Multiples for valuing Banks
Why do we use P / BV for valuing banks over something like EV / EBIT? I understand EBITDA should not be used since financial institutions are not capital intensive, but won't EBIT be a good metric of profitability. How does P / BV even tell anything about profitability??
Bank Valuation Multiple
Here's an intuitive perspective on valuing financial services firms. Additionally there is a pdf attached about valuing financial services firms from NYU Stern.
from certified user @SpacemanSpiff"
Think of a bank's balance sheet. What do you have? On the asset side you have financial assets earning some sort of interest income. On the liabilities side you have deposits costing some sort of interest expense. Banks use deposits (and a lesser extent, debt) as raw material to acquire assets that produce interest income.
- Tell me how you get to earnings before interest and taxes if you earnings are literally just interest income
- What do you define as debt? Are deposits debt? How do you estimate cashflows before debt payments in that case?
- Bank assets are (or should be) marked-to-market on an ongoing basis. This inherently implies that the equity value of the bank will, more-or-less, be a reasonable approximation of the actual value of the business.
What P/BV (and P/TBV) tell you is simple. If your P/BV is less than 1, the market is saying either your assets are overvalued, or you are earning a poor (or even negative) return on your assets. If your P/BV is greater than one, the market is saying your assets are undervalued (rare) or that you are earning a good return on your assets.
The higher the P/BV multiple the more the market is giving you respect for your ability to earn more given a dollar of additional equity (i.e. your return on equity is greater)
Here's a short video on valuing a financial services service firms.
Having a hard time understanding valuation and modeling? Get the proper training to maximize your skills for success.
Recommended Reading
I'm not in FIG but my understanding is that EV isn't a good metric for banks due to their capital structure.
I've used Price/Book Value and Price/Tangible Book Value. If these match up close to your DCF, then you're in the clear. Write back if they don't.
I'm going to take a shot here but I may be wrong.
Financial institutions are a special industry in which interest is pretty much the main operating expense. As a natural consequence, EBIT is a poor operating metric because it is pre-interest, and does not account for that operating expense.
P/BV, or rather P/TBV seem to be metrics that are commonly used to value financial institutions. One reason that I can think of is that it is because financial assets/liabilities on their balance sheets would/should be marked-to-market, and therefore be a fairly accurate reflection of the overall worth of the company. This is of course, contrasted with a company which owns many "real" assets like factories or ships, where over time, the book value of the assets they own will deviate from the "market value" of those assets - and will therefore be an inaccurate "snapshot" of how much that company is actually worth.
Moving on, from a theoretical standpoint, if the Law of one price holds, one would assume that financial institutions should trade at a P/BV or P/TBV of 1.0x. After all, a value smaller than 1.0x would imply that it is undervalued, and a value larger than 1.0x would imply the opposite.
That is where profitability/growth may come in - to explain why its P/BV or P/TBV isn't 1.0x. A highly profitable financial institution, or one that has good growth prospects will probably trade at values over 1.0x and obviously the opposite should occur in a bearish market.
This could possibly explain why banks like Morgan Stanley is currently trading at 0.64x P/BV and Goldman Sachs at 0.84x - the outlook for the short to medium term is pretty gloomy.
Think of a bank's balance sheet. What do you have? On the asset side you have financial assets earning some sort of interest income. On the liabilities side you have deposits costing some sort of interest expense. Banks use deposits (and a lesser extent, debt) as raw material to acquire assets that produce interest income.
What P/BV (and P/TBV) tell you is simple. If your P/BV is less than 1, the market is saying either your assets are overvalued, or you are earning a poor (or even negative) return on your assets. If your P/BV is greater than one, the market is saying your assets are undervalued (rare) or that you are earning a good return on your assets.
The higher the P/BV multiple the more the market is giving you respect for your ability to earn more given a dollar of additional equity (i.e. your return on equity is greater)
Read this for more information if you're interested http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch21.pdf
Very good answer. Thank you! BTW, what is the name of the book you provided in the URL.
You might also use P/E as an appropriate valuation metric as it is post-interest.
Higher P/E would imply a higher earning potential, vice versa for the opposite.
Yes, P/E's are used in better (profitable) times when the first worry on everyone's mind is relative profitability of banks and not capital adequacy
Maxime quis culpa eum facilis. Ut eveniet cum omnis ut debitis eveniet et. Sit nulla perspiciatis cumque rerum nesciunt laudantium.
Eveniet tempora voluptatibus facere quo consequatur amet. Harum ut esse dignissimos quia. Fugit reprehenderit alias ad harum nihil sed. Eaque cumque architecto et et quo sit maxime. Odit possimus aliquam ipsam nobis. Temporibus rerum dolorem rerum earum voluptates aperiam. Libero molestias recusandae nobis occaecati odio molestiae iure.
Tenetur quis culpa et ex aut ipsam aut impedit. Aliquam ut sapiente asperiores quo accusamus recusandae quasi ut. Reiciendis ratione nobis voluptatem et et voluptatum impedit. Et beatae veritatis sint possimus. Magnam sit non facere voluptatibus ut minus mollitia. Ut et aliquam voluptate rem corrupti.
Unde et quia cum mollitia quia ea. Accusamus necessitatibus fugiat velit praesentium eligendi pariatur molestiae.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...