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Valuation games

31 October 2013 By John Foley

What if investors valued China’s big lenders the same way they do global banks? By one measure, lenders like ICBC and Bank of China would be worth twice what they are today. Instead, the country’s banks languish in a valuation twilight zone. It’s a sign of the deep scepticism facing China’s financial sector.

A bank’s shares are effectively a bet on the returns the lender can generate on its reported book value – the bit shareholders own. Chinese banks, which just reported third-quarter earnings, generate returns of over 20 percent. Their ten biggest global rivals are expected to earn just half that next year, according to Datastream.

All else being equal, investors should be prepared to pay twice as much for Chinese banks’ book value as they do for the rest. However, Chinese lenders trade on the same multiple as their big global peers – less than one times book.

There are two possible explanations: one is that investors think they might be called upon to provide more equity if banks take big write-downs on their loans. In simple terms, it’s as if investors fear they’ll be asked for one new dollar of equity for each dollar they already own.

Another reason is that investors expect earnings to fall. Some warning lights are already flashing: Bank of China, Bank of Communications, China Merchants Bank and China Minsheng all reported lower net interest margins in the third quarter. That squeeze would intensify if China removed the mandatory maximum rate on bank deposits, intensifying competition.

Valuations are unlikely to normalize until investors have a clearer view of where both equity and returns are heading. A first step would be for banks to come clean about what’s on their balance sheets. Reported levels of bad debt, at just one percent of total loans, are improbably low. An imminent audit of borrowing by local governments should shed some light on banks’ exposures. Another helpful step would be to disclose how much is owed by state-owned enterprises unlikely ever to pay back.

It may take years before investors believe that Chinese bank earnings are sustainable. In the meantime, the only way out of the twilight zone is to let in some sunlight.


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