Book Value: A Meaningless Measure of a Bank’s Worth

[flashl]

Call it the downgrade that launched a thousand “sells.”

Goldman Sachs Group downgraded Citigroup to a “conviction sell” and had a go at Merrill Lynch–which it expects to take a $4.2 billion third-quarter write-down–and J.P. Morgan, which Goldman expects to take a $1.2 billion write-down. Then, just as the selling frenzy in the markets hit fever pitch, Fitch Ratings caved to Ambac Financial Group and MBIA and stopped rating them.

On a day when the market was a whole suffered a more than 350-point downgrade, the financial sector is a bright, shining light of disaster for investors. And today’s downdraft highlights a growing problem for investors in the financial sector: “book value,” a measure of the strength of a financial institution’s balance sheet, has been a meaningless term nearly all year.

Here is the problem: bank balance sheets have massive amounts of debt. As write-downs related that debt pile up–and may even ascend to $1.3 trillion for the industry, according to hedge fund manager John Paulson–it is nearly impossible to pin down just how much debt is actually affected. With no reliable picture of the bad-debt exposure, you can’t get book value.

Sanford C. Bernstein analyst Brad Hintz wrote today: “Bernstein has used price-to-book metrics to value the large capitalization securities firms. Because earnings were difficult to be accurately forecasted and book value was viewed as a hard number, price-to-book was preferred to price-to-earnings. Historically, the price-to-book valuation of the securities firms has been correlated with ROE/cost of equity, credit ratings and business mix….Unfortunately, with the book value being used for future valuation uncertain, cost of capital increasing, credit ratings at risk and the business mix of these firm’s shifting as leverage changes, the results of these valuation regressions should be viewed only as long-term estimates in a ‘normalized environment.’”

WSJ

[Mountainman]

1. Book value is always meaningless. When a business is sold the assets are revalued to market value.

Reason being that market value is the amount of cash that an asset could be exchanged for. Book value may or may not be anywhere near the amount of cash that an asset could be exchanged for.