Is Bank of Ireland fairly valued at its current share price?

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.

When the return on equity rises relative to its cost, the value of the bank, its share price, will rise. That’s why bank management is always so keen to get those returns up. It’s also why they try to operate with as little equity capital as possible: thats another way of (artificially) increasing those returns

The global financial crisis was caused by banks boosting returns by increasing leverage: you can raise your return on equity, in the short run at least, by simply lending ever increasing amounts of other people’s money - bank deposits of one kind or another. This makes banks more risky which in turn implies that its cost of equity should rise - but investors missed this subtlety and kept supplying the banks with cheap capital. It wasn’t just regulators that were fooled.

Forcing banks to hold more equity capital is now the name of the regulatory game. A good rule of thumb for regulators: banks cannot have too much capital, whatever their CEO might tell you. Competition authorities should always ask why a bank is able to earn returns way above its cost of capital: it may be leverage but it just might also be an old-fashioned lack of competition and, therefore, the existence of excess profits.

A typical (and sensible) analysis of Bank of Ireland is currently provided by Emer Lang of Davy stockbrokers. She thinks that BoI will, over time, earn a return slightly above its cost of equity with a resulting fair value share price of 32c, above where Mr Ross is selling but not so far away that he might be leaving an excessive amount of money on the table. There is upside from the current share price, but not enough to interest the likes of Mr Ross. I wonder what that other large shareholder, Michael Noonan, thinks.