Tutorial: value a bank
For a bank, price to book and return on equity are the whole game, and the loan book is the risk.
Analyse a financial company without applying tools that were built for a factory.
How value a bank works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
Why a solvent bank can die in 48 hours
The bank lent your deposit out. That is not a scandal, it is what a bank is. It only becomes fatal when everyone asks for their money on the same afternoon.
- 1
Throw away free cash flow
For a bank, borrowing is not a financing decision, it is the raw material. Deposits are liabilities and loans are assets. The usual cash flow framework produces numbers that are technically correct and completely meaningless.
- 2
Use price to book, because here it actually works
A bank's assets are financial, so book value genuinely approximates what they are worth, unlike a software company whose value is code and people and appears nowhere on the balance sheet. This is the one place P/B earns its keep.
- 3
Pair it with return on equity
A bank earning 15% on equity deserves to trade above book. One earning 4% does not. The two numbers must be read together: P/B alone tells you the price, ROE tells you whether that price is deserved.
A bank trading far below book is not automatically cheap. The market may simply be correct that the loan book is worth less than stated.
- 4
Then read the loan book
This is where banks die. Look at loan loss provisions and non-performing loans, and at what the bank has been lending against. Every banking crisis in history has been a loan book that everyone agreed was fine until it very suddenly was not.
Ordinary. The market expects steady, unremarkable growth.
You can explain why a bank at 0.6x book might be a bargain or a bankruptcy, and what would tell you which.
Read next
For a bank, price to book and return on equity are the whole game, and the loan book is the risk.
Price to book and return on equity read together, which is the only way a bank makes sense.