One of the easiest ways to spot a seemingly cheap bank stock is to look at its price-to-book value (P/BV) ratio. The lower the ratio, the cheaper the stock may appear relative to its equity.
For example, a bank that is trading at 0.5 times book value means investors are paying only 50 centavos for every peso of shareholders’ equity. Compared with another bank trading at one times book value, the first bank may appear to offer better value.
But a low P/BV does not necessarily mean that a bank is undervalued. Two banks can trade at similar discounts to book value even though their profitability and future prospects are different.
So how can we know whether a bank’s low P/BV actually represents an attractive valuation?
Research has shown that bank valuations are closely related to profitability. In a study of 72 banks across 14 countries, Bank for International Settlements economists Bilyana Bogdanova, Ingo Fender and Elod Takáts found that return on equity (ROE) was among the important factors that explained bank P/BV ratios.
Another BIS study by John Caparusso, Ulf Lewrick and Nikola Tarashev found that P/BV ratios of major global banks increased with analysts’ forecasts of future ROE. This suggests that investors do not simply value the equity accumulated on a bank’s balance sheet, but also consider how profitably that equity can be used in the future.
One way to understand this relationship is through the justified P/BV model, expressed as P/BV = (ROE – g) / (r – g), where ROE represents the return generated from shareholders’ equity; ‘g’ represents long-term growth and ‘r’ represents the return investors require for taking risk.
Since we already know the P/BV that investors are paying, we can rearrange the model to estimate the ROE consistent with the current valuation: implied ROE = g + P/BV × (r – g).
Current ROE shows how much the bank is earning today, while implied ROE shows the level of long-term profitability that investors are pricing into the stock.
If current ROE is higher than implied ROE, the stock may be potentially undervalued because the bank is generating higher profitability than what investors are pricing in. If current ROE is lower, the stock may be potentially overvalued because investors are already pricing in an improvement in profitability.
For example, China Bank generates an ROE of about 15.4 percent, while its P/BV implies a long-term ROE of only about 6.8 percent. Since the bank is already generating an ROE well above its implied level, the stock may be potentially undervalued if it can sustain much of its current profitability.
Bank of the Philippine Islands (BPI) shows the opposite. Its current ROE of about 14 percent is below its implied ROE of about 15.6 percent. This means investors are pricing in higher future profitability. If BPI cannot increase its ROE toward the implied level, the stock may be potentially overvalued.
Now, we can apply this model to 14 banks listed on the Philippine Stock Exchange. We estimated the required return for each bank based on its market risk and assumed a long-term growth rate of 7 percent.
Based on the results, the median current ROE was about 10.4 percent, compared with a median implied ROE of only 7.9 percent based on a median P/BV of about 0.42 times.
This suggests that the banking sector may be potentially undervalued. Banks are currently generating higher returns than the level of long-term profitability reflected in their market valuations. If they can sustain ROEs above their implied levels, their current valuations may be too conservative.
Among individual banks, six appeared potentially undervalued. These were China Bank, Asia United Bank (AUB), Bank of Commerce, EastWest Bank, Philippine National Bank and Metrobank. China Bank had the largest gap, followed by AUB, whose current ROE of 18.5 percent was well above its implied ROE of 11.1 percent.
On the other hand, five banks appeared potentially overvalued. These were Philippine Savings Bank, BPI, Rizal Commercial Banking Corp. (RCBC), UnionBank and Security Bank. Their implied ROEs were higher than their current ROEs, which means investors are already pricing in higher future profitability.
These banks will need to prove that they can generate higher profitability in the future to justify their current valuations.
The remaining three banks, BDO Unibank, Philippine Business Bank and Philippine Bank of Communications, had relatively small differences between their current and implied ROEs, which suggests that they are closer to fair value under the model.
Our model also shows why the bank with the lowest P/BV is not necessarily the cheapest. RCBC, for example, traded at only about 0.37 times book value, but its current ROE of 6.2 percent was below its implied ROE of about 7.6 percent. Despite its large discount to book value, RCBC appears potentially overvalued under the model.
So, this comparison shows why P/BV alone is not enough. Banks that sustain ROEs above their implied levels may offer potential value, while those with higher implied ROEs will need stronger profitability to justify their valuations.