Is this a good measure?
Bank stocks are known to trade at prices below the book value per share, even when a bank’s income and profits are rising. As banks grow and engage in non-traditional financial activities, especially trading, their risk profiles become multidimensional and more difficult to construct, increasing business and investment uncertainties.
This is probably the main reason why bank stocks tend to be priced conservatively by investors who need to be concerned about a bank’s hidden risk exposures. Trading on their own as brokers in various financial derivative markets exposes banks to potentially large losses, which investors have decided to take fully into consideration when valuing bank stocks.
Key points to remember
- Book value per share is a company’s book value for each common share outstanding. Book value is the difference between total assets and liabilities.
- Bank stocks tend to trade at prices below their book value per share, as the prices take into account the increased risks associated with a bank’s trading activities.
- The price to book ratio (P / B) is used to compare a company’s market capitalization to its book value. This allows the stock price to be compared to assets and liabilities rather than earnings, which can fluctuate more often, especially through trading activity.
- A P / B ratio greater than one means the stock is valued at a premium in the market to the book value of equity, while a P / B ratio less than one means the stock is valued at a discount from the book value of equity.
- Companies that have large trading activities usually have P / B ratios of less than one because the ratio takes into consideration the risks inherent in trading.
Book value per share
Book value per share is a good measure for valuing bank stocks. The price-to-book ratio (P / B) is applied with a bank’s share price relative to the book value of equity per share, which means that the ratio looks at a company’s market capitalization compared to its book value.
The alternative of comparing a stock’s price to earnings, or the price-to-earnings (P / E) ratio, can produce unreliable valuation results, as bank profits can easily fluctuate in large swings in money. quarter to quarter due to unpredictable factors. , complex banking operations.
Using book value per share, valuation refers to equity whose continuing volatility is less than quarterly earnings in terms of percentage changes, as equity has a much broader basis, providing a more stable evaluation measure.
Banks with a discount P / B ratio
The P / B ratio can be greater or less than one, depending on whether a stock is trading for more or less than the book value of equity per share. A P / B ratio greater than one means the stock is valued at a premium in the market to the book value of equity, while a P / B ratio less than one means the stock is valued at a discount from the book value of equity. For example, Capital One Financial (COF) and Citigroup (C) had P / N ratios of 0.92 and 0.91, respectively, in the third quarter of 2018.
Trading for own account in banks can generate substantial profits, but trading, especially derivatives, carries significant risks, often through leverage, which should be taken into account when valuing a bank. .
Many banks rely on trading operations to improve their basic financial performance, with annual profits of billions of dollars in their trading accounts. However, trading activities have inherent risk exposures and could quickly turn down.
Wells Fargo & Co. (WFC) in 2018 saw its shares trade at a premium due to its book value of equity per share, with a P / B ratio of 1.42 in the third quarter of 2018.One reason was that Wells Fargo was relatively less focused on trading activities than its peers, potentially reducing its exposure to risk.
While trading primarily in derivatives can generate some of the biggest profits for banks, it also exposes them to potentially catastrophic risks. A bank’s investments in the assets of the trading account can reach hundreds of billions of dollars, which takes a large part of its total assets.
For the fiscal quarter ending September 30, 2018, Bank of America (BAC) saw its equity trading revenue increase 2.5% to $ 1 billion, while its fixed income trading business grew. fell 5% to $ 2.06 billion over the same period.Moreover, business investments are only a part of a bank’s total risk exposure when banks can leverage their derivative transactions to almost unimaginable amounts and keep them off balance sheets.
For example, at the end of 2017, Bank of America had a total derivative risk exposure of over $ 30 trillion, and Citigroup had over $ 47 trillion.These stratospheric numbers of potential business losses eclipse their total market caps at the time of $ 282 billion and $ 173 billion for the two banks, respectively.
Faced with such a magnitude of risk uncertainty, investors are best served to discount any profit from trading a bank’s derivatives. Although partly to blame for the magnitude of the 2008 stock market crash, banking regulation has been minimized in recent years, leading banks to take increasing risks, expand their trading portfolios and pull back from their derivative positions.
The bottom line
Banks and other financial companies can have attractive price-to-book ratios, which puts them on the radar of some value-oriented investors. However, on closer inspection, it is worth paying attention to the enormous derivative exposure that these banks carry. Of course, many of these derivative positions offset each other, but careful analysis must nonetheless be undertaken.