Lesson 8 of 9
Valuing a bank or an insurer
A bank's debt is raw material, not a cost to strip. Price it on book value against return on equity, not a cash flow model blind to the balance sheet.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A bank's deposits and borrowings are its raw material, not borrowing to strip out, so a free-cash-flow model built for an industrial company does not apply.
- Price a financial on price to book against its return on equity: a bank earning more on its equity than its cost of equity is worth more than one book value.
- Book value works as the anchor because a bank's assets are carried nearer their current worth than a factory is; the formula then says how far above or below book the returns justify.
A discounted cash flow model needs a clean line between operating profit and financing. A bank's business is financing, so that line cannot be drawn. Its equity is instead priced against what it earns on the book value shareholders have put in.
Justified price to book at three returns on equity
- Return on equity: 6% · below the 10% required return0.43x
- Return on equity: 10% · equal to the required return1.00x
- Return on equity: 14% · above the 10% required return1.57x
Book value, return on equity equal to the required return: 1.00x
The formula
Justified price to book equals Return on equity − growth divided by Required return − growth.
Example(0.14 − 0.03) ÷ (0.10 − 0.03) = 1.57x
This is the residual income model turned into a ratio rather than a currency figure. A bank earning exactly its cost of equity is worth exactly its book value, a price to book of 1.0x. Above that return, book value understates what the equity is worth; below it, book value overstates it.
Why book value works here and not elsewhere
For a manufacturer, book value is historical cost: old factories at what they cost decades ago, worth nothing in particular today. For a bank, most of the balance sheet is loans and securities, carried at amortised cost or at market value, which is usually nearer to current worth than a factory's cost. Not always: when rates rise, securities held to maturity can sit far below their carrying value. Book value is therefore a reasonable anchor for a financial in a way it rarely is for an industrial company, which is the whole reason price to book is the multiple banks are read on.
Buffett made return on equity the test of management in the 1979 letter, arguing that operating earnings against shareholders' equity, at cost, is the most useful single measure of a single year's performance. His own qualifier, without undue leverage, is the one a bank tests hardest, so read return on equity beside equity to assets. For a bank, once goodwill is taken out, equity is close to tangible, which is why banks are read on price to tangible book, and the same ratio does most of the work a discounted cash flow model does elsewhere as the business turns that equity into loans.
What this leaves out
Return on equity blends everything a bank does: net interest margin, fee income, credit losses, expenses. Two banks can report the same return on equity by different routes, one carrying real credit risk building quietly in its loan book and one not, and the ratio alone cannot tell them apart. Reading which route produced the number is a separate question, answered by net interest margin and credit costs read from the filing itself.
An insurer's book value carries the same idea with a different source of uncertainty. Its equity is close to tangible, but the liability side is an estimate: reserves set against claims that have not yet been paid, sometimes for years. A justified price to book built on a return on equity that itself depends on reserve assumptions inherits whatever is wrong with those assumptions.
Check yourself
A bank earns exactly its cost of equity, 10 percent, with 3 percent growth. What is its justified price to book?
- 0.70x
- 1.00x
- 1.30x
Show the answer
Answer: B.
When return on equity equals the required return, the justified price to book is exactly 1.0x: the equity is worth its book value, no more and no less.Why is a free-cash-flow model a poor fit for a bank?
- Banks do not report cash flow statements
- A bank's deposits and borrowings are its raw material, not financing to strip out of operating profit
- Banks have no operating profit
Show the answer
Answer: B.
A free-cash-flow model needs to separate operations from financing. For a bank, taking in deposits and lending them out is the operation, so there is no clean line to draw.Two banks report the same return on equity. What can that ratio alone not tell you?
- Their book value per share
- Whether the return came with hidden credit risk building in the loan book
- Their required return on equity
Show the answer
Answer: B.
Return on equity blends net interest margin, fees, expenses and credit costs into one number. Two banks can reach the same figure by very different, and differently risky, routes.Sources
- Penman, Financial Statement Analysis and Security Valuation, on reformulated statements and residual earnings, the model this ratio is built from.
- Berkshire Hathaway shareholder letter, 1979, on return on equity as the test of a single year's management performance.
What this leaves out
- The worked example uses round invented inputs so the arithmetic can be checked by hand.
- The formula assumes return on equity and growth both hold steady. A bank's return on equity moves with the credit cycle, and a figure taken from one year can be a cycle position rather than a steady state.
- Price to book says nothing about loan quality on its own. A bank carrying reserves that understate its true credit losses can show a justified price to book that is too high.
- Nothing here is advice about any security.