Why is Price to Book Ratio (P/B) is preferred over P/E while valuing Banks
There are 3 main reasons for this
1) Banks are regulated entities. They use Depositors’ money to Lend and earn interest. Hence they are required to have some Equity, as a % of total assets, defined as Capital Adequacy Ratio.
Without this Capital (Book Value), banks can’t lend. The growth thus depends on the Book Value. Hence, comparing against Book Value makes sense.
2) Book Value = Assets – External Liabilities
For banks, Assets are financial in nature, and hence Book Value reflects the current value of assets.
It also reflects the utilization of assets, since bad debts (Non Performing Assets – NPAs) would reduce the book value.
Hence comparing banks on P/B gives an idea about who is managing risk and utilizing assets better
3) A bank’s income statement is slightly different. A bank is supposed to put aside provisions for NPAs every quarter. While the provisions are stipulated as per regulations, there is scope of some movement across quarters.
A bank that has higher provisions, will be inherently less risky, but will also show lower earnings.
A bank with lower provisions will appear better on earnings, but would be riskier.
P/E ratio will reward the riskier bank, since it would appear to be lower for this bank.
Also, banks which are making losses today can be valued on P/B
Hence the Price to Book Ratio is preferred for valuing and comparing banks. P/B is also preferred over DCF – since DCF is difficult given the nature of cash flows for the banks (Large flows of debt)
That is broadly it in this week. Till next week. Keep learning.