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Should investors buy bank shares or should they rather avoid bank stocks? Personally, I avoid investing in banks, not because I believe the share prices are overvalued, but because I have no visibility on what is going on within the bank.
This being said, bank shares can be a good investment, as it was over the last year or so. Maybe they will be over the next few years, but here's what I recommend in investigating bank shares:
A typical bank borrows money from depositors and lends it to borrowers. The book value of a bank is assets minus liabilities, and therefore it equals the amount it lends minus the amount it borrows.
Shares of a listed companies usually do not trade at book value, but rather at a multiple of the book value. The reason being that the assets are expected to generate more cash than the cost of the liabilities.The same principle applies to banks.
Assuming that a bank borrows money from depositors at 1% (this is low, but interest rates are at an all time low) and further assuming the bank lends at 4% on average, the margin the bank makes is 3% on the money it borrows.
We can therefore expect banks should trade at more than book value since they are highly leveraged (a good and sound leverage factor would be 10) since the assets generate more than the liabilities.
This is indeed true in a perfect world, but in the real world things are not so simple. Add now the costs of the bankers in charge to manage the risks. Although they are not good at it (we've seen it before...), these fat cats cost a lot to the shareholders. Add on top of that all the costs to service the depositors and borrowers, the IT (imagine the mainframes and the security), etc. There is not much left after the bonuses have been paid out. But wait a minute, this still takes into account there is no default on the loans. Imagine that the bank makes 3% interest spread on the loan it makes, if 2% of the borrowers default, there is only 1% left for the bank.
So, it is then up to the investor to estimate the value of banks based on their balance sheet and an assumption on the default rate.Taking a look at the defaults that we can expect in the future as explained in this blog post, I would not be too bullish on the bank multiple!
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