How to value dif­fer­ent sec­tors

There are very spe­cific things to con­sider when de­ter­min­ing the value and in­vest­ment po­ten­tial of spe­cific sec­tors. This week, Si­mon Brown looks at the bank­ing sec­tor.

Finweek English Edition - - MARKETPLACE - Editorial@fin­week.co.za *The writer owns shares in Capitec.

dif­fer­entin­dus­tries have nu­ances on how to deter­mine value and if they’re worth in­vest­ing in. This week I want to fo­cus on banks. At the core they’re sim­ple: they take de­posits from clients, lend that money out to other clients at a higher rate and pro­vide bank­ing ac­counts and ser­vices.

But banks have sev­eral dif­fer­ent met­rics we need to con­sider when eval­u­at­ing them. For me, the most im­por­tant of these is the costto-in­come ra­tio. In a way, this is like an op­er­at­ing mar­gin as it’s the per­cent­age profit they make from any in­come. Gen­er­ally, the large banks lo­cally are on a ra­tio of around 55%, and while they all talk of achiev­ing a lower cost-toin­come ra­tio, it is un­likely to get much bet­ter than maybe 52% due to higher costs in the in­dus­try these days. Capitec* is an ex­cep­tion with a cost-to-in­come ra­tio of around 35%, but even this will rise in time as they roll out more tra­di­tional bank­ing prod­ucts. It is likely to set­tle around 45%, thus still giv­ing it a solid profit edge on the competition.

Another im­por­tant num­ber we need to fo­cus on is im­pair­ments – banker speak for bad debts. Be­cause it fo­cuses mostly on smaller un­se­cured loans, Capitec stands out here with the higher ra­tio, but one needs to dig into all the banks. Com­pare the dif­fer­ent di­vi­sions (per­sonal ver­sus cor­po­rate) and con­sider the trends. All banks will have bad debts, but the lev­els and trends will help us un­der­stand the suc­cess of their lend­ing cri­te­ria. Pre­vi­ous com­men­tary could also give us an in­di­ca­tion if they’ve been be­com­ing stricter on their lend­ing cri­te­ria.

Another very use­ful tool that works very well for bank­ing stocks is price-to-book. This is the cur­rent share price ver­sus the net as­set value (NAV) of the bank. Banks sel­dom have a price-to-book of more than 2 times, and a price-to-book at be­low 1,5 times is well worth hav­ing a closer look at. This is an ex­cel­lent and quick val­u­a­tion tool if we com­pare them over the pre­vi­ous few years. I also watch the growth in non-in­ter­est rev­enue. Tra­di­tion­ally banks made money mostly from charg­ing in­ter­est on lend­ing at higher rates than the rates they bor­rowed at, and prof­it­ing from the dif­fer­ence. But these days other non-in­ter­est in­come is the real growth area for them. This in­cludes sim­ple costs such as ac­count fees and penal­ties, but it also in­cludes other ser­vices and prod­ucts they can profit from. This would in­clude in­sur­ance, wind­ing up of es­tates, stock­broking and the like. While they must be care­ful with the fees and penal­ties part of non-in­ter­est in­come, the other prod­ucts and ser­vices cer­tainly of­fer great po­ten­tial for profit growth. Here we need to see what the growth looks like, but also try and get an un­der­stand­ing of what they are suc­ceed­ing at so that we can make an in­formed de­ci­sion on whether or not it’s likely to con­tinue to grow. Cap­i­tal ad­e­quacy and Basel III are ex­tremely im­por­tant, and while many large in­ter­na­tional banks are strug­gling with this, our lo­cal banks are all very cap­i­talised and are not ex­pected to have any is­sue with Basel III when it is fully in­tro­duced in 2019. Lastly, we still use all the old in­vest­ment met­rics such as re­turn on eq­uity (RoE), div­i­dend yield (DY) and price-to-earn­ings ra­tios (P/Es). Banks as a sec­tor typ­i­cally trade at much lower P/E ra­tios than the gen­eral mar­ket, with a high P/E be­ing around 13 and a low P/E be­ing a high sin­gle-digit value. They also of­fer bet­ter DY than other sec­tors, so when we’re com­par­ing we need to com­pare within the sec­tor rather than across sec­tors.

All banks will have bad debts, but the lev­els and trends will help us un­der­stand the suc­cess of their

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