Bank valuations look unkind, but not irrational

Published Tue, Feb 16 20164:42 PM EST

Breakingviews

George Hay

Banks are either imploding, or they're a screaming buy. Those are two ways to interpret the 22 percent slump in the share prices of European lenders since the start of January. But play around with a few bank valuation metrics, and a third possibility emerges – that markets are being unkind, but not irrational. For investors, a bank must at least earn back its cost of equity, which is around 10 percent. On average, European banks will make a return on equity of 7 percent in 2016, Citi forecasts, creating a 3 percent destruction of value. Extend that out for five years, discount it back at the cost of equity, and the sector would have erased more than a tenth of its book value. Now let's say that after those five years are up, banks can once again meet their cost of equity – just. More from Breakingviews : Jamie Dimon aligns money and mouth So heading into perpetuity, the bank neither destroys nor creates any value for shareholders. The total value of a lender would therefore be its book value, minus the value it eroded in those difficult five years. In this case, they would trade at 0.9 times book – a bit higher than their current valuation of 0.8 times. Some banks are getting rougher treatment. Deutsche Bank , whose shares have fallen by a third since New Year, is currently trading at 0.35 times 2016 book value. Yet even if Deutsche generated a return on equity of just 3.5 percent for five years before eventually returning to its cost of equity, it would be worth twice that valuation. Instead, the current price suggests Deutsche may never exceed a 5 percent return on equity. That's a bit harsh - while Deutsche and many European Union peers have struggled to beat their cost of equity since 2008, it's another thing to say their investors are doomed to economic losses for eternity. Read More Pro Talks: Prof. Aswath Damodaran on valuations Still, a negative view can be justified. The main shift in the last few months is that central bankers have made it clear rates will stay lower for longer, which undermines bank business models. Investment banks like Deutsche have bet the slowdown in fixed income is cyclical. If they are right, bank shares look cheap. But investors can't be blamed for being skeptical. For more independent commentary and analysisfrom Reuters Breakingviews, visit breakingviews.com

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For investors, a bank must at least earn back its cost of equity, which is around 10 percent. On average, European banks will make a return on equity of 7 percent in 2016, Citi forecasts, creating a 3 percent destruction of value. Extend that out for five years, discount it back at the cost of equity, and the sector would have erased more than a tenth of its book value.