Banks are different entities to industrial or service companies and require a different approach to valuation. We look at some typical ways investors evaluate banks.

Indeed in banks cash is the product, whilst in other types of businesses, cash serves as a lubricant to run the business.

When valuing a company there are typically two types of methods that an investor would choose from; the income approach (discounted cash flow,) or the market approach (ratios.) The one chosen (or the weight applied to each one) would depend on the stability of historical earnings, projected future earnings, number of tangible assets appearing on the balance sheet, and the quality of available information.

As discussed earlier, the income approach which involves the discounting of projected future cash flow is not a reliable measure for banks, because of the risk of mixing the banks (cash) inventory, with the cash being generated from the operation of the business. The discounted cash flow method of valuation has been discussed and described extensively in previous issues of Smart Investor; historic articles are available to our subscribers from our website www.smartinvestorafrica.com.
The market approach or more accurately  Comparable Company Market Multiple Approach  looks at the relevant price ratio and compares it to similar companies in the market. In the case of banks the three important ratios that are used are:

I) The price to book ratio  market price per share divided by tangible book value per share.
 
Ii) The price to earnings ratio  market price per share divided by earnings per share (this is important when the banks earnings have shown stability or directional consistency over several years.)

Iii) The price to invested capital ratio  market price divided by total invested capital (comprising long term debt and shareholder equity.) This ratio is superior to the pure price to book ratio in that it does not favour banks that are financed with higher amounts of debt capital compared to those with less debt and more equity.

Typically an investor would look at these ratios for a number of banks (or even all of them,) remove the outliers and calculate the average.

The investor would then need to decide whether the bank they are analyzing should be selling at a premium or a discount to the average bank. To do this the investor looks at some concrete indication of the banks quality. The four popular gauges of bank quality are:

(i) NIM or Net Interest Margin, which is the net interest income divided by interest bearing assets (cash, marketable securities, loans and investments). This gives an indication of how much return the bank is able to get for the funds it has available.

(ii) NPL or None Performing Loan Ratio, which is the non performing loans divided by the total loan book. This gives a good indication as to how good its credit risk processes are and ultimately the likelihood of it losing money as bad loans.

a. Other ratios that investors use to judge how much risk is associated with the banks loan book include Credit Loss Ratio (CLR) which is the provision for bad loans divided by total loans and

b. The Coverage Ratio (CR) which is the provision for loan losses divided by the Non-Performing Loans.

(Iii) Efficiency ratio, which is the operating expenses divided by the operating income, gives an investor an indication of how well the bank is controlling its expenses.

(iv) Return on Equity: Earnings per share divided by book value per share. This gives an overall indication of how efficiently the bank is deploying shareholder funds.

When coming to an overall opinion on quality the investor must weigh the four different ratios; for instance if a bank has high NIM but also high NPL (Non -Performing Loans) it would be obvious that the bank is taking on more risk in order to get higher interest rates and the two are countering each other.

E.g. Figure 1 below

GTBank appears fairly valued, though it is trading at a premium in terms of P/B and P/E. It clearly has higher NIM and efficiency ratio, higher quality loan portfolio (looking at its NPL and CLR) and higher return on equity.