How to Value a Bank
Singapore’s place in modern history is one of the important financial centres of the world, alongside London, and New York. To be sure, there are a clutch of Asian contenders, such as Tokyo, Hong Kong, and more recently, Shanghai and Shenzhen. But all these other Asian financial centres serve a more specialised function. For example, they serve the domestic Japanese or Chinese market, act as a gateway to China, etc. Singapore remains a leading global financial centre in Asia, especially for offshore financing. As a result, commercial banks also dominate the Singapore stock market, in terms of market capitalization, as well as influence on the overall economy. An investor is not likely to miss having Singapore bank shares in his/her investment portfolio. And this, naturally brings us to the question of: how do we value a bank?
The most straightforward way of bank valuation: Price-to-Book
As we usually look at a commercial bank as a complex business spanning loans, deposits, investments, trading, payments amongst other businesses, it therefore comes as a surprise that the most reliable valuation metric for valuing a bank and bank shares is the Price-to-Book ratio (P/B ratio). And to simplify it even further, most bank shares will trade around a PB ratio of 1X. Here’s a chart of the historical P/B of the Singapore banks.
Price-to-Book ratio of Singapore Banks
Leaving aside the heights of optimism, and depths of despair from the Global Financial Crisis (and also currently in the Covid-19 crisis), Singapore banks have traded around a P/B ratio of 1.1X for much of the last decade.
Why does such a simple valuation metric work for banks? For a start, most of the assets which account for the book value of a bank are loans. Or financial assets to be exact. Due to the strict accounting and regulatory rules around how to recognize the impairment of such assets, for example, when a borrower misses payments, even if these financial assets are not marked-to-market, they will not stray very far from their book values. And when there is impairment of a financial asset, the bank needs to make provisions against future losses. This, in turn, reduces the book value of the assets. Hence, this is unlike the treatment of fixed assets in other businesses, where there is a large amount of management discretion in judging the impairment of an asset.
And regardless of the sophistication of a bank is in trading and other businesses, fundamentally, a bond trade or a derivative trade is a contract whereby the other party promises to pay a certain amount at the end. So it is very much like a plain vanilla loan. Hence, banks, for all their complexities, are very much a bunch of loans, subject to strict accounting and regulatory rules.
What about other valuation metrics?
Investors usually have a lot more financial metrics to use for valuation of companies and shares, such as Price-to-Earnings (P/E), Return on Equity (ROE), discounted cashflow and the like. Do they not work on banks as well?
Well, most banks make loans in a competitive environment, so a discounted cashflow analysis of the loans will probably tell you that the loans net of provisions are worth … wait for it … book value! The predictability of the loan interest and principal repayments also mean that P/E analysis will not give many surprises. And finally, there has been a lot of regulatory standardization recently of the amount of equity a bank needs to hold, driving banking businesses to high single digit ROEs for most part. Hence, this metric will not be effective in distinguishing between banks.
What else can we look at to value a bank?
At this point, you might rightly ask: Is that all there is about how to value a bank? Surely there are other factors, which determine why a bank may trade at 1.1X book value, and another at 0.9X book value? Well, there are. For example, there are concerns about the Net Interest Margin, and how it may be permanently lower due to Covid-19. Others have pointed to increasing loan loss provisions, which will reduce profitability. And there is the share of non-interest income, usually a sign of how resilient a bank’s earnings are. Let’s look at a few of these and how they affect a bank.
1. Net Interest Margin
The Net Interest Margin (NIM) of a bank is the Interest Income minus the Interest Expense, divided by Interest Earning Assets. Banks earn interest income from making loans and this is usually the main source of income . As a result, a fall in the NIM means that income will be lesser. Singapore banks have had NIMs in the range of 1.60% to 1.90% over the past decade, so the fall in NIMs due to Covid-19 below the lower end of that range could spell trouble for the banks.
Now, the low NIMs have been associated with the fall in the interest rates in Singapore. This actually sounds illogical in theory, because most loans in Singapore are pegged to floating interest rates, and hence there is nothing to stop a bank from charging a spread of 2% above SIBOR instead of the 1% or so now. Except for the competition between banks. And because it seems optically and practically easier to charge customers 2% above SIBOR when SIBOR is at 2%, rather than when SIBOR is at 0.5%, even if the operational and credit costs of the loan are exactly the same in both cases. Go figure.
But that is not the whole story. After all, banks in Malaysia enjoy NIMs of between 2.50% to 3.00%. Banks in Thailand have NIMs of 3.50% to 4.00%, and the NIMs of Indonesian banks are even higher. And yet, their valuations are around the same level of book value (or even lower) than the Singapore banks! And the truth about lower NIMs is that, we have been there before!
Singapore Banks’ NIMs
Those with sharp eyes can see that NIMs for Singapore banks fell below 1.60% back in 2013. And yet the P/B of Singapore banks maintained at 1.1X book value for the next couple of years. That’s because the lower NIMs were more than compensated for by high loan growth. That is what we look at next.
2. Loan Growth
High NIMs are not necessarily better if loan growth is low. And loan growth in Singapore tends to outstrip that in the neighbouring countries, because Singapore is a booking centre for offshore loans in ASEAN.
Singapore System Loan Growth (DBU + ACU)
In fact, loan growth in Singapore averages 2X the growth in nominal GDP, a far higher ratio than our neighbors’ (usually 1.0X to 1.5X). As a result, even with lower NIMs, Singapore banks can out-earn their foreign counterparts due to loan growth. What happens when GDP growth is negative? As we can see in 2009 and 2016, when the economy tanks, loan growth does not go into reverse by the same extent. This is what has happened so far this year, with the Singapore banks maintaining loan growth at around 0% despite the plunge in economic growth, which means that earnings can still be maintained.
3. Provisions for bad loans
The quest for loan growth does not mean growth at all costs. Bad loans will need to be provisioned for or written off, ultimately hurting earnings (provisions are a cost) and book value (provisions reduce net assets). Hence, the provisions a bank makes (as a percentage of total loans) is something to look out for.
Singapore Banks’ Provisions
Since 2018, provisions for potential loan losses have been governed by a new set of accounting regulations. There is less leeway now for a bank to under-provision for bad loans. So far, the 3 major banks in Singapore foresee provisioning up to 1.30% of loans over the next 2 years to cover the potential losses from Covid-19. This means that they are actually well positioned for withstanding such losses, since this figure (on an annual basis) is lower than the provisions back in 2009.
Note that provisions can be either specific provisions (for losses already incurred), or general provisions (for potential losses). So, if Bank A and Bank B both forecast the same losses in the future, and make the same provisions, but Bank B puts more into specific provisions, we can conclude that Bank B is in worse shape than Bank A. Because Bank B has not yet fully provisioned for its old losses. Also, if the economy recovers and loan losses are lower than forecast, general provisions can be written back into earnings, but specific provisions cannot.
Singapore Banks’ Non-Performing Loans (NPLs)
Non-Performing Loans (NPLs) is a popular way of assessing the loan losses and risk of a bank. However, that figure nowadays is so carefully managed that it is next to useless. Incidentally, the higher risk of loan losses of the banks in our neighboring countries (something you cannot really tell from their reported NPLs) also explains why their valuations are not higher than Singapore banks, despite having higher NIMs.
4. Cost-to-Income ratio
Other factors to consider in how to value a bank include the Cost-to-Income ratio. This is a measure of how much operating expenses are. In general, most banks have a cost-to-income ratio of between 40% to 50%, so there is not much to distinguish between them, except for the ones with poorer cost control. There are a rare few, however, with cost-to-income ratios of 35% (such as Public Bank in Malaysia). Banks which are heavily into Investment Banking, or Private Banking, tend to have higher cost-to-income ratios, which is also why such banks make more money for their employees than for their shareholders!
5. Non-Interest Income
Another factor used in assessing banks is the share of income which comes from fees, or the non-interest income portion of total revenue. Interest income comes along with high bank capital requirements, and hence lower ROEs, whereas non-interest income is asset-lite and capital-lite. Unfortunately, this works better in theory than in practice, because many of the fees banks earn depend on making loans (e.g. late fees, loan fees). Which is just calling interest income by another name.
Other non-loan related fees such as trading income, investment banks or private banking tend to be cyclical in nature, more in good times, and less in bad times, and so the quality of such earnings is not high. Moreover, these revenues are also associated with very high operational costs. For example, the cost-to-income ratio in Investment Banking and Private Banking can be 80% or more!
Perhaps the safest form of fee income is for payments. The trouble with this is of course that it is very little. Which is probably why banks have usually left it for the fintechs to make inroads into payments first, since they would only cannibalize their own more lucrative credit card payment networks if they moved first. Sales of investment products to retail customers also rate highly for the volume and stability of fee income. After all, who would turn down the sweet young financial consultant or teller who offers to put your fixed deposits into something sexier?
6. Return on Assets and Return on Equity
Earlier, we noted that Return on Equity (ROE) is largely ineffective for valuing bank shares, because of the strict bank capital requirements, which makes almost all commercial banks have an ROE in the high single digit percentages, or low double digits. This is very different from just 10 years ago, when laxer bank regulations allowed two similar banks to have ROEs which ranged from high single digits to 20+%, due to the magic of classifying loans as being less risky, and financial engineering of what constituted bank capital. But those days are long gone now, thankfully, making banks safer than they were a decade back.
In contrast, the Return on Assets (ROA) is more useful in understanding how hard a bank is making their assets work for them. Banks normally have ROAs in the range of 0.5% to 1%. Well run banks focused on retail customers may even achieve sustainable ROAs of 1% to 1.5%. But anything higher than that is either unsustainable in the longer term, or the result of too much financial engineering.
7. Geographic spread and industrial reach
Finally, we cannot run away from the various markets and segments the banks are in to make an honest assessment of their valuation. At the end of the day, banking in good ol’ developed Singapore is a lot safer than venturing out into the wild, wild west of the other developing Asian countries. Banks with operations in China have seen it go from earning next to nothing to making major contributions to the bottom line. Those with Indian and Indonesian operations have seen these once major contributors dwindle to zero.
The same goes for industrial sectors. Offshore and Marine was the major deal driver ten years ago, but is now an albatross around the banks’ necks. Real estate and mortgages have always been safe in Singapore, as there is a vested interest not to allow house prices to fall, given the high degree of home ownership. But the decline in real estate prices in once hot markets like China, Malaysia, Thailand have changed fortunes for banks there quite quickly.
How is the outlook for Banks now?
So, what does knowing how to value a bank mean for Singapore banks right now? Back in March 2020, at the depths of the market downturn, the shares of Singapore banks traded at P/B ratios of between 0.7X to 0.8X book value. Now, they have recovered somewhat to levels which are still low by historically standards, between 0.8X to 1.0X book value. So this means that there is potential for the bank share prices to go up by another 10% to 20% as they recover to the long term average P/B ratio.
Of course this would be conditional on loan growth recovering as well. So far, the sizes of the bank loan books has only declined slightly since January 2020, and have not gone down in tandem with the negative economic growth. This is thanks to the moratorium on interest and principal repayments. These moratoriums help to stave off loan default losses, when the borrowers are low on liquidity to repay the loans. Hopefully, when the economy recovers, they will be able to meet the payments in full. If loan growth picks up upon the economic rebound, then the book values of the banks could rise by another 10% or so over the next year, so there can be another 10% upside in the share prices.
All in, there is a potential upside of 20% to 30% in bank share prices in the best case. There are still pitfalls of course, for example, that provisions will end up being higher than expected. Or because some of the current provisions are actually going towards writing off old bad loans. Or because of large exposures to customers in our neighbouring economies which might be faring worse than us (e.g. OCBC and UOB in Malaysia).
But what may be really interesting are banks beyond our shores. For example, HSBC is trading at a low of 0.5X book value. Clearly this valuation is far lower than can be justified by the non-payment of dividends. The bank has enough money, and wants to pay out dividends to avoid having too much capital and hence lower a ROE. It is just that the Bank of England does not allow them to pay these profits out as dividends to increase bank capital.
Nor can it be justified by the potential loan losses as a result of Covid-19. Even during the Great Depression, loan losses in US banks averaged 10% of all assets, a figure lower than the implied destruction of half of HSBC’s book value. Maybe these two factors, plus the branding of HSBC as an “unreliable” foreign company can justify this loss in value, but it could also be an opportunity for investors.
PS: We were caught off-guard by how quickly the valuations of bank stocks have recovered from October 2020 (when this was posted) and December 2020. So what happens next? Read about it here!