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BY MICHALIS MAKROMINAS
The ratio of Book Value of Equity to Market Value of Equity (henceforth B/M ratio) has always presented a puzzle in contemporary finance. Book Value of Equity is typically defined as the difference between a company’s assets and liabilities. The Market Value of Equity equals the share price of a company multiplied by the number of shares outstanding. Even though Book Value and Market Value of equity are both quantitative expressions of the net worth of a company they rarely provide the same number.
When the Book Value of Equity is the same as the Market Value of Equity, the B/M ratio equals 1, sometimes called a “Normal” B/M ratio. For most stocks, the B/M ratio is actually less than 1. B/M ratios greater than 1 are also to be found, even though these ratios are rather transitory and they have been shown to diminish under unity after a certain amount of time. Normal B/M ratios nonetheless, are sparse for all classes of stocks, but one: banks.
The B/M ratio of banks is not only shown (on average) to approximate 1, it is expected to be so. The reason behind this convergence lies in the composition of a bank’s balance sheet: most of its assets (loans) and most of its liabilities (deposits) are easier to record using mark-to-market accounting, hence eradicating the disparity between book value and market value. The above argument is of course over-simplified and experts will point out that a bank’s balance sheet is vastly more complex and that non-tradable loans are no easier to record than any other type of asset. If any, though, a more elaborate analysis of modern banks, should, in the presence of intangibles and growth options, point out to B/M ratios less than 1.
So what does it mean for Cyprus banks to have B/M ratios greater than 1?
Table 1: B/M Ratios of Cyprus Banks as at 31 December
2011 2010 2009
Bank of Cyprus 6.25 1.18 0.83
Marfin Popular Bank 10.00 3.13 1.89
Hellenic Bank 5.56 2.00 1.41
Source: Bloomberg
First, the financial reporting of the banks, which gives the book values, and the investor sentiment, as reflected in share prices, are in disagreement. Second, the direction of disagreement suggests that investors believe that the banks are worth less than what their managers and accountants assert to. Third, the degree of disagreement is substantial. At the end of 2011 the three banks were traded (on average) 7.27 times below book value compared to 1.38 in 2009. Fourth, one can look at the source of disagreement. Since the Book Value of Equity equals the difference between assets and liabilities and since liabilities consist mostly of deposits, the value of which is known, it must be that assets, comprising loans, are overstated. This points to the exposure of Cyprus banks to Greek bonds and/or to portfolios of loans linked to Greek households.
Interestingly enough, and irrespectively of the looming “haircut”, one can calculate how much of these loans need to be written off (all other factors constant) for the B/M ratios to return to normality. Once the amounts that need to be written off are established, one can further estimate the amount and quality of “fresh” capital that is needed for banks to meet regulatory requirements. Finally, one may even dare gauge a bonafide probability of default, by assessing the availability of needed funds and the likelihood that these funds are in fact given to banks.
It is a fanciful, albeit disheartening exercise. One thought may alleviate the gloominess: perhaps the market is also wrong and the share prices should have been higher. After all, the well functioning of a market is subject to such factors as liquidity, free float and the presence of rational investors.
Michalis Makrominas is Lecturer in Finance at Frederick University.
