Analyzing banks

Or why are some banks (much) more

expensive than others?

How to analyze banks?

Banks are valued by
price/(tangible) book.
But why some banks
more expensive than
others?

US Banks

P/B value

Wells Fargo

1.47

US Bancorp

1.73

Bank of America

0.69

Citigroup

0.67

Goldman Sachs

0.96

Deutsche bank

0.42

JP Morgan

0.99

Morgan Stanley

0.81

Similarly elsewhere
Hong Kong banks

China banks (crisis mode?)

HK banks

P/B value

P/B value

Hang Seng Bank

1.89

China-operating
banks (HK-listed)

Bank of East Asia

0.85

ICBC

0.80

BOC(HK)

1.29

CCB

0.78

HSBC

0.75

BOC

0.72

Standard
Chartered

0.53

ABC

0.79

Bank of Comms

0.63

Citic bank

0.63

China Minsheng
Bank

0.79

China Merchants
Bank

0.98
3

P/B valuation
History doesnt repeat
itself but it rhymes
- Unknown author

Bank

P/B value (Mar

2009)

Wells Fargo

0.86

US Bancorp

1.29

Citigroup

0.136

Bank of America

0.207

P/B ratio and stock price

Buffetts view on banks

Best investment guru ever

CNBC interview
Q: What will it take for Bank of America and Citigroup to trade
above tangible book value like Wells Fargo and JPMorgan Chase?
Buffett: Well, a bank that earns 1.3% or 1.4% on assets is going to
end up selling above tangible book value. If it's earning 0.6% or
0.5% on asset it's not going to sell. Book value is not key to
valuing banks. Earnings are key to valuing banks. Now, it translates
to book value to some extent because you're required to hold a
certain amount of tangible equity compared to the assets you
have.
But you've got banks like Wells Fargo and USB that earn very high
returns on assets, and they at a good price to tangible book. You've
got other banks ... that are earning lower returns on tangible assets,
and they're going to sell -- they're going to sell [for less].

Buffetts love affair with WFC

Stretches back to 1989

Berkshire first buys WFC

Good idea then?

Didnt appear so then

At the time, California was in the midst of a significant real estate crisis. Banks with exposure
to the real estate market were being hammered in the markets, notably Wells Fargo and
BankAmerica (a predecessor to today's Bank of America). Because Wells had by far the
largest concentration of real estate loans in California, many investors considered
BankAmerica a safer investment. But those investors were missing some key details.
First, Wells was exceptionally conservative in classifying a loan as being a problem. When
banks identify a loan as being a problem, they pull cash aside as a reserve against any
potential future loss. Those reserves show up as an expense on the income statement,
effectively dampening net income to protect the balance sheet.
Even the loans that Wells had already classified on its balance sheet as "nonperforming"
were actually earning interest for the bank. ... Nonperforming loans are loans that are in
some way substandard -- either loans that are not paying any interest, [loans that are] not
paying the full interest obligation, or loans where it is merely anticipated that future interest
charges and principal payments might not be met on a timely basis. Far from being worthless,
these nonperforming loans ... still had a cash yield of 6.2 percent. Greenblatt
10

Berkshire Hathaway 1990 letter

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry -- mistakes that involve only a small portion of
assets can destroy a major portion of equity. And mistakes have been the rule
rather than the exception at many major banks. Most have resulted from a
managerial failing that we described last year when discussing the "institutional
imperative:" the tendency of executives to mindlessly imitate the behavior of their
peers, no matter how foolish it may be to do so. In their lending, many bankers
played follow-the-leader with lemming-like zeal; now they are experiencing a
lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and

weaknesses, we have no interest in purchasing shares of a poorly managed bank
at a "cheap" price. Instead, our only interest is in buying into well-managed
banks at fair prices.

With Wells Fargo, we think we have obtained the best managers in the business.
Source: Berkshire Hathaway 1990 letter to shareholders

11

Why not Citigroup? (2010)

When a CNBC viewer asked Warren Buffett if and when he
is going to buy Citigroup (NYSE: C) shares, because of its
"cheap" book value, Buffett basically laughed at the notion.
Buffett explained that for a bank he is not looking for book
value, but earnings power. Buffett said Citigroup's earnings
power is hard to figure out and said Citigroup pays more
for funds than others. He said he would rather own Wells
Fargo (NYSE: WFC), which is a large position in his portfolio.
Citigroup currently trades at a 0.82x its Q4 tangible book
value per share of $4.15. This is well below peers that trade
at 1.75x tangible book.
12

Assessing bank performance

So now we have a framework focus
on value!

13

Banks performance
Two metrics:
Profitability (ability to make money)
Bank capitalisation (ability to minimise losses)

Offense vs defense

14

Profitability
Offense

15

Return on asset (ROA)

US banks

2014 ROA (%)

P/B

Wells Fargo

1.47

1.47

US Bancorp

1.54

1.73

Bank of
America

0.23

0.69

Citigroup

0.40

0.67

Goldman Sachs 0.96

0.96

Deutsche bank

0.10

0.42

JP Morgan

0.87

0.99

Morgan Stanley 0.45

0.81

16

China/HK banks (1H15 results)

Bank

ROA(%)

P/B value

ICBC

1.39

0.80

CCB

1.51

0.78

BOC

1.20

0.72

ABC

1.25

0.79

Bank of Comms

1.12

0.63

Citic bank

1.06

0.63

Minsheng Bank

1.31

0.79

China Merchants Bank

1.33

0.98

SC

0.44

0.53

HSBC

1.01

0.75

HSB

1.50

1.89

BEA

0.80

0.85

HK banks

17

Efficiency ratio
Defined as:
Non-interest expense /
revenue
Inverse of net margin

US banks

Efficiency ratio
(2014) (%)

Wells Fargo

58.1

US Bancorp

53.2

Bank of America 88.25

Citigroup

72

Goldman Sachs

64.2

Deutsche bank

86.7

JP Morgan

65

Morgan Stanley

89.6

18

Asia Pac efficiency ratios

HK banks

China banks

Bank

2014 ratio (%)

Bank

2014 ratio (%)

SC

60.24

ICBC

27.93

HSBC

67.3

CCB

28.92

HSB

31.8

BOC

28.57

BEA

54

ABC

34.56

Citic

30.41

SG banks 2014 ratio (%)

Minsheng

33.4

DBS

45

Bank Co

30.52

OCBC

41

UOB

42.2
19

How conservative is the bank?

Defense

20

Leverage ratio
Traditionally defined as
total equity / total
assets (sometimes
inverted)
Basel re-definition
expands to include
O/BS items

Bank

2008 leverage
ratio (tangible
asset/capital)

2014 leverage
ratio

Wells Fargo

13.34x

10.46x

US Bancorp

17.08x

12.33x

Bank of
America

18.25x

12.01x

Citigroup

18.90x (underreported?)

9.95x

Lehman
Brothers
(2007 AR)

39.8x

NA

Bear
Stearns
(2007 2Q
report)

30.76x

NA

21

Citigroup 2008 leverage ratio

22

Other calculations

23

Lehman Brothers (2007 AR)

24

Leverage ratio (with O/B sheet items)

Leverage ratio (%)
China banks

Jun 30

Sept 15

ICBC

6.65

7.05

CCB

6.69

6.95

BOC

6.73

6.80

ABC

5.90

6.15

Bank of Comms

6.15

6.47

Citic bank

4.98

4.98

Minsheng Bank

5.40

5.51

China Merchants Bank

4.96

5.55

SC

5.00

4.80

HSBC

4.90

(no update?)

HSB

7.70

no update

BEA

7.40

No update

HK banks

25

SG banks
Bank

Leverage ratio (%)

Jun 30

Sept 15

DBS

7.30

7.10

OCBC

7.40

7.60

UOB

7.60

7.20

26

Non-performing loans
NPLs are bad loans recognised by banks
Banks exercise discretion for NPL discretion
Less leeway for overdue loans

Overdue loans

NPLs

27

Loan-loss provisions
Lenders provision for losses in advance,
because loans can turn bad.
Metrics for bad loan coverage
Coverage ratio (Allowances / NPLs) [common]
Allowances / (Overdue + NPL)
Allowances / Total gross loans

28

1H15 Asia Pac bank comparison

Banks
Big 4 China banks
ICBC
CCB
BOC
ABC
Selected 2nd tier banks
Minsheng
Citic
China Merchants
Bank Co
Foreign Banks
SC
HSBC
Singapore banks
DBS
OCBC
UOB

NPL NPL
%
coverage

% overdue %
or
allowance
impaired of overdue Allowance
loans and or NPL
% of total
advances loans
gross loans

1.40%
1.42%
1.41%
1.83%

163.40%
185.29%
157.37%
238.99%

2.50%
2.07%
2.84%
2.78%

91.74%
127.30%
77.83%
157.42%

2.29%
2.63%
2.21%
4.37%

1.36%
1.32%
1.50%
1.55%

162.13%
178.53%
204.17%
148.77%

3.88%
3.60%
3.13%
3.22%

56.60%
65.42%
97.52%
71.67%

2.20%
2.36%
3.06%
2.30%

2.36%
2.34%

54.48%
38.87%

3.89%
3.49%

33.08%
26.14%

1.29%
0.91%

0.88%
0.69%
1.24%

165.92%
156.37%
144.13%

1.46%
1.14%
3.49%

99.49%
94.89%
51.13%

1.45%
1.09%
1.78%

29

1H15 Asia Pac bank comparison

Banks
HK banks
(overdue loans > 3 mths only)
HSB
BEA
BOC(HK)
DS Financials

NPL
NPL % coverage

0.43%
1.03%
0.27%
0.29%

71.89%
35.48%
161.07%
113.61%

% overdue
or
impaired % allowance Allowance
loans and of overdue % of total
advances or NPL loans gross loans

0.57%
1.76%
0.81%
0.61%

54.05%
20.70%
53.01%
55.19%

0.31%
0.36%
0.43%
0.33%

30

Cost of funds
Lenders arbitrage
interest rates to make
money
1. Borrow cheaply, lend at
higher rates
2. Pocket the difference
3. PROFIT!

Q: Why did Buffett buy

BAC given its
performance?

US banks

2014 Interest
on L (%)

2014 deposit
costs (%)

Wells Fargo

0.38

0.14

US Bancorp

0.58

0.24

Citigroup

1.02

0.75

Bank of America

0.82

0.15

ICBC

2.12

2.04

CCB

2.11

1.92

Citic

3.02

2.43

Minsheng

3.18

2.39

Bank Co

2.82

2.35

DBS

0.75

0.70

OCBC

1.07

1.07

UOB

1.02

1.04

China banks

SG banks

31

Other banks
Foreign banks

2014 interest
on L (%)

2014 deposit
costs (%)

SC

1.10

0.60

HSBC

1.05

0.84

32