Karnataka Bank is Undervalued?Analysing a bank stock - Part 1

Consider Karnataka Bank, for example; the stock's book value is ₹263, but the share price is ₹247. This means the stock is currently trading below its book value (PB < 1) - PB ratio.  Book value is the total assets minus liabilities, which means if the bank were to be fully liquidated, a shareholder would get ₹263 now.  In the banking industry, the P/B (Price-to-Book) ratio is often considered a more relevant valuation metric than the P/E (Price-to-Earnings) ratio.  Let us understand why PB is more relevant than PE when evaluating a bank stock.(Book value vs Current Price of Karnataka Bank as of Jan 30 2024)

First, let's grasp the concept of Book value and delve into the meanings of PE (Price-to-Earnings) and PB (Price-to-Book) ratios.

What is Book value?

The book value of a stock is theoretically the amount of money that would be paid to shareholders if the company was liquidated and paid off all of its liabilities. As a result, the book value equals the difference between a company's total assets and total liabilities.

The price-to-book (P/B) ratio gauges a company's market capitalization in relation to its book value.

Calculated by dividing the current stock price per share by the company's book value per share (BVPS), this ratio offers insight into how the market values a company's assets relative to its market price. It's crucial to note that a company's market value often surpasses its book value, as the market considers intangible assets like brand recognition and intellectual property not reflected in the book value. Consequently, a high P/B ratio may indicate optimistic market expectations for a company's future growth and profitability.

Value investors often use the P/B ratio to identify potential investment opportunities. A P/B ratio below 1.0 is generally considered favorable, suggesting the stock trades at a discount to its book value. However, the appropriateness of a P/B ratio is relative to the specific company and its industry, as comparing the ratios of companies with differing business models may not yield meaningful insights.

The price-to-earnings (P/E) ratio measures a company's current share price relative to its earnings per share (EPS). Also known as the price multiple or earnings multiple, P/E ratios assist in comparing companies on an apples-to-apples basis and evaluating a company against its historical performance or comparing markets over time. P/E ratios can be trailing (backward-looking) or forward (projected), with a high P/E suggesting overvaluation or expectations of high future growth rates.

However, companies without earnings have no P/E ratio, presenting limitations. Two common types of P/E ratios are forward (based on projected earnings for the upcoming year) and trailing (based on the past 12 months' actual earnings).

Understanding the disparities between the P/B and P/E ratios is crucial. The P/B ratio compares a company's market value to its book value, indicating whether the stock is trading at a discount (P/B below 1) or at a premium (P/B above 1) to its book value. In contrast, the P/E ratio compares a company's stock price to its earnings per share, reflecting investors' willingness to pay for each dollar of revenue generated.

For banks, the P/B ratio holds greater relevance for several reasons. First, banks' unique business model involves holding substantial assets like loans, which generate interest income, and significant liabilities such as deposits used to fund operations. Given this model, a bank's book value becomes a more reliable indicator of its financial health than its earnings.

Second, banks often experience more volatile earnings due to economic factors like interest rates, inflation, and credit risk. This volatility makes the P/E ratio less reliable for valuing bank stocks compared to the P/B ratio.

Third, banks frequently carry large amounts of goodwill on their balance sheets, representing the premium paid for acquisitions over fair value. Goodwill can inflate a bank's book value and P/B ratio, but since it generates no earnings, using the P/E ratio may not accurately reflect the bank's actual value.

Despite the advantages of the P/B ratio, drawbacks exist. It doesn't consider a bank's future earnings potential, making it challenging for investors to gauge growth prospects. Additionally, changes in accounting standards can impact a bank's book value and, consequently, its P/B ratio.

Despite drawbacks, many investors prefer the P/B ratio for valuing bank stocks due to its simplicity and ability to assess a bank's financial strength and asset quality. As banks hold significant assets on their balance sheets in the form of income-generating loans and securities, the P/B ratio offers a clearer picture compared to the P/E ratio, which centers on earnings. Investors in the banking sector should consider the P/B ratio as a crucial valuation metric for identifying undervalued banks and making informed investment decisions.