Monday, February 05, 2007

Canadian Bank Valuations at New Heights

Investment Executive, Carlyle Dunbar, 5 February 2007

Banks are pushing the upper limits of their long-term profitability ranges. Their valuations have also risen to new heights. And to value-conscious investors, this suggests the risk of investing in banks has now become high.

Canada’s Big Six banks have continued to improve their net income despite dropping net interest margins, a real achievement when short-term interest rates have risen so strongly and steadily.

At the same time, most measurements of financial strength have continued to improve. The Big Six are now in a better position than ever to withstand a storm of loan defaults, even though the multi-layered derivatives market has never really been tested.

The banks’ annual reports have become complex, heavyweight beasts, running to 170 pages or more. Banks have become more diverse and complex operations, and their reporting requirements have grown like jungle vines.

Still, there is no substitute for looking at the basic results of their endeavours — growth, profitability and how the market values them. If these measurements disappoint, then no amount of minute analysis of “risk exposure to cross-border exposure transactions,” “goodwill adjustments” or any other management discussion and analysis item will change the situation.

“Too much of a good thing is wonderful,” actress Mae West was quoted as saying — and she probably had good reason to believe that. But in the business world, too much of a good thing invites trouble. Businesses are cyclical, and banking is no exception — and long runs of great success invite caution on the part of investors.

Profitability is the first result to examine. Return on equity is one measurement that applies to all businesses in all industries. Taking our cue from legendary American financial analyst Benjamin Graham, let us consider bank profitability through averages.

As the accompanying table shows, banks have earned between 14% and 18% on their shareholders’ equity over the long term. (This excludes preferred capital, which is so often mixed in with common share capital.)

However, some individual bank returns for the 2006 fiscal year were exceptionally high, with CIBC’s ROE reaching 27.9%. But such a high result is usually an isolated event.

In 1999, for instance, TD Bank Financial Group earned 34.3% on its equity; the following year, it earned only 8.9%; and two years after that, it saw a loss.

So, the average ROE for the three latest years is a more indicative number for the banks, as it would be for any business. The three-year average ROE is better than the 10-year average ROE.

Bank profit trends do vary. Over the past 10 years, Bank of Montreal and National Bank of Canada have had the best records, with per-share profit gains in nine of those years. Bank of Nova Scotia’s profit increased in eight of the 10 years, Royal Bank of Canada and TD in seven, and CIBC in five.

The gains have not come consecutively, so you cannot be overly confident that a trend of rising earnings will continue in any given year. The probability of earnings rising for six consecutive years is one in 64.

That is the challenge that faces Bank of Montreal, whose earnings have risen for the past five consecutive years. Bank of Nova Scotia’s and National Bank’s earnings have risen for four consecutive years, while the earnings of Royal Bank have risen for two consecutive years.

Valuation is a second basic measurement. For banks, this is fairly easy, because book value — common shareholders’ equity — is an excellent measurement of both value and growth.

This is where a wide variation in long-term results shows. Compound growth rates that are shown in the table above also hearken back to Graham’s methods, measuring the growth in three-year averages of book value at the start and the end of the past 10-year period.

Further, as the table above shows, buyers of bank shares are currently paying high multiples — about 3.4 times book value for Royal Bank, down to 2.4 times for Bank of Montreal and National Bank.

Compared with average price/book value ratios, these are high. The long-term average valuation for bank stocks is about twice book value.

The banks’ strong results in recent years have dampened stock-price volatility. Over the past five years (2002-06), the annual high price of the bank shares has been on average 1.3 times the average low price.

In the five years ended 2002, which was both the peak and downturn of the bull market, price volatility was greater. Annual high prices averaged almost 1.6 times average low prices.

Low price volatility can be viewed as market complacency — the charge that is often made nowadays about the Chicago Board Options Exchange’s volatility index measurement of U.S. stock price volatility.