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Why Can It Be Difficult To Value A Bank Stock?

Our local stock market in Singapore’s home to three large banks: DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Ltd (SGX: O39), and United Overseas Bank Ltd (SGX: U11).

They’re not only some of the largest banks in the Southeast Asia region (DBS happens to be the largest bank in said region), they’re also particularly important to Singapore’s financial markets. As just one example of how much weight they carry, DBS, OCBC, and UOB collectively accounted for 33.75% of Singapore’s 30-stock market barometer, the Straits Times Index (SGX: ^STI), as of 30 June 2015.

Given their significance, it might be worthwhile for investors to at least have a brief idea on how banks are commonly valued and the flaws of the method.

A peek at the book

One of the most relevant tools to value a bank stock is the price-to-book value (PB) ratio. The book value of a bank (or any company for the matter) is also known as shareholder’s equity and it is obtained by subtracting the bank’s total liabilities from its total assets. To get to the PB ratio, we can then divide a bank’s market capitalisation by its book value.

The use of the PB ratio as a measure of value is generally suitable for asset-heavy companies and banks do fall under that category. But, investors need to bear in mind that as relevant as the PB ratio can be, it is far from perfect. In fact, there are some serious limitations in the PB ratio when using it to value a bank.

A true test

The main issue with the PB ratio is that investors often use the reported value of a bank’s total assets. A bank’s assets are mainly financial assets (unlike that of say a car manufacturer, where factories and equipment may make up the bulk of total assets) and they may not be as liquid and easy to value as one might imagine.

When we look at the finer details of a bank’s financial assets, it’s often the case that these assets consist largely of loans that the bank has given to individuals and organisations.

Some loans, including mortgages, are long term (up to 30 years) in nature and this makes their true value harder to estimate – how confident can the bank be that the loans it has made to Individual A or Organisation B can be repaid fully? As such, the bank has to make assumptions on its part about the quantum of loans in its loan-portfolio that will result in losses.

This then means that the bank’s assumptions on the nature of its assets (how much of my loans will go kaput?) will have a big impact on the actual book value of said bank.

If a bank is very aggressive in its assumptions and thinks that its loans are of great quality when in actual fact they’re not, its book value might be wildly inflated. In such a scenario, what looks like a bargain bank stock to an unsuspecting investor may turn out to be a painful lesson when the risks eventually come home to roost and the bank realises that it has suffered large losses on its loans.

The assumption-driven nature in valuing a bank’s assets also creates a problem when investors are comparing PB ratios between different banks. As most banks will have different assumptions and accounting methods when it comes to valuing their loans and other financial assets, it’s good to bear in mind that a comparison of PB ratios between different banks may at times not be an apples-to-apples view at all.

Foolish Summary

It is a common notion that the PB ratio is one of the most appropriate methods of valuing a bank stock. But, as the book value of each bank may differ greatly from one another due to diverse accounting assumptions, investors need to understand the limitations of the PB ratio and not use it blindly.

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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 writer Stanley Lim doesn’t own shares in any companies mentioned.