• Slight Upward Target Revisions. We are raising our bank target prices by 7% to reflect our 2007 EPS estimates. Our new lower assumed target forward P/E for the sector at 13.1x correlates to an assumed Canada 10-year bond yield of 4.25% by end of 2006, below our previous 13.4x target multiple which was based on a lower assumed 4.0% bond yield. The group currently trades at 13.6x consensus 2006 EPS (Thomson First Call), in our view, pricing in a 10-year bond yield of 3.9% by early 2007.
• Valuation Full By Historical Standards But Is History Appropriate? Banks are re-testing the bounds of historical P/E ranges in absolute terms. Forward bank P/E’s have risen steadily over the past two decades to now exceed 13x, recently holding at 90% of the market multiple and at a clear 20% premium to comparable U.S. bank stocks. Measured by price/book, Canadian bank stocks are clearly at all-time highs (in part reflecting the 3x book value afforded CIBC during its post-Enron capital rebuild) but also reflecting the sector-wide improvement in return on equity.
• Potential Revaluation Catalysts. Near-term, a number of fundamentals should help maintain solid valuation: (i) improving revenue growth and quality; (ii) tip-top capital levels, and; (iii) benign credit conditions. Long-term, more sustainable factors may argue for even higher valuations, including: (i) a shift in business mix toward wealth products; (ii) rising proportionate fee income, and; (iii) higher ROE related dividend-payout potential. Macro factors are similar to the 1960’s when interest rates were below 6% for a prolonged period and recurring bank P/E’s averaged 13x.
• Risk to Bank Valuation. The clear risk to bank valuation would be higher-than-expected interest rates, presumably driven by a sustained bout of price inflation – this risk we judge as moderate at worst. Specific risks to bank valuations are inherently unforeseen, but typically manifest themselves in over-optimistic valuation or credit ‘bubbles’. Corporate loan concentrations, the usual source of volatility, are at all-time lows so we are no longer focused in this area for incremental risk. However, wholesale trading assets are at record highs, in part driven by increasingly leveraged ‘market bets’ by a small pool of hedge fund capital. Inter-reliant and structural risk mitigation techniques, while highly developed are not fully tested. Also worrisome is that earnings visibility is low, and employee compensation high.
• Valuation. Our Market Weight recommendation reflects a view that sector valuation is full. Since May’05, the bank sector is up 17%, largely on the sharp 11% revaluation to 13.6x from 12.2x forward consensus earnings. Our new target valuation outlook at 13.1x 2007E is lower to factor a 10% higher bond yield in the coming year. We expect EPS revisions will drive price performance among banks in the coming year. In RBC Capital Market's view, revenue and earnings growth will surprise on the high side for TD, RY and NA.
New Price Targets: BMO $71.00; BNS $51.00; CM $81.00; NA $71.00; RY $103.00; TD $72.00
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• Valuation Full By Historical Standards But Is History Appropriate? Banks are re-testing the bounds of historical P/E ranges in absolute terms. Forward bank P/E’s have risen steadily over the past two decades to now exceed 13x, recently holding at 90% of the market multiple and at a clear 20% premium to comparable U.S. bank stocks. Measured by price/book, Canadian bank stocks are clearly at all-time highs (in part reflecting the 3x book value afforded CIBC during its post-Enron capital rebuild) but also reflecting the sector-wide improvement in return on equity.
• Potential Revaluation Catalysts. Near-term, a number of fundamentals should help maintain solid valuation: (i) improving revenue growth and quality; (ii) tip-top capital levels, and; (iii) benign credit conditions. Long-term, more sustainable factors may argue for even higher valuations, including: (i) a shift in business mix toward wealth products; (ii) rising proportionate fee income, and; (iii) higher ROE related dividend-payout potential. Macro factors are similar to the 1960’s when interest rates were below 6% for a prolonged period and recurring bank P/E’s averaged 13x.
• Risk to Bank Valuation. The clear risk to bank valuation would be higher-than-expected interest rates, presumably driven by a sustained bout of price inflation – this risk we judge as moderate at worst. Specific risks to bank valuations are inherently unforeseen, but typically manifest themselves in over-optimistic valuation or credit ‘bubbles’. Corporate loan concentrations, the usual source of volatility, are at all-time lows so we are no longer focused in this area for incremental risk. However, wholesale trading assets are at record highs, in part driven by increasingly leveraged ‘market bets’ by a small pool of hedge fund capital. Inter-reliant and structural risk mitigation techniques, while highly developed are not fully tested. Also worrisome is that earnings visibility is low, and employee compensation high.
• Valuation. Our Market Weight recommendation reflects a view that sector valuation is full. Since May’05, the bank sector is up 17%, largely on the sharp 11% revaluation to 13.6x from 12.2x forward consensus earnings. Our new target valuation outlook at 13.1x 2007E is lower to factor a 10% higher bond yield in the coming year. We expect EPS revisions will drive price performance among banks in the coming year. In RBC Capital Market's view, revenue and earnings growth will surprise on the high side for TD, RY and NA.
New Price Targets: BMO $71.00; BNS $51.00; CM $81.00; NA $71.00; RY $103.00; TD $72.00
