Banks look good value as economy shows promise

Investor/An insider's guide to the market: Large financial institutions, both at home and abroad, tend to make newspaper headlines on a regular basis. This is not surprising given the pervasive influence that the banking and insurance industries exert on overall economic activity.

In recent years Irish financial institutions have generated more than their fair share of negative headlines. The banks' role in enabling customers to evade DIRT tax through bogus non-resident accounts has been the most significant story so far.

The recent revelation from AIB that it inadvertently overcharged customers for foreign exchange transactions over a long period of time is very much a self-inflicted wound. It damages the bank's reputation in the eyes of its customers and the regulator, irrespective of the fact that AIB is prepared to make full restitution to its customers.

From an investment perspective it might be expected that these various mishaps would have a negative impact on the share prices of banks. However, analysis of share price movements shortly after the announcement of bad news suggests otherwise. The recent foreign exchange overcharging revelations at AIB have had no apparent impact on its share price. This may be due to the fact that the financial impact is relatively small as the €25 million set aside by AIB is only a fraction of its annual profits of approximately €1,000 million.

The loss associated with the fraud perpetrated by John Rusnak was much larger at $700 million and this did depress AIB's share price for a short period. However, within a relatively short space of time the share price recovered.

Presumably, the key factor from a valuation perspective is that these financial hits are one-off events and so far they have not inflicted any lasting damage to the capacity of the bank to generate healthy profits over the long-term.

The current flow of news regarding business trends from Irish financials has been generally positive. For example, at its recent annual meeting Irish Life and Permanent was very upbeat regarding trends across its business divisions. The group stated that it was experiencing exceptional growth in new mortgage lending. On the life side the company reported that consumer demand was strong for both its investment and pension products. On the pension front management stated that it viewed the PRSA initiative as a core element in the stronger demand for its pension products.

Bank of Ireland's results for the year ending March 2004 provide further evidence of the capacity of Irish banks to generate healthy returns. The recovery in world stock markets over the past year enabled the bank's life division to grow its profits by 69 per cent whilst asset management services grew profits by 11 per cent. The core retail banking operation in Ireland also performed well due to a very strong rise in the total loan book.

Unlike AIB, Bank of Ireland did not slip on any banana skins recently. However, as the accompanying table shows Bank of Ireland is valued at a discount to AIB, giving some credence to the view that one-off negative events tend to be ignored by the market.

Bank of Ireland currently trades on a price-earnings ratio (PER) of 8.9 compared with AIB's PER of 9.6. Banks are also often compared on the basis of the relationship between share price and the net asset value or book value per share. At current share prices Bank of Ireland is estimated to trade at 2.1 times book value whereas AIB trades on a higher price-to-book ratio of 2.6.

This valuation comparison indicates that Bank of Ireland offers better investment value than AIB. However, this discrepancy in relative valuations is not particularly large, as a positive relative move of 5-10 per cent in Bank of Ireland's share price would erode most of the difference.

A more interesting issue is why Irish banks as a whole seem to be undervalued in terms of the most widely used valuation metrics. As discussed earlier the various one-off hits to banks' profits do not seem to be the cause. In fact UK banks are also valued similarly to Irish banks.

For example, Royal Bank of Scotland and Northern Rock are each trading on a PER of 9.7, which is the same as that for AIB. Both the Irish and UK economies are performing much better than the European average and the medium-term prospects for both economies are good.

Against such an economic backdrop Irish and UK banking stocks should be capable of delivering attractive growth in earning and dividends over the medium term. In this context current bank valuations look anomalously low and if the Irish and UK economies continue to perform well then it should only be a matter of time before bank share prices on the Irish and London stock exchanges improve in tandem.