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.
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