Lloyds is selling off 25% of TSB at what looks to be a very low price – much lower than the value Lloyds currently trades on the stock market for. So is TSB cheap? Or does it just mean that Lloyds shares are currently too expensive?
I want to answer this question – and in the process, give you an idea of how to weigh up banking shares. I’ll warn you right now – this gets a bit technical in places – that’s banks for you. But I’ll try to keep it as straightforward as possible, and hopefully shed a bit of light on just why banks are such tricky investments.
Banks are risky investments
If the financial crisis taught us anything at all, it’s that investing in banks can be very risky. The trouble is that outside shareholders like us don’t really know what the bank owns, and who it owes money to.
I know plenty of professional investors who reckon that it’s virtually impossible to decipher a bank’s balance sheet. You only tend to find out about the bad stuff when things go wrong – and by then it’s too late.
Why are banks so risky? Like many things, it boils down to debt. Banks finance themselves with a lot of borrowed money. Some of this comes in the form of current and savings accounts, deposited by the likes of you and I.
It may seem odd to think of this as borrowed, but that’s exactly what it is. We give it to the bank, it pays us interest in return, and we expect to be able to get it back on demand – in effect, the bank is simply borrowing our money.
Banks can also then go out into the money markets – ie they can borrow from big investors – if they want to have more money to lend out. This is known as wholesale financing, and it’s one of the things that brought down Northern Rock in summer 2007, for example.
In short, banks are very much like a householder with a big mortgage. They have very small amounts of equity to absorb any losses. So when things are going well, banks make lots of money. But when the tide turns, they can be wiped out by just a small fall in the value of their assets.
How to weigh up banking shares
So how do you go about working out whether to invest in a bank or not? For most stocks, you might start with the price/earnings ratio (p/e), or the dividend yield. But many professional investors view banks differently.
You can easily calculate ROE by using numbers from the accounts. You just take the after-tax profit, and divide it by equity. This shows the overall return that the bank has made from the money invested in it.
Shareholders are of course looking for high ROEs, as this shows that the bank is making a big return off the money invested in it.
The trouble is, banks have too often achieved this high ROE in the past by borrowing too much money. So if you want to dig a little bit deeper you can break this calculation down further, by throwing ‘leverage’ into the mix.
I don’t want to turn this into a maths class. But if you want to dispel some of the mystery around bank balance sheets, it’s worth understanding a little about how to calculate this. This will teach you a lot more about how a bank really generates its returns.
To calculate the leverage, you take the bank’s assets (in the case of a bank, that’s the quantity of loans it has made as well as other assets it owns), and divide by the shareholder equity.
This basically shows you how much money the bank has had to borrow to make a respectable ROE.
I’ve done this calculation for Lloyds for the last ten years. By looking at the results you can learn a lot about why it did well and then got into big trouble.
Here are the relevant numbers taken from Lloyds’ accounts:
Lloyds Banking Group
And this is how its returns on equity worked out:
|Year||ROA (net profit/assets)||Leverage (assets/equity)||ROE (ROA x Leverage)|
The first thing that should strike you is that banks aren’t really that profitable. Lloyds’ return on assets was less than 1% even during the boom years.
It’s also very telling that between 2004 and 2007 it juiced up its returns by adding more leverage without actually improving its underlying returns on assets that much.
Then things started to go wrong. It bought HBOS and its leverage soared. As a result, by the end of 2008, it had a mere £2.20 of equity for every £100 of assets – no wonder the government had to rescue it. (To put it into perspective, that’s like having a 97.8% loan-to-value mortgage).
Since then, Lloyds has been shrinking its balance sheet and getting rid of bad assets. The bank has not made a profit for the last four years, because it has been writing off bad debts and shelling out compensation for mis-selling payment protection insurance (PPI). It also still uses a lot of borrowed money, but its finances are in better shape now.
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Why bank shares are likely to be worth a lot less from now on
However, Lloyds is very unlikely to make an ROE of 26%, as it did in 2007, any time soon, if ever again. You see, banks now have to hold more equity and other reserves to make them less risky. Lloyds’ medium term target for ROE is 12.5% – 14.5% to reflect this.
So how does this translate into a value for a bank share?
It all boils down to what sort of return a stock market investor expects to get for taking the risk of investing in a bank. We could debate the right number all day. But to keep things simple, I’ll assume that bank shareholders want at least a 10% annual return (income plus capital gain) to take the risk of buying a share.
If you assume this, then it suggests that Lloyds and most bank shares aren’t particularly good value now. Lloyds, HSBC, Barclays and Standard Chartered all trade at higher prices than you’d expect, if 10% is the sort of return that shareholders should be looking for.
The table below shows how this works. First, we look at the actual price/net asset value (NAV) being paid for the bank. This is shown in the first three columns.
|Market value (£bn) (A)||Net asset value (£bn) (B)||P/NAV (A/B)||ROE (C)||Cost of equity (D)||Implied P/NAV (C/D)|
|Lloyds Banking Group||£56bn||£40.6bn||1.38||-2.04%||10%||?|
Then we look at the price/NAV you’d expect investors to be willing to pay if they were looking for a 10% return. You calculate this by taking the return on equity, and diving by the 10% return investors want (also known as the ‘cost of equity’).
As you can see, they are all currently trading above this level.
Now of course, business may improve and returns may get better. However, for Lloyds, a lot of future improvement looks prices in. If it can make sustainable returns of between 12.5-14.5% that would imply a price to net asset value of between 1.25 (12.5/10) and 1.45 (14.5/10). It currently trades on 1.38.
What does all this mean for TSB?
Looking through the prospectus for TSB it seems that it does not make much money. Its finances look in good shape – its leverage is only 17 times – but its profits are not impressive, even although it has been lent some good mortgages by Lloyds.
Last year its net profit was £172m, but that included a £105m credit from the taxman. Take that out, and profits before tax were £67m. Tax that at 20% – the UK rate for corporation tax – and you get net profits of £53.6m. On an equity base of £1.58bn, that gives an ROE of just 3.4%.
Using the valuation method above, that implies a price to book value of 0.34 (3.4/10). If TSB is priced in the middle of its indicative range (220p-290p) at 255p it would start trading at a price to book value of 0.8, more than twice that estimate.
So while TSB may look cheap at first glance, its shares could actually be very expensive. As I’ve said in MoneyWeek magazine this week, this is yet another IPO you should avoid. (If you’re not already a subscriber, get your first four copies free here.)