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Why the banks’ sweet spot could be about to sour

There are two classic ways of valuing and comparing financial institutions:

1. Price/book ratio. This is essentially the value you would see if the business was liquidated and liabilities paid out. A ratio of 1 indicates shareholders can only expect a return of book value. A ratio above 1 indicates the extent to which shareholders are potentially exposed to market risk.

2. Return on assets (five-year average). A low return on assets can indicate a lending institution is vulnerable to economic factors such as a rise in interest rates or unemployment, competition, impaired loans and a cyclical decrease in demand.

It is interesting to see how the top retail banks compare on these structural ratios.

ANZ (ASX: ANZ) has a price/book ratio of 2.08, indicating buyers are prepared to pay over twice the ‘intrinsic’ value for a share in this company. This is ok if the investor can see medium-term growth opportunities for the purchase. In ANZ’s case this may be the move into Asia, the relatively secure 60% funding percentage (deposits) and the steady development of trade/corporate loans. Against this, ANZ only has a .89% return on assets.

Commonwealth Bank (ASX: CBA) has a price/book ratio of 2.81, one of the highest in the world. This demonstrates the popularity of the Commonwealth as an icon investment for anyone’s portfolio. Largely reflecting the exposure to residential housing, Commonwealth has a return on assets of .97%. The recent announcement of a $2 billion quarterly profit has fired further enthusiasm for this stock.

National Australia Bank (ASX: NAB) has a price/book ratio of 1.77 which is comparatively low; however the average return on assets is a measly .6%.

Westpac (ASX: WBC) has a price/book ratio of 2.38 and a return on assets of .95%. As with the Commonwealth, Westpac’s relatively higher return on assets reflects the large exposure to housing, which supplies high returns on capital due to the leverage allowable.

So how come the banks are making all these profits? Well for one, provisioning is historically low. As with insurance companies banks have traditionally used good times to build up provisions for the inevitable bad times. This approach no longer applies. Secondly, all banks have been on a cost-cutting drive, aided by technological improvements. The net result of these measures is a short term boost to profits.

Foolish takeaway

Looking outside the yield attractions, retail banks are priced for a perpetual Goldilocks scenario and are extremely vulnerable to any negative changes in economic conditions or investor sentiment. In my view the amber lights are flashing brightly – better value elsewhere.

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Motley Fool contributor Peter Andersen doesn't own shares in any companies mentioned.

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