the other, with all things being equal (business, growth rates, assets, number of shares, everything), then the one with the lower P/E is deemed to be more attractively priced.
P/E is calculated as Price divided by EPS. Trailing P/E uses the EPS of the last four quarters, while forward P/E uses the projected EPS of the next four quarters. P/E is also an indication of what the average market investor is willing to pay for a particular stock at a particular point in time. Usually stocks with higher forecasted earnings growth will have a higher P/E than stocks with lower earnings growth. That means that people are willing to pay more for earnings from a company with a higher forecasted growth, which can be dangerous.
I follow Benjamin Graham & Warren Buffet’s investment philosophy again – buying stocks at a discount to their intrinsic value. A low P/E can indicate a POTENTIAL price discount. Again, the P/E is only one metric, and we need to look at many to determine if a company is indeed trading at a discount.
Avoid purchasing at high P/E multiples. I would say the market average P/E is the average P/E of the S&P in the last 10 yrs. I would consider anything above that to be high. Remember in a sense you are paying for rights to future earnings. How much are you willing to pay for a money making machine? If you were to buy a machine that earned $5 last year for $10, and you expect it to earn about the same each year, then its current P/E is 2. Now what makes the P/E so interesting to look at is that our money making machine may be expected to earn more and more each year. Some money making machines’ rate of earnings increases, are expected to be higher than others.
For example, tech stocks are usually found to have high P/E multiples because people expect them to have ever increasing rates of earnings each year. At one point this year (spring & early summer), Research In Motion’s (RIMM) P/E was 61.00! It means at that time, people were willing to pay 61 times its then earnings. They were willing to do so because they expected RIM to earn more and more at increasingly larger rates. The problem is that eventually the company may not be able to meet the increasingly lofty & often over enthusiastic future earnings expectations that people in the market have. Its difficult for businesses in any industry to continue to sustain extremely high growth rates over a lengthy number of years. Remember, FUTURE earnings may or may not come to fruition. When actual earnings disappoint the public (no matter how high they are) its very likely the stock will be punished in the form of analyst downgrades, sell recommendations, and removal from recommended stock picks, which will result in a massive sell off. RIM’s P/E in following months had dropped to 17x, when its stock price dropped from a year high of $148 to the current $53 mark! What we want to do as a minimum, is to pay a reasonably lower price than the market average. I am only willing to pay as high as 15 times. That being said, I tend to look for banks that are significantly lower than 15x. Negative P/E’s don’t help either, because negative earnings mean the company lost money.
Why are high P/E stocks are favored by analysts and average investors? Benjamin Graham describes this pretty well. 1. Better market action. 2. Faster growth in recent earnings. Sticking with conservative investment principles: Reason 1 is not valid as you would become a speculator not an investor. Reason 2 is valid, but within limits. Can the past growth justify the large price over recent earnings? Not for careful investors who wants to be reasonably sure they are not committing to the typical Wall Street error of over-enthusiasm for good performance in earnings.
The P/E history & trend of a stock is also important. To make things more confusing, average P/E norms are different for various industries. Banks generally have lower P/E ratios than other companies. So how do we use the P/E to determine if a stock might be potentially cheap? Since its all relative, we can look at its 10 yr P/E trend & history:
1. Compare the current P/E to its average P/E over the last 10 years.
– We want to see that the current P/E is much lower than its average. We want a discount relative to its own P/E history.
2. Compare the P/E over the last 10 years to the S&P P/E over the last 10 years.
– We want to look at the percentage difference in P/E when compared to the S&P P/E (market) over the years. Not only do we want to see a discount relative to its own P/E, but also to the market.
– Wells Fargo & Co (WFC) had a 2007 annual P/E of 11.4, which is lower than the S&P 10yr average of about 25, and is much lower than 15. Its 10 yr average P/E was 17.7. In early 2008, its price had declined to around $27. When we look at the year to year P/E comparison of the 2007 P/E with the P/E over the last 10 years, we can see that 11.4 was the lowest it has been in 10 years. When we compare year over year with the S&P, we can see that WFC’s P/E has always been lower than the S&P’s. When the price was $27, the difference was the largest it has been in 10 yrs at -31% lower than the S&P’s. The price earnings metrics indicated that it was potentially a bargain at that price. But we still need to do more work and look at more price metrics to be sure.
– Royal Bank Of Canada (RY) had a 2007 annual P/E of 12.0, which is lower than the S&P 10yr average of about 25, and is lower than 15. Its 10 yr average P/E was 14.3. In early 2008, its price had declined to around $47. When we look at the year to year P/E comparison of the 2007 P/E with the P/E over the last 10 years, we can see that 12.0 was the lowest it has been in 10 years, but not by much. In 1999 its P/E was 12.9 and in 2006 it was 15.4. When we compare year over year with the S&P, we can see that RY’s P/E has usually been lower than the S&P’s. When the price was $47, the difference was not the largest it has been in 10 yrs at -34% lower than the S&P’s. In 1999, 2000, 2001, RY’s P/E was the lower at -54%, -37%, and -38% respectively. In 2003 it was -34% as well. The price earnings metrics indicated that it could have been a potential bargain at that price, but was by no means the best bargain its stock has seen in the last decade.
– Citigroup (C) had a 2007 annual P/E of 40.8 (due to massive writedowns in its 4th quarter), which is much higher than the S&P 10yr avg of about 25. Its 10 yr average P/E was 17.7. In Oct 2007, its price declined from around $50 to just under $30. When we look at the year to year P/E comparison of the 2007 P/E with the P/E over the last 10 years, we can see that 40.8 was the highest it has been in 10 years. In 1998 its second highest P/E was 20.5 declining to a low of 9.5 in 1999, 12.7 in 2005, and 13.1 in 2006. When we compare year over year with the S&P, we can see that C’s P/E has usually been lower than the S&P’s. But when the price was $30 at the end of 2007, it was the total opposite with the largest difference being 147% above the S&P’s P/E. The price earnings metrics indicated that the large price decline was not a potential bargain even at $30. In 2008, its current P/E is negative, due to net losses this year. Its massive price decline was probably warranted.
The price someone is willing to pay for something, always comes down to being an individual choice & preference. But for investments, you must have a good reason behind the price you are willing to paying.
Next week in Bank Valuation VI, I will continue to discuss other metrics related to the price. In the mean time feel free to browse older articles such as Investment Risk, or How To Start Investing I. The articles related to Warren Buffet and the Berkshire Hathaway portfolio are interest as well. Other articles in the Interesting Notes section are interesting to look back on, especially in times like this.
PS. If you’ve made it this far in the series, you are have exceeded the average reader of my investment blog. Most average readers can’t stick with learning something long enough to benefit. Give yourself a pat on the back, because the reason for being able to continue through the series is probably the same reason that some investors are above the average investor.
Thanks & Happy Investing!
The Investment Blogger
Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.