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By WM in the Classroom
April 21, 2016 | 11:40 | Dubai
In our recent post, Valuation Over Price: Analysis Of DFM Listed Stocks, we traced the average Price to Earnings ratio across sectors within the DFM. Within the same, we highlighted how the P/E ratio may not be the most ideal ratio for some of the sectors listed. One of the foremost of these sectors referred to is Banking, which is generally tracked using the Price to Book ratio.
So what makes up the constituents of this ratio.
As the name suggests,
Calculating the Price-to-Book Ratio
We take the example of NBAD. A look at the Balance sheet for 2015, reveals 3 major components – Assets, Liabilities and Equity. The Equity as of 31st December 2015 stands at AED 43218.65 mn, which reflects the book value. However, the ratio involves calculating the Book Value per Share. For the same, we require the number of Outstanding shares, which from the footnotes within the report shows as 5197.83 mn shares. Thus, the Book Value per share emerges as 8.31 (AED 43218.65 mn / 5197.83 mn). This becomes the denominator of the ratio.
As per yesterdays data, NBAD closed at a level of AED 8.90 (making up the numerator). Thus, the Price to Book Value ratio for NBAD is 1.1.
What does this mean?
The market value, reflected in the price, exceeds the book value, reflecting a premium to the book value. Here’s how it stacks up compared to other regional and global banks.
Why use the Price to book ratio for banks?
The reason here is simple; it is explained by the nature of the banking industry. Banks typically hold assets consisting of loans, investments, cash and other financial securities, enabling an ease of valuation, which is not necessarily the case with tangible assets. Thus, in an ideal scenario, a dirham is worth a dirham indicating why on an average, the Price-to-book, (market value to net worth) for the banking sector would be 1. Based on the macro-economic situation, at times of an economic downturn or slowdown, as concerns around bad loans and NPA’s increase, the market value (price) takes a beating and thus the ratio may move to levels below 1. The premium, as witnessed across all banks above, signifies the sentiment of the market towards the bank, reflective of the quality of management, consistency of earnings, etc.