A quick scan of the markets nowadays shows that many banks are selling for below their net tangible assets. For a value investor such as me, this is usually a great sign that an investment is undervalued. If a company has net assets above its market value then it can simply liquidate and return cash to shareholders, giving an instant return. However banks are different, a bank can’t just liquidate assets and return money to shareholders. They are prevented by regulations.
I first started considering this when I read a post on Wexboy about European Islamic Investment Bank (EIIB). Now this is not your usual bank, they are scaling down their banking operations and turning the company into an asset management company. This is great for shareholders as it is focusing on a high growth business which should provide profits (as opposed to the losses it currently makes) in the long term. But after reading its Annual Report I just can’t get excited about this investment. EIIB sells at a large discount to its tangible book value, however it still has a banking licence, and is subject to capital requirements which are becoming increasingly stricter over time. About half its book value is restricted regulatory capital so as a shareholder you can pretty much write that off in my opinion. You will never get your hands on it.
I feel the same way about every bank, what use are net tangible assets if you as a shareholder will never get your hands on it? Imagine a simplified investment which consisted of a locked box with £100. Lets consider this is a magic box and spits out £1 per year whilst retaining the initial £100, but the box can never be opened. Would you really pay £100 to own this box? Personally I wouldn’t. I’d pay maybe £10, and get a 10% yield on that into perpetuity.
It’s for that reason that I value banks only for their earnings stream to the shareholders. If a bank can create returns on equity in excess of 10%, whilst having reasonable risk and leverage, than I’ll pay book value for them, but most banks are far from those kind of returns on equity nowadays. Warren Buffett once referred to a book about valuing investments, called The Theory of Investment Value by John Burr Williams. In it he puts forward a method for calculating the value of an investment. For equities, he says it is the discounted dividends you will receive as a shareholder. It is a variation of the discounted cash flow model, and it is the earliest work I have seen which gives explicit formulas for calculating it so I always remember it. And I think this is the most sensible method of valuing banking stocks personally. I’d rather buy a cash flow, than cash in a locked box and that’s why I much prefer investments like Kentz to banks.
Disclosure: EIIB no position, Long Kentz