I have seen that finance companies are valued mostly as multiple of Price to book. Why so?
I understand that
Book Value = Assets - Liability
Assets mostly in case of finance companies should be loan given.
Liability should be money taken into the company via NCD, banks etc to give loans.
Finance companies usually MTM their assets, so its kind of a rough valuation. Whereas for other companies assets are not MTM so assets may be much more than their book value or much lower
The main reason why finance companies are valued on Price to Book is because their raw material is cash. Their most productive asset is money. Hence the networth (i.e book value), which is mainly in different forms of cash, is a truer reflection of the worth of the company. Compare this to a manufacturing entity, where the productive assets are mainly plant and machinery, and cash typically forms a smaller part of the balance sheet. The earnings power of these assets are a better reflection of the value of the company, and hence PE is a better measure.
Having said that, in times of distress, PB can give a better idea of the worth of a manufacturing concern, whereas when times are good (bull markets), PE is used to justify higher valuations for a financial entity. For eg. in 2008-09, Hindalco was quoting at just a fraction of the book value (which mainly comprised of its factories), even after putting an adjusting % for past over-invoicing etc. (I use this as an example, because I had personally used this metric, and it resulted in my making decent returns when things turned around).
Having said that, I prefer the use of PE as a valuation tool even for banks and NBFCs, because I believe that some firms are better at managing their raw material (cash) to make it more productive, with lesser risk, than others. Otherwise, its a matter of individual comfort what one wants to use.
Read Accounting for Value by Pennman for understanding Book Value and related concepts. It’s a must read for value investing,
