Having confusion in using valuation ratios for financial institutions? Here's how you can connect the dots between ratios for investment decision

When there are lots of ticker symbols to choose from while investing, investors tend to adopt the habit of asking for a tip from the experienced investor as to which company will be the next hot stock which itself is not bad. That is because choosing from all those options comes at a cost for new investors. They have to sacrifice their precious time and energy into selecting the stock. But the sad part is, the investor still lags the analytical skill even after getting a tip which makes them their own greatest enemy in the stock market.

In terms of the Nepalese stock market, more than 250 companies are being traded currently, and Financial institutions make up about 80% of the total market. There are Commercial Banks, Development Banks, Finance, and Microfinance companies to choose from. So, today we will focus on one of the valuation metrics which will allow investors to shortlist the cheap stocks in less time.

It is without a doubt that financial institutions are relatively confusing and challenging to value even for skilled analysts. That is because, financial institutions unlike any other business have different business models i.e., collecting the deposit from its customers and lending out the money to their borrowers. But it doesn’t mean that it is not easy. Warren Buffet in one of his shareholder's meetings said that we should value banks like we value any other stock. So, from all the metrics that we use to value other stocks which metric can we use to value banks? The answer is the Price to Book Ratio. But here’s the catch, Price to Book should always be compared to what the company is earning on its book which is measured by Return on Equity (ROE). This is because, when we are using the P/B ratio, we are paying in relation to its book and it is important for the bank to increase the return overtime for the shareholders.

Formula to Calculate the two metrics:

A basic rule of thumb is, P/B lower than 1 is considered undervalued from a Price to Book perspective. Higher than 1 indicates that the company is trading above its book signifying the company price might be relatively overpriced, again from a P/B perspective only.

So, let's dive directly into the numbers reported by the commercial banks in the first quarter and see which company might be a bargain.

Note: To calculate the P/B ratio, we took the closing price of Thursday (DEC-03)

For this Study, Sharesansar took the median of P/B ratio and ROE as a benchmark, and those trading below-median P/B but above-median ROE might be considered as low priced and those with above-median P/B and below-median ROE might be considered overpriced.  

When we take a bird’s eye view of all the numbers of the banks, it is quite obvious that those banks which have been trading at a premium in relation to its book have reported higher Return on Equity which is a good thing because they giving good returns for the shareholder's money.

However, when we carefully look into the numbers, some of the companies have also been trading at a premium despite lower Return on Equity. In this case, Nepal Investment Bank (NIB), Nepal SBI Bank Limited (SBI), Everest Bank Limited (EBL), and Himalayan Bank Limited (HBL).

Those with lower median P/B ratio and above-median ROE are Citizens Bank International Limited (CZBIL), Nepal Bangladesh Bank Limited (NBB), Kumari Bank Limited (KBL), and Mega Bank Nepal Limited (MEGA).

Easy, right?

Well, Calculations might show the mispriced stocks but there’s more to it. The company might be assigned a lower valuation because it might deserve it. And here’s why, (a) the company might not have growth potential, (b) the company might be relatively small compared to its peers, (c) maybe the investors are not satisfied with the management. There can be various reasons, and those reasons can also be applied to those companies which have higher P/B ratios. And this is why investors have to make themselves clear as to why the stocks are mispriced. 

Investors should focus on the trend of ROE and P/B ratio because it will give a clear indication as to how the price has behaved in terms of ROE over the years.

(Disclaimer: Do not take this as investment advice. This article is prepared to give a clear view of how to use the valuation metric with other metrics, not to provide the undervalued or overvalued stocks. Investors are requested to do their due diligence before buying any stock to ensure their margin of safety)