MARKET COMMENT
Why Banks Are Cheap

By David Kuo (TMFDragon)
September 16, 2004

One of the stock market's long-standing unsolved mysteries is why banks are always so lowly rated. In recent years, British banks have churned out, with the odd exception, decent increases in profits, and yet they are very often valued at P/Es of below 10. 

The table below shows the current valuation of UK banks. Both yield and P/E figures are forecasts.

Take Barclays for example. In 1999, Barclays announced pre-tax profits of £2.9b, and this year, the UK's third biggest bank is expected to deliver profits of £4.7b. So, over the last five years, Barclays has seen its profits improve at a compound rate of 10% per year. Earnings are forecast to rise 11% to £5.2b in 2005, but its shares are priced at 9.5 times forward earnings. 

Other banks have equally impressive profit records. With such consistent earnings growth you would expect higher valuations than just 8.6 times forward earnings in the case of Royal Bank of Scotland, and a measly 8.4 times prospective earnings for HBOS.

I believe banks are on low valuations because their earnings can be quite unpredictable. Their profits are heavily dependent on prevailing interest rates, of which they have no control over.

In good times, banks can deliver exceptionally high profits as consumers and businesses borrow more. However, in lean years, when interest rates are high, their profits can quickly collapse as provisions for bad debts hurt their bottom lines. Furthermore, in the past, interest rates have been quite volatile, so bank profits have gyrated considerably. In recent years though, as rates have been more stable, profit growth has been smoother.

Another factor to consider is the higher levels of efficiency that have been achieved through recent consolidation in the sector. The mergers of Royal Bank of Scotland and NatWest, and the that of Halifax and Bank of Scotland, have enabled these banks to reduce operating costs significantly, which in turn has boosted profits. However, with merger opportunities now less obvious, profit increases through consolidation may be harder to come by.      

However, over the long-term, banks have been some of the stock market's best performers. Since 1986, the FTSE All-Share Bank Index has improved 784%, equivalent to growth at a compound rate of 13%. By comparison, the FTSE All-Share Index has increased by 231%, which equates to 7% per annum. 

Personally, the short-term risks of banks do not bother me much. I've always had one bank in my portfolio. I prefer to focus on the long term and their dividend payouts, which are currently clustered around 4.5%, and look very attractive.

David owns shares in Barclays.