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How Buffett Values Banks

The Straits Times Index (SGX: ^STI) is a widely followed stock market index in Singapore and many investors use it as a proxy for the local stock market. But with banks dominating the index with a 28% weightage, it is worth taking a closer look at what determines market value for a bank.

For that, we can turn to Warren Buffett, Chairman and CEO of conglomerate holding company, Berkshire Hathaway. Berkshire Hathaway owns 8.9% of the US bank, Wells Fargo, and it will likely become one of American investment bank Goldman SachsTop 10 shareholders come October this year. So, when Buffett talks about valuing a bank, it pays to sit up and take notice.

During a recent interview on CNBC, Buffett mentioned that, ‘a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it’s earning 0.6% or 0.5% on asset it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks.”

In other words, investors should pay more attention to a bank’s return on assets. According to Buffett, banks that can achieve a high return on asset should deserve a better premium over their tangible book value. Is that true for our local banks though?

Let’s take a look at 2 local banks; DBS (SGX: D05) and UOB (SGX: U11).

Bank ROA (last 12 months) TBV per share** Share Price Price to TBV
DBS (SGX: D05) 1.1% $10.99 $15.60 1.42
United Overseas Bank (SGX: U11) 1.18% $11.91 $20.51 1.72
**Data Source: Banks’ latest annual report

 

DBS, with its lower return on asset, trades at a smaller premium to tangible book value as compared to UOB. While it seems that Buffett’s general rule of thumb with regard to bank valuations does carry some weight, there are other important considerations.

For one, local banks are a lot more conservative than their western counterparts. This is evidenced by how the three local banking stalwarts, DBS, UOB and Overseas Chinese Banking Corporation (SGX: O39) managed to escape relatively unscathed even while their western counterparts were struggling to stay afloat. That sort of conservatism and stability might also result in the market willing to pay a higher price on local banks’ tangible book value.

Valuation of stocks has been said to be more of an art than science. Buffett’s rule-of-thumb generalisation with regard to valuing banking stocks is very useful for investors, but it should not be their only consideration.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.