The Motley Fool

How To Value Bank Shares

Valuing banks used to be easy. As well as the usual P/E ratio and dividend yield, price to book value was a reliable measure of a bank’s valuation.

Post-financial crisis the same fundamentals still apply, even if the situation is somewhat clouded.

Back to basics

There are sound reasons why price to book value is a good measure. A bank’s balance sheet is composed mainly of financial assets and liabilities, which generate its income (interest received) and costs (interest paid).

If a bank were only engaged in borrowing and lending, then the value of its current business should equal its net assets, which is the same as book value. If it just collected its debts and paid its depositors, that is what would be left over.

Of course banks engage in a diverse range of activities, but in some degree the scale of those activities are related to net assets.

If we value a bank this way, then we should add something on for the future business that the bank will undertake. This is its goodwill value as a going concern. It should mean that the price is at a premium to book value.

We can relate this goodwill to net assets. If all banks earned the same return on equity (RoE) and paid out the same proportion of earnings as dividends, then the goodwill value would be proportionately the same. So a bank which earns a higher RoE should have a bigger premium to book value than one which earns a lower RoE.

A caveat

We must add a caveat to this approach. The current business is only worth the net assets if the balance sheet correctly reflects the true value of individual assets and liabilities. If investors doubt that the assets are all collectable (above the levels of provisions for bad debts) or that the values are incorrectly recorded, then the price may be at a discount to book value.

The price to book ratio of the major UK banks rose from 1.0 in 1990 to a peak of 4.0 in 1997, easing to around 2.0 times by 2000. It dropped rapidly to 0.5 in 2009 before recovering to around 1.0 again.

That trajectory tells quite a story of the ebbs and flows of investor confidence. For valuation purposes, what is most useful is comparisons; between individual banks, and with historic figures.


Banks borrow many times their capital base and on-lend their depositors’ money. They can function only because depositors have confidence they will be repaid.

A bank fails for one of two reasons. Firstly, depositors may doubt its solvency, i.e. that the bank has enough funds to pay back all its depositors if necessary. Making bad loans or investments could undermine that. Lehman Brothers failed through insolvency.

Secondly, the bank may not have enough ready cash — liquidity — to pay back depositors, even if it is solvent. Borrowing short term and lending long term is the main problem here. Northern Rock failed because it relied too much on the wholesale markets to fund its mortgage book.

The rules of the Basel Committee of national regulators, which are in the process of being strengthened, require banks to keep minimum Tier 1 capital (essentially shareholders’ funds) equal to 4% of their risk weighted assets (total assets adjusted for riskiness by type of asset). Total capital (including more broadly defined Tier 2 capital) must be at least 8%.

The markets and individual national regulators have imposed more stringent conditions. UK banks had an average Tier 1 ratio of 12% at the end of 2009.

Financial strength metrics

The risks of insolvency and liquidity, and the regulatory regime, point us to the main measures of financial strength. These include:

  • Tier 1 capital (after deducting intangibles) as a percentage of risk weighted assets (tier 1 ratio), and total capital as a percentage of risk weighted assets (capital ratio);
  • Leverage ratio: either expressed as a percentage (equity: total assets) or a multiple (assets: equity). This measures leverage without risk weighting the assets; and
  • Loan: deposit ratio: total loans divided by total deposits. The higher this ratio, the more the bank relies on wholesale funding.

Performance metrics

The nature of banks’ activities also leads to distinctive performance measures. Some common measures are:

  • Return on equity: as described above, this is a fundamental driver of a bank’s value;
  • Net interest margin: interest earned minus interest paid as a percentage of interest-earning assets. This is the “gross margin” of the lending business; and
  • Cost: income ratio: operating costs divided by operating income. This measures the operating efficiency of the bank.

Banks are such an important sector of the economy that, like them or loathe them, it is useful to understand them.

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