SINGAPORE (July 25): Low interest rates are one reason why the financials sector is lowly valued, and the prospect of disruption may be another.
We think all industries are likely to be vulnerable to disruption in the coming years. We’ve seen it already in retail and media, for example, and this is likely to be a growing theme in markets for the long term. Financials, and banks in particular, are currently facing disruption to their business models. We can see this to some extent in valuations already.
The chart below shows that the price-to-earnings ratio (P/E) for the global developed market stock index, the MSCI World, is 17.4x (as at 31 May 2019) while financials are the most cheaply valued sector at 12.4x. Within financials, banks are even cheaper, with an average P/E ratio of just 10.1x.
The price-to-earnings ratio is a commonly-used valuation metric that divides a company’s price per share by its earnings (profits) per share. A higher number indicates a more highly-valued company.
We think the current relatively low valuation of financials partly reflects the threat of disruption to banks’ existing business models. This largely comes from new technology and new online businesses that are supplanting banks’ traditional services. Consumers are becoming more confident in seeking different solutions, often technology-based, to their banking and insurance requirements.
There are other reasons why banks are so cheaply valued. Chief among these is the low interest rate environment that has been in place since the 2008-09 global financial crisis.
Low interest rates put pressure on banks’ net interest income. This is the difference between money generated from assets (e.g. interest charged on loans to customers) and money the banks themselves pay out to customers (e.g. interest paid on savings).
However, we think disruption is also being reflected in valuations and it’s a theme that’s here to stay.
Roy Bateman is head of equities for Schroders