The stocks of financial-services firms such as Citi (C), Bank of America (BAC), and Morgan Stanley (MS) continue to drop, but the price of credit-default swaps–a proxy for future solvency–have recovered (WSJ). This suggests that the market is getting more optimistic about the firms’ ability to survive…and more pessimistic about their ability to make much money doing it.
For some banks–Washington Mutual (WM), for example–bankruptcy still seems a real possibility. For most however, it probably isn’t. For investors trying to call the bottom, therefore, the most pressing question is how much banks can earn once the market stabilizes…and how much the market will be willing to pay for them.
Before the financial services boom of the last decade, investment banks (for one) used to trade at or below 1X book value. A couple of years ago, after massive increases in debt leverage cause earnings to soar, multiples of book had jumped over 2X (Bear Stearns said it would only consider a takeout at 4X). Now, after the firms’ stocks and book values have been smashed, most “healthy” firms are trading at 1X-2X, and most troubled ones are between 0X-1X.
Goldman Sachs (GS): 1.8X
Morgan Stanley: (MS): 1.3X
Merrill Lynch (MER): 1.3X
JP Morgan (JPM): 1.0X
Citigroup (C): 0.8X
Bank of America (BAC): 0.8X
Lehman Brothers (LEH): 0.6X
Wachovia (WB): 0.4X
Washington Mutual (WM): 0.2
The reason the market was temporarily willing to ignore the huge risks banks were taking was the profit they were (temporarily) minting while doing it. Now that the firms have (at least temporarily) reduced their leverage, their earnings power will be significantly decreased. In other words, we would not count on multiple expansion to drive the stocks going forward. This leaves earnings growth, which will likely be far slower than it was in the boom years.
If and when these firms clearly demonstrate that they won’t further dilute shareholders by raising additional capital or destroy book value by taking additional writedowns (likely a ways off), we expect their multiples of book value will probably return to or slightly above historical norms (i.e., 1X-1.5X). After that, the financial-services sector is probably looking at a market rate of return.