Bank stocks can be confusing for investors. Some trade at less than half their book value, while others command prices equal to or even higher than the equity on their balance sheets. It is tempting to assume that the stocks with the biggest discounts offer the best opportunities.
But there is another way to look at these discounts. Instead of asking only how much investors are paying for a bank’s book value, investors can also look at how much profit the bank generates from that book value and how much profitability its current market price already expects.
This approach was explored recently by registered financial planner Henry Ong in his Philippine Daily Inquirer article, “How to tell if a bank stock is worth buying.” The article examined 14 banks listed on the Philippine Stock Exchange and compared their current profitability with the level of long-term profitability implied by their market valuations.
The results were revealing. Six banks appeared potentially undervalued under the model, five appeared potentially overvalued, while three were closer to fair value. More importantly, the analysis showed why a bank with a very low price-to-book value, or P/BV, is not necessarily the most attractive bank stock.
Understanding the analysis starts with one of the most important measures of bank profitability: return on equity, or ROE.
Why ROE matters for bank stocks
ROE measures how much profit a bank generates from the capital provided by its shareholders.
Suppose two banks each have ₱100 billion in shareholders’ equity. Bank A earns ₱15 billion while Bank B earns only ₱6 billion. Their ROEs would be 15 percent and 6 percent, respectively.
Although both banks have the same amount of equity, Bank A generates considerably more profit from that capital. Investors may therefore be willing to pay a higher price relative to its book value.
Research cited in Ong’s Inquirer article supports this relationship. A Bank for International Settlements study of 72 banks across 14 countries found that ROE was among the important factors that explained bank P/BV ratios. Another BIS study found that P/BV ratios among major global banks increased with analysts’ forecasts of future ROE.
This helps explain why two banks trading at similar discounts to book value may not necessarily offer the same investment opportunity.
What is implied ROE?
The Inquirer analysis approached bank valuation from a different direction. Instead of forecasting how profitable a bank might become and then estimating what the stock should be worth, it started with the price investors are already paying and worked backward.
The result is what we call market-implied ROE.
Current ROE tells us how profitable the bank is today. Implied ROE estimates the level of long-term profitability consistent with the bank’s current market valuation, based on assumptions about long-term growth and the return investors require for taking risk.
The calculation begins with the justified P/BV model:
P/BV = (ROE − g) ÷ (r − g)
In the formula, ROE represents return on equity, g represents long-term growth and r represents the return investors require for taking the risk of owning the stock.
Normally, this formula can be used to estimate the P/BV that a bank might deserve based on an assumed future ROE. But because we already know the P/BV at which a bank is trading, we can reverse the calculation.
This gives us:
Implied ROE = g + P/BV × (r − g)
For the 14 Philippine banks studied, the analysis assumed a long-term growth rate of 7 percent, while the required return for each bank was estimated based on its market risk.
Why implied ROE is important
The advantage of implied ROE is that it converts a stock’s valuation into something investors can understand more easily: an expectation about profitability.
Suppose a bank currently generates an ROE of 15 percent, but its share price implies a long-term ROE of only 8 percent. The market valuation is effectively consistent with the bank’s profitability eventually falling toward 8 percent.
Investors can then examine whether such a decline makes sense.
If the bank faces deteriorating asset quality, slower loan growth or weaker margins, a lower future ROE may be reasonable. The apparent discount in the stock may therefore be justified.
But if the bank can sustain an ROE of 12 percent, 13 percent or even 15 percent, the market may be underestimating its earning power.
The reverse can also happen. A bank may currently earn an ROE of 10 percent while its share price implies an ROE of 14 percent. In that case, investors are already paying for an improvement in profitability that has not yet occurred.
This makes implied ROE useful because it helps investors move beyond simply asking whether a bank looks cheap.
Instead, they can ask: What level of profitability is already reflected in this price, and can the bank actually deliver it?
China Bank has the widest positive gap
China Bank provides the clearest example from the study.
Its current ROE was about 15.4 percent, while its market valuation implied a long-term ROE of only about 6.8 percent.
The difference between the two was about 8.6 percentage points.
This does not mean China Bank will continue earning an ROE of 15.4 percent indefinitely. Profitability can change as interest rates, loan growth, credit costs and economic conditions change.
However, the large gap suggests that the market is pricing in considerably lower profitability than the bank currently generates.
Even if China Bank’s ROE declines somewhat, it could still remain well above the level implied by its valuation. If it can sustain much of its current profitability, its shares may potentially be undervalued.
AUB showed a similar pattern. Its current ROE of about 18.5 percent was well above its implied ROE of 11.1 percent, a difference of about 7.4 percentage points.
When investors are already expecting improvement
BPI provides an example from the other side.
Its current ROE was approximately 14 percent, while its market valuation implied an ROE of about 15.6 percent.
Here, the market is effectively pricing in an improvement in BPI’s profitability.
That does not necessarily make BPI a poor investment. The bank could increase its ROE and justify the expectations already reflected in its share price.
But the comparison tells investors that BPI has more to deliver. If its ROE remains around its present level, its valuation may be harder to justify under the model.
This is why the ROE gap should not be treated automatically as a buy or sell signal. Instead, it identifies what investors should investigate next.
What the 14 banks tell us
Across the 14 banks studied, the median current ROE was about 10.4 percent, compared with a median implied ROE of only 7.9 percent. The median P/BV was approximately 0.42 times.
Six banks appeared potentially undervalued under the model: China Bank, AUB, Bank of Commerce, EastWest Bank, PNB and Metrobank. Their current profitability was higher than the level implied by their valuations.
Five appeared potentially overvalued: PSBank, BPI, RCBC, UnionBank and Security Bank. Their implied ROEs exceeded their current ROEs, which means their valuations already reflect expectations for stronger profitability.
The remaining three banks, BDO, Philippine Business Bank and Philippine Bank of Communications, had relatively small differences between current and implied ROEs and were therefore closer to fair value under the model.
Why the lowest P/BV may not be the best bargain
RCBC illustrates why investors should be careful about choosing bank stocks based solely on P/BV.
The bank traded at only about 0.37 times book value, which means investors were paying just 37 centavos for every peso of shareholders’ equity.
At first glance, that looks inexpensive.
But RCBC’s current ROE was only about 6.2 percent, below its implied ROE of approximately 7.6 percent. Despite the large discount to book value, the bank appeared potentially overvalued under the model because its existing profitability was still below the level reflected in its valuation.
A low P/BV can therefore sometimes reflect low profitability rather than an overlooked bargain.
Use implied ROE as a starting point
No valuation model can determine with certainty whether a bank stock will rise or fall. ROE can change as interest rates, loan growth, credit quality, operating expenses and economic conditions change.
Implied ROE also depends on assumptions about long-term growth and the return investors require for taking risk. Change those assumptions and the implied ROE will also change.
Its real usefulness is not to produce a precise buy or sell signal. It gives investors a way to understand what expectations appear to be embedded in the current share price.
When current ROE is considerably higher than implied ROE, investors can investigate whether the market is being too pessimistic or whether there are good reasons to expect profitability to decline.
When implied ROE is higher than current ROE, investors can examine whether the bank has a credible path toward delivering the improvement that its valuation already expects.
This gives investors a more useful way to study bank stocks than simply searching for the lowest P/BV.
A bank trading below book value may look inexpensive, but the size of the discount tells only part of the story. What matters is how much profit the bank can generate from that book value, how sustainable that profitability is and how it compares with what the market price already expects.
