Must-know: Understanding the price-to-book value ratio (Part 2 of 6)
Banking explained in layman’s terms
Let’s say you are the owner of your own bank. You accept deposits from your relatives, and then you lend out cash to your friends. The deposits from your relatives are short-term loans and show up on the balance sheet as liabilities (after all, the money is not yours). This may look simple, but you use these deposits to fund your lending activity and that’s how you make money. The loans are assets that drive revenue. So the nature of your bank’s assets and liabilities is very fluid. You need a metric that you can rely on for valuation. It should be a metric which one should be able to apply across different types of financials. It should be applicable to traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), full service banks like JP Morgan (JPM) or any other financial companies included in an ETF like Financial Sel Sect SPDR FD (XLF).
All banks use mark-to-market accounting, unlike non- financials in which there may be wide disparity between book value and actual market value of the assets. So the book value of a bank is likely to be a good indicator of the assets held by a bank. This makes book value a very useful measure. The table above gives price-book value ratios of all industries in the financial sector.
What can you infer from the table above? Firstly, the return on equities from the financial sector is clearly lower than the market as a whole. This is mainly because of the business’ commoditized nature, where there are many players (except reinsurance), leading to lower pricing power. Secondly, there’s a strong correlation between price-book value multiple and return on equity. This makes you think that you need to look at this ratio more closely to understand it better and use it for making investment decisions.
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