Is Bank of Ireland fairly valued at its current share price?
Figuring out the true value of a bank is as much art as it is science
http://www.irishtimes.com/business/sectors/...t-share-price-1.1827026
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Wilbur Ross’ explanation for selling down his stake in Bank of Ireland, at a near 150 per cent profit, looks, on the face of it, eminently reasonable: thanks to those (and other) profits, he suggests he now has more than enough exposure to European banks. Diversification is one of the few “free lunches” available to all investors and it is always wise to make sure that risks are appropriately spread.
Of course, Mr Ross is too polite to mention the possibility that the easy money has now been made. If Bank of Ireland is near some measure of full or fair valuation - or even higher - then there are plenty of good reasons to sell, irrespective of the merits of the diversification argument.
Anybody with only a passing acquaintance with the vagaries of stock markets will not be surprised to learn that valuing a bank is tricky. The complexities and oddities of modern banking mean that figuring out the true value of a bank is as much art as science. While the complexities may or may not be necessary, their existence leaves clues as to why regulation of the sector remains fraught with difficulties.
So, is Bank of Ireland fairly valued at its current share price (or the one achieved by Mr Ross)? There are many ways to value any asset but they all come back to one basic principle: how much money (profit) will be made? The exploration of this simple statement has filled many libraries and sustained many an academic and hedge fund career. Peering into the future, particularly of the far-flung variety - opens up all sorts of possibilities for serious analysis and snake oil salesmen. The investment world is full of both: the key skill is the ability to distinguish between the two.
One of the reasons why we observe so much focus on simple accounting ratios - like the humble price-to-earnings (PE) ratio - is that they summarise an awful lot of work (including all of that guessing about future profits). And, of course, they are simple . So, when somebody says that the correct PE ratio for a bank is, say, 15, we need to figure out, first, whether they have done the weeks of work necessary to generate such a conclusion, second, whether that work can be trusted or, third, whether they have just thought of a number. Either way, it can look the same.
Like a lot of banks, Bank of Ireland doesn’t have any earnings to put into that simple PE ratio. By the end of 2014 we hope that this will have changed but, for now, we have to use a slightly different method (but one that is equivalent). We need to figure out what investors, like the Irish Government, are charging for supplying equity capital to the bank. We then need to estimate the likely returns that the bank is likely to generate for those investors. There is then a very simple formula that links these costs and returns on equity capital that tell us what the market value of the bank should be.
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