Richard X. Bove, vice president of equity research financial sector at Rafferty, highlighted shifts in bank valuation methods. He explained that variables used to evaluate banks have shifted from earnings to tangible book value and most recently to return on equity. Bove also studied the relationship between price to book value and return on equity for banks. The correlation between both variables has become stronger after 2000. Banks considered included universal, regional, trust and Canadian.
Use of return on equity to calculate banks’ excess returns
Aswath Damodaran uses return on equity and compares it to cost of equity for banks. He determines if the bank generates excess returns over the cost of equity and then values such returns. Then, he compares his valuation to bank stock prices and chooses undervalued banks to invest in. When determining excess returns over the cost of equity, Damodaran considers risks banks incur. Banks that face low returns doing traditional banking have ventured into other areas including private equity, trading and investment banking. While these areas offer higher return on equity, the excess return can be offset by the additional risk incurred.
Banks achieving higher return on equity is more challenging
Both Bove and Damodaran point out that increases in regulatory capital requirements reduce return on equity and excess returns for banks. Bove indicates that bank executives have more difficulty in improving return on equity and stock prices than before. Regulators, in Bove’s view, have imposed unrealistic demands on common equity and forced banks to reduce return on assets by increasing requirements to hold “safe” assets including cash and Treasuries. Bankers need to resort to raising prices and increasing loan repayment risk to improve their returns. Another source of returns are segments that are not capital intensive including wealth and asset management and services for businesses. The latter includes managing bank’s short term accounts and employee benefits. Bove believes that banks not focusing on loaning funds at reasonable prices and risk levels increases risk in the financial system over the long term.