Measuring P/E Ratios for Financials

I was reading a report by the New York Times today, which outlined that Wall Street has earned half of what it earned last year because of massive credit losses. That’s a pretty spectacular fall. What it actually got me thinking about was how one measures P/E ratios.

Only a year ago, Wall Street reveled in an era of superlatives: record deals, record profit, record pay. But a mere 12 months later, nearly half of the profits that major banks reaped during that age of riches have vanished.

The numbers are staggering. Between early 2004 and mid-2007, a period of unprecedented wealth on Wall Street, seven of the nation’s largest financial companies earned a combined $254 billion in profits.

But since last July, those same banks — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — have written down the value of the assets they hold by $107.2 billion, gutting their earnings and share prices. Worldwide, the reckoning totals $380 billion, much of which reflects a plunge in the value of tricky mortgage investments.

The New York Times, 16 Jun 2008

The truth is banks are cyclical too. Their earnings go up in good times and decline when the credit cycle turns. So why is it that analysts try to estimate target prices based on forward P/E multiples? At a cycle trough P/E multiples are decidedly biased to the downside. The reverse is true when the economy booms.

In Robert Shiller’s book “Irrational Exuberance,” he fixes the problem by measuring P/E ratios over a full business cycle (he uses 10 years) to capture so-called ‘non-recurring’ items. Doing so for the financial services industry would reveal that their P/E/ has still not reached capitulation levels, suggesting more writedowns are to come. Parroting many investors, the New York Times article was unduly optimistic, suggesting the worst is behind us.

The threats to the broader financial system have receded in large part because of the extraordinary government-led effort to rescue Bear Stearns. And Wall Street seems to have the ability to come back from just about any downturn with new ways to churn even greater riches. That new, new thing may already be brewing across Bloomberg terminals and trading desks.

For now, investors are not holding out hope. They have dumped bank stocks with each round of bad news, and recently the financial sector lost its perch atop the nation’s stock market.

For financials, years of booking revenue and earnings on derivative instruments without the related longer-term losses artificially pumped up their earnings over the past five years. The chickens are now coming home to roost.

Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years
-Warren Buffett, 2003

Nearly Half of Wall St. Bank Profits Are Gone, The New York Times, 16 Jun 2008

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