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Two Key Numbers to Understand Banks

In Singapore, the banking industry plays a vital role in our economy. Think of it as a funnel by which funds can be channelled from savers and investors into other people, projects, organisations, and companies that require capital to build a better tomorrow.

In addition, the local banks, comprising of DBS Group Holdings (SGX: D05),  Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank  (SGX: U11), have a giant presence in our stock market.

For instance, the three banks combined, make up almost one-third of the market-capitalisation-weighted Straits Times Index (SGX: ^STI) due to their giant market values that range from S$33b to S$42b.

Because of the banks’ importance to investors, who inadvertently wind up with large chunks of the financial institutions even if they’re invested in a simple index tracker like the Nikko AM Singapore STI ETF (SGX: G3B) or SPDR Straits Times Index ETF (SGX: ES3), it might be worthwhile to take a closer look at them from an investor’s point of view.

But, there’s some difficulty there. David Kuo, my colleague here at The Motley Fool Singapore, recently wrote: “In many ways a bank is not dissimilar to a mysterious black box. Money goes in one end and (hopefully) money comes out the other. But what goes on inside the box can be almost unfathomable.”

I think that tends to be true as well; banks can be really complicated beasts. That said, there are certain key metrics that you can still focus on to gain a better investor’s perspective on banks.

Here are a couple:

1. Price to Tangible Book Value

My American colleague, Patrick Morris, calls tangible book valuethe essential valuation metric for banks.” Just like the more ubiquitous Price to Earnings ratio, the higher the PTBV ratio is, the more expensive a bank is.

The book value of any company, including a bank, is calculated by subtracting all its liabilities from its assets. With a bank, we’ll like to go one step further and take away all the intangibles – assets that are not represented by real capital that accrue to common shareholders.

Mathematically, it’s represented as:

TBV = Total Equity – Minority Interests – Goodwill & Intangibles – Preferred Equity

Here’s how the current PTBVs for the three local banks compare against their own historical averages  going back to the start of 2003:

Bank Current PTBV Average PTBV since start of 2003
DBS 1.50 1.93
OCBC 1.70 1.70
UOB 1.70 2.05

Source: S&P Capital IQ

Based on the table above, it seems that investors have been less enamoured lately in paying up for the assets of the banking trio as compared to the past.

2. Return on Asset

This metric measures how profitably a bank manages its assets. It ties in intimately to the PTBV ratio as the ROA of a bank gives us a gauge on how much premium the market would likely place upon a bank’s assets.

Here’s what American billionaire investor Warren Buffett – a keen investor in American banks – has to say on the topic:

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.”

This is how the local banks’ ROAs stack up against each other:

Bank Last 12 months’ Return on Asset
DBS 1.08%
OCBC 1.14%
UOB 0.96%

Source: S&P Capital IQ

Using Buffett’s rule of thumb, it seems that the premium over tangible book value that the market has placed on the three banks is still within reasonable boundaries.

A more meaningful comparison could also be made by comparing the trio’s current ROAs with what it has earned in the past.

Bank Last 12 months’ ROA Average ROA from 2003 to 2012
DBS 1.08% 1.06%
OCBC 1.14% 1.22%
UOB 0.96% 1.21%

Source: S&P Capital IQ

We can see that DBS is the only bank to have managed to make better use of its assets by bumping up its ROA slightly. With a dip in the profitability-metric, there seems to be some logic behind the market awarding a lower PTBV for OCBC and UOB.

But, why is it that investors were willing to pay a higher price of each dollar of tangible book value for DBS in the past as compared to now?

There can be two possible reasons. One, size matters. DBS’ total assets has grown from S$160b in 2003 to S$401b today. The bigger a bank becomes the tougher it is to grow. So, the lower PTBV awarded by the market could be a reflection of lesser enthusiasm for the bank in terms of future growth.

Two, the market might well have overpriced DBS’ shares in the past such that a lower PTBV is more reflective of its economic realities. Thing is, that’s a tough question to answer, and I wouldn’t pretend to know otherwise.

Foolish Bottom Line

So there you go, two metrics that can provide you with a better perspective on banks from an investor’s point of view. Do note, however, that this is just the beginning. Any investment in a bank would likely require a much deeper dive.

And in any case, investing is more art than science – there are no secret formulas or magic numbers that can point to instant success. There’s much more to do.

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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.