With a ban on shorting most financial stocks are there any buying opportunities? Should investors be buying banking shares and spread betting on banking stocks to increase in value?
Two ways of looking at banking share fundamentals are from a price to earnings (P/E) and price to book (P/B) ratio perspective.
For the sake of brevity this analysis does not observe other fundamental data such as cost to income, advances to deposits and liquidity ratios and does not consider holdings of mortgage backed securities.
The P/E multiple compares a bank’s share price with its latest annual earnings per share. A high ratio may mean that a company is overvalued or could reflect investors’ willingness to pay a premium on every unit of earnings, whereas a low P/E may indicate that a company is relatively undervalued. However, a low P/E does not necessarily mean that a stock is a good buying opportunity; it may in some circumstances suggest that a company is close to bankruptcy. In the case for banks, low P/E’s reflect the reduced earnings prospects originating from further writedowns and credits losses.
The P/B multiple compares a company’s share price with its book value of equity, also referred to as ‘shareholders funds’ (total assets less total liabilities). A high P/B ratio may mean that a company is overvalued or that investors are willing to pay a premium over a company’s ‘accounting book value’. Unlike the P/E (which reflects a company’s ability to generate profits), the P/B multiple reflects a company’s ability to grow its net asset base and generate higher returns on equity.
A P/B ratio below 1 indicates that the market believes that a company is not worth the value of its net assets (as is the case with most banks). Banks are predominantly trading at low P/B multiples because investors are concerned with the quality of their loan books. The current sub-prime crisis and slowdown in the real estate market have exposed banks to rising bad debts. Banks also hold structured securities, which are extremely complex to value (hence they are classed as off-balance sheet items) and carry an element of leverage. Because of the leverage, small adverse movements (depending on exposure levels) could result in huge chunks of a bank’s book value being eroded and could even cause collapse. Investors are aware of these potential dangers and this is the reason why most banks are trading at significant discounts to their book value.
Banks are currently struggling due to turbulent economic conditions, but how does their current value compare to that of the previous downturn six years ago? Should we be buying into the sector?
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Anthony Grech, Analyst, IG Index, said in his 2008 FTSE Banking Report that:
“Looking at the lowest P/E and P/B ratios of the previous banking sector downturn which occurred between 2000-2002…most of the FTSE 100 listed banks are already trading at lower P/E and P/B multiples.
“The fact that most of the banks in my report are trading below comparable 2000-2002 P/E and P/B multiples shows an absence of fundamental support levels.
“Therefore, an absence of a fundamental support and the likelihood of increased systematic and unsystematic risks occurring as a result of a more pronounced downturn in the UK real estate market, leads me to believe that the sector has not reached a bottom yet.”
The above comments do not constitute investment advice and neither IG Index nor Clean Financial accept any responsibility for any use that may be made of them.
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Risk Warning: Financial Spread Trading and CFDs carry a high level of risk to your capital. You may lose more than your initial investment. They may not be suitable for all investors. Only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved and seek independent financial advice where necessary.
Article provided / approved by IG Index which is authorised and regulated by the Financial Services Authority (FSA), FSA Register number 114059.
'Spread Bets and Banking Valuations' edited by DB, updated 07-Oct-08
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Risk Warning:
Please note that spread betting and CFD trading carry a high level of risk to your capital. You can lose more than your initial deposit. These products may not be suitable for all investors. Only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved and seek independent financial advice where necessary.
* Tax law is subject to change or may differ if you pay tax in a jurisdiction other than the UK.
