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How to value Banks properly?

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There’s something very strange I came across while trying to value Banking stocks…

The Return on Assets (ROA) for all the Banks in the S&P 500 seems to be ridiculously low and in the 0% – 1% range over a 10 year average! Even the ROE is very low, <7%, and so are profit margins of EBIT to loans <1%…! Something is SERIOUSLY wrong with traditional valuation metrics because Banking salaries are often the most highly paid on average out of all industries and they are often envied for it!

So how is this even possible with such low profit margins and ROE??? Because I'm pretty sure if this happened in any other industry, such high salaries on non-existent profit margins would not be tolerated by shareholders.

I asked the same question to some people in other investing forums and even they don't seem to have any idea of valuing banking stocks, often choosing to avoid investing in Banks completely because the ridiculously low ROEs in their stock filters automatically disqualify them. I have seen some even claim that a declining "loans to deposits" ratio is a good sign of a profitable bank because they believe if the ratio was too high then there would not be enough deposits to cover non-performing loans…!

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Posted by Incognito 7
Posted on 07/03/2017 6:24 AM
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You can honestly apply this idea to any company. I have never found “value” to be a very reliable factor. I used to run some pretty extensive forensic style accounting on companies when I ran my hedge fund and I never found value to be a good predictor of future returns. Here’s the question you have to resolve when using value:

“Is the asset cheap because it’s shit or is the asset cheap because the market is it shit at valuing it”? The fact that an asset is cheap does not mean it doesn’t deserve to be cheap. There is usually good reason for that asset to be cheap. People sometimes assume that value is a good predictor of future returns, but while that’s true in some eras, it’s been horribly wrong in others (like the last 15 years).

So, I guess my advice here would be to ignore valuation metrics and multiple ratios. They aren’t telling you half the story.

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Cullen Roche Posted by Cullen Roche
Answered on 07/03/2017 12:32 PM
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    Valuation metrics may have their flaws, but my question was why are they particularly poor at valuing Banks? If Banks are supposedly profitable businesses, seems like an awful lot of effort to fight for a 1% profit margin…!

    Also compensation schemes are often correlated with the performance of the firm, so it doesn’t make sense how Banking consistently has high salaries on average compared to firms that are actually profitable with margins of >20%.

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    Posted by Incognito 7
    Answered on 07/03/2017 1:29 PM
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      Banks are strange entities in that their equity is their biggest cost. Retaining capital just for the sake of retaining capital is not really a good thing for a bank. So the key to banking is running a razor thin margin of capital requirements. You have to maintain regulatory requirements, but you don’t want to leave money on the table doing nothing. You have to scratch and claw for 3% net interest margin. So yeah, banking is a shitty business to try to make good risk adjusted returns. But banks are no longer just banks. They are diverse financial firms now. And the main reason why big finanical firms make gobs of money and pay their employees so well is because we have an extremely financialized economy. The financial system is at the heart of everything in the economy. It is the piping in our economic house. But these pipes have become increasingly opaque and difficult to understand. I mean, it’s virtually impossible to properly account for the assets on a big bank’s balance sheet. Half of it is too illiquid to even know the value of! So yea, these are really difficult to understand entities. But they are also crucial economic entities.

      Not sure that answers your question, but it kind of explains where we’re at….

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      Cullen Roche Posted by Cullen Roche
      Answered on 07/03/2017 1:42 PM
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        Companies with low profit margins, like retailers for example, generally pay barely above minimum wage for most of their core jobs that aren’t in management. Your average bank trainee gets paid twice as much than that. Surely there is a valuation metric somewhere which justifies this? Why would investors even invest in Banks if the valuations are terrible to begin with?

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        Posted by Incognito 7
        Answered on 07/03/2017 2:08 PM
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          Why would a bank trainee, who presumably has a graduate degree or at least a college degree, earn the same income as an employee at a retailer? There is a reason why employers pay a premium for people with a college education – they have proven that they are more capably of performing a sustained duty at a high level. Banks require enormous stability in the liabilities of which employees are the main source. High turnover like you see in a retailer would be a nightmare for a bank….

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          Cullen Roche Posted by Cullen Roche
          Answered on 07/03/2017 2:14 PM
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            First of all you need to find and define exactly from what and how the ROE number was calculated for the banks.

            https://www.investopedia.com/terms/r/returnonequity.asp

            A profitable company aims to have a highest return on the money invested by shareholders, but banks are obliged to moderate this particular metric to buffer possible losses.

            If you risk weight the return you may find it is reasonable.

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            Posted by Dinero
            Answered on 07/03/2017 3:19 PM
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              If you look at the H.8 banking report and look at the residuals.

              Assets – liabilities = net worth.

              They’ve fallen to the lowest levels since FEB. Yet , here we are with bank stocks booming ??

              Nothing makes any sense anymore.

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              Posted by Derek Henry
              Answered on 07/03/2017 6:47 PM
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