Bank stocks in Singapore are getting cheaper by the day.
As you can see in the chart immediately below, the pair of Oversea-Chinese Banking Corp Limited (SGX: O39) and United Overseas Bank Ltd (SGX: U11) are carrying price-to-book (PB) ratios that are at multi-year lows at the moment. Meanwhile, DBS Group Holdings Ltd (SGX: D05) is valued at a multiple to book value that was last seen only in August 2014.
Source: S&P Capital IQ
The PB ratio is a commonly used metric to analyse how expensive or cheap a bank stock is. With the PB ratio of the three banks being low today, they can be potential opportunities for bargain hunters who are betting on a reversion to the mean.
Mean reversion’s deftly explained by investor Dean Williams as the simple idea that “something usually happens to keep both good news and bad news from going on forever.” In a more investing-specific context, it can be seen in how below-average (above-average) valuations result in good (bad) outcomes.
But, what is that “something” that may help push the banks’ valuations higher in the future? To answer that, we first have to understand why Singapore’s banks are getting cheaper.
Turns out, a bank’s PB ratio is roughly guided by its returns on equity. Generally speaking, the better a bank’s ability to generate a return on its shareholder’s equity, the higher the PB ratio it can command.
This relationship is aptly demonstrated by the following chart from my U.S. colleague, John Maxfield, which compares the PB ratios and returns on equities for 10 big banks in the U.S. such as Bank of America and Warren Buffett favourite Wells Fargo.
Source: John Maxfield, Fool.com
In the case of Singapore’s banks, the chart just below shows how their returns on equity have been steadily declining over their past 10 quarters. Now, you can see just why our local banks have been getting cheaper!
Source: S&P Capital IQ
Given what we’ve seen above, anyone who thinks the local banks are a bargain as a result of their low PB ratios will also have to consider the banks’ ability to pull up their returns on equity in the future.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.