Published November 19, 2008

Are bank stocks looking cheap?

By CONRAD TAN

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HOW much lower can bank stocks go? That turns out to be surprisingly difficult to answer.

Savvy investors have all but given up on trying to base their buying decisions on traditional measures such as the historical price-earnings ratio.

Wisely too - in the current environment, judging whether to buy a bank by measuring its share price relative to its past profits seems absurd, now that the outlook for earnings is decidedly gloomy as the economy slides into recession.

Looking at the forward price-earnings ratio, which compares a company's stock price with its expected future earnings, seems a better idea, except that the measure is only as reliable as the underlying estimates of future profits. Banks' profits - already hard to forecast correctly when times were good - are exceptionally difficult to predict right now, amid volatile financial markets and rapidly changing economic forecasts.

Similarly, the dividend yield, which measures the return an investor can expect to receive in dividends as a proportion of the current share price, assumes that dividend payouts will continue to be as generous. These are difficult times and banks could well justify cutting future dividends.

Guessing game

So some investors have taken instead to trying to guess how much further the share prices are likely to fall so that they can jump in at the bottom.

For that, the book value per share - a measure of what a company's assets, less its liabilities, are worth on its books - seems a sensible floor, though the stock price may sometimes fall even below this. During the Asian financial crisis, bank shares were at times trading at just over half their estimated book value. Still, the book value seems a reasonable gauge of the fundamental value of a company, below which it may become attractive to predators.

Analysts' estimates show Singapore-listed banks are already trading at around 0.8-1.2 times their book value per share. But here again there is a note of caution. In a recent report, Morgan Stanley analysts Matthew Wilson and Anil Agarwal suggested that even the book value may be overstating the value of banks' assets in the current crisis.

That's because book value also includes goodwill - the excess value recorded separately as an intangible asset when a company pays more than the market price for another firm's assets in an acquisition.

Goodwill on books

As economic growth slows to a crawl and stock markets continue to be pummelled, at least part of that goodwill - usually inflated during good times as companies pay high prices for acquisitions - is likely to be written off, which means that banks' book values, not just their earnings, could shrink further.

By Morgan Stanley's estimates, nine major banks operating in Asia-Pacific have more than a quarter of their book value made up of goodwill. The nine include DBS Group, as well as Standard Chartered Bank, HSBC and Maybank.

OCBC Bank and United Overseas Bank aren't among the nine, but neither are they far behind - goodwill makes up more than a fifth of their book value, according to Morgan Stanley. Other analysts, such as Leng Seng Choon of DMG & Partners Securities, have produced similar estimates for the difference between the Singapore-listed banks' book values and their net tangible assets, which exclude goodwill and other intangibles.

'We see some risk of impairment at year-end and see no fundamental reason why investors should pay a multiple on goodwill at this stage,' said the Morgan Stanley analysts. Quite so.

If they are right, and banks do start to write down the value of goodwill on their books - a move which by accounting rules cannot be reversed later - bank stocks may not look so cheap after all and the floor offered by book value may feel rather hollow.