Bank Valuation VI
In this article I will discuss a second metric 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
– Stock Price & Price/Earnings
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.
Net Asset Value (NAV) or Book Value in the context of business valuation, is the value of assets minus liabilities. This is the value of the company’s assets that shareholders would theoretically receive if it was to be liquidated.
Investors should be aware that the term NAV is different in the context of mutual funds or exchange-traded funds (ETF). For funds, the NAV per share is the total market value of all the securities it holds in the portfolio minus any liabilities, divided by the number of outstanding shares. Because the market value of the securities it holds changes daily, the NAV changes daily, and is not the best gauge of mutual fund performance.
Warren Buffet once said that for insurance companies & financial institutions, changes in their book value reflects changes in their intrinsic value. This was also stated in the 2007 annual report for his own company, Berkshire Hathaway: “In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.” This metric is very useful and applicable to insurance companies other than Berkshire, as well as banks, but of limited use elsewhere.
Similarly, we can look at the change in the Price/Book ratio.
The Price To Book Value ratio (P/B) is very similar to the P/E. It compares the current market price of a stock as a multiple of its book value. Its generally used to weigh the price attractiveness of a stock. P/B is calculated as Price divided by Book Value.
The NAV or book value will usually be below the market price. One reason is because it describes the company’s current asset & liability position at that moment in time, while investors “price in” future growth prospects, which they are usually willing to pay more for. Another reason is that the current value of a company’s assets may be higher than the historical financial statements used for the calculation.
Avoid purchasing at high P/B multiples. I would say the market average P/B is the average P/B of the S&P in the last 10 yrs. I would consider anything above that to be high. Again, we want to pay a reasonably lower price than the market average. The S&P 10 yr avg P/B is around 2.99. I am only willing to pay as high as 3.0 times the book value. That being said, I tend to look for banks that are significantly lower than that. The lowest year end P/B for the S&P was 2.60 in the last 10 yrs, which was at the end of the year 2000. Negative P/B’s don’t help either, because negative book value mean the company is worthless.
The P/B history and trend of a stock is also important. Like the P/E, average P/B number norms are different for various industries. Banks generally have lower P/B ratios. So how do use the P/B to determine if a stock might be potentially cheap? Since its all relative, we can look at its 10 yr P/B trend & history:
1. Compare the current P/B to its average P/B over the last 10 years.
– We want to see that the current P/B is much lower than its average. We want a discount relative to its own P/B history.
2. Compare the P/B over the last 10 years to the S&P P/B over the last 10 years.
– We want to look at the percentage difference in P/B when compared to the S&P P/B (market) over the years. Not only do we want to see a discount relative to its own P/B, but also to the market.
In economically difficult times such as the one we are currently in, it is particularily useful to subtract potential losses & writedowns from the NAV that the bank may experience in the near future to see how it affects the P/B. Even though they may be approximations, it gives a clearer picture of whether the bank may attractively priced or actually expensive.
– Wells Fargo & Co (WFC) had a P/B of 2.2 at the end of 2007, which is much lower than the S&P 10yr average of about 2.99, and the S&P’s 2007 year end of 2.70. Its 10 yr average P/B was 2.6. In late 2007, its price had declined %18 from a high of about $37 to $30. When we look at the year-to-year P/B comparison of the 2007 P/B with the P/B over the last 10 years, we can see that 2.2 was the lowest it has been in 10 years (except in 1998 when it was 1.5). When we compare year-over-year with the S&P, we can see that WFC’s P/B for the most part has always been lower than the S&P’s. When the price was $30, the difference with the S&P was the largest it had been in 10 yrs at -47%. The price to book metrics indicated that it was potentially a bargain at that price. At that time WFC’s NAV was about $13.71 a share. However, news of net losses from writedowns and other related losses were emerging from various financial institutions & investment firms. It was likely that WFC may also have to writedown a few billion over the course of a couple of quarters. Assuming that they would have writedowns and other loan related losses of -$5 billion (an overly negative number considering this bank’s conservative nature), the NAV becomes $10.83, increasing the P/B to 2.44.
– Wachovia (WB) had a 10 yr average P/B of 1.54. In late 2007, its price had declined %30 from a high of almost $60 to $50 by the 3rd quarter with a P/B of 1.36, which was much lower than the S&P 10yr average of about 2.99 and the 2007 end of 2.70. By the end of 2007 Wachovia’s P/B was just 0.90 with at a price of about $35 a share. When we look at the year-to-year P/B comparison of the 2007 P/B with the P/B over the last 10 years, we can see that 0.90 was the lowest it had been in 10 years.
When we compare year-over-year with the S&P, we can see that WB’s P/B for the most part had always been lower than the S&P’s. When the P/B was 0.9 at the end of 2007, the difference with the S&P was the largest it had been in 10 yrs at -66%. The price to book metrics indicated that it was potentially a bargain at that price. At that time WB’s NAV was $$39.22 a share. However, news of net losses from writedowns were emerging from various financial institutions. It was likely that Wachovia may also have much more significant losses down the road over the course of a couple of quarters. They just started to reveal their own writedowns in the low billions, but have also prided themselves on the number one market leader of real estate and structured products (master servicer of US CMBS, CMBS fixed rate loans, manager of US CDOs, etc). Taking this into consideration, it would not be out of the question to assume that they would have to writedown a total of $50 billion off their balance sheet (guesstimate). Factoring this in, the 2007 NAV then becomes $13.71, increasing the P/B dramatically to 2.55, which is well above their 10 yr average. This may not be the bargain we are hoping for. Again, this shows that one metric alone is not enough to determine anything..
During the course of 2008, WB issued preferred stock offerings of $3.5 billion in February, as well as $7 billion offering of both preferred & common stock in April to shore up capital.
For 1Q2008 (April) they had a net loss of $393 million and reduced their dividend. For 2Q2008 they had a net loss of $8.9 Billion with another dividend reduction. For 3Q2008 they had a net loss of $23.9 Billion. The total 2008 loan losses, charge-offs, writedowns, credit losses, various impairment charges, various market disruption related charges, etc, well exceeded the $50 billion guesstimate we had earlier.
Next week in the Bank Valuation VII, I will discuss qualitative metrics before wrapping up the series in Bank Valuation VIII (intrinsic value of a bank). 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 continued up to this point, by now you can see how all the metrics put together start to form more concrete pictures of banks, giving you many tools to determine their value. There are just 2 more in this series!
Thanks & Happy Investing!
The Investment Blogger
Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.