Bank valuation in US mispriced by strength of fundamentals

21 May 2018 Authored by Consulting.us

The financial crisis hit banks hard, particularly in developed countries. Recovery has been slow, as profitability went on the back-burner in favor of stability. New analysis shows that US banks are relatively profitable; however, concern around valuation is growing as both weak and strong performing banks are garnering high price-to-book ratios.

The global banking system hovered close to a full-scale meltdown during the financial crisis, with a domino effect spawned by a subprime mortgage crisis rippling through the sector. In the years since, regulators have sought to make the system more robust, and less liable to collapse completely if a strategic card were to fall out of place.

European banks have taken longer to recover from the crisis than US banks, though even weakly performing US banks are seeing high price-to-book ratios. For some analysts, this is a major cause for concern.

Components of the banking health check scoring modelLeading strategy consultancy Bain & Company has developed a ’health check’ scoring model, based on publicly available information, which it uses to assess the performance of hundreds of US and European banks. Bain’s evaluation includes insolvency override analysis, profitability and efficiency metrics, and breakdowns of assets and liabilities. The results are published in its recent report: “Are Investors Mispricing US Bank Risks?”

The consulting firm places the 601 banks assessed on a broad scale that runs from ‘at risk’ to ‘winner’. Overall, 141 banks fall into the ‘high concern’ category, exhibiting poor asset and liability scores, as well as weak profitability and efficiency performances. Both US and European banks are marked as ‘high concern,’ including some of the biggest 25 banks in each region. US banks are, however, more likely to fall into the extreme end of the high concern category.

US banks are resilient as their European counterpartsBanks with a weak business model – delivering little in the way of profitability and efficiency while boasting a healthy asset and liability score – are predominantly in Europe, where recovery has been slower and controls tighter. The large group of banks with weak balance sheets but strong business models – which translate to better profitability and efficiency scores – are more likely to be found in the US. 

While US banks tend to perform better in terms of their ability to turn a profit, there are concerns that overvaluation from investors is a problem, while in Europe investors are more modest in their expectations. Price-to-book ratios in 2016 were high in the US, even when asset and liability scores were poor.

Those in the ‘high-concern’ bracket were given a 1.46 price-to-book ratio, compared to 1.32 for those in the weaker business model bracket. To compare, banks in the ‘winners’ category have a price-to-book ratio of 1.70. In Europe the high-concern banks have a price-to-book ratio of just 0.31, substantially lower than banks in the winners category, which record a ratio of 1.31. Banks with weak balance sheets have a 0.72 ratio in Europe.

Investors are giving the least resilient US banks relatively high valuationsEvaluating the data, the authors of the Bain report express concern that investors are “disconnected from the realities of banks’ financial health.” One alarming parallel they cite is the situation before the financial crisis took hold, when investors similarly failed to draw essential distinctions between weak and strong banks while making their valuations. The report calls for a more “integrated view” to help banks identify weak points and work on a plan towards establishing robust health.

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