Name the measures analysts watch in four industries where the accounts work differently.
Marcus built a comps table for Larkspur in earlier lessons. They then tried to build one the same way for the bank shares they hold, and gave up before reaching EV/EBITDA. A bank has no meaningful EBITDA, because interest is both its main revenue and its main cost, so EV/EBITDA does not work for banks.
Lesson 8.7, "Valuing banks and REITs, where a standard DCF breaks", showed why a bank needs its own valuation method. Banks are one of four kinds of business whose reported figures the tools from modules 7 to 9 read badly. The other three are insurers, commodity producers and subscription software companies. Analysts who cover these four watch a handful of industry measures instead of standard multiples.
A bank borrows from depositors and lends at a higher rate. Five measures cover most of what a bank analyst watches: net interest margin, loan growth, credit costs, capital ratios and return on equity.
Net interest margin is net interest income divided by average interest-earning assets. To get net interest income, take the interest earned on loans and securities and subtract the interest paid on deposits and borrowing. A bank with net interest income of S$2.2 billion on S$100 billion of interest-earning assets (example figures) has a net interest margin of 2.2%. Singapore rates follow US rates, as lesson 4.6, "Singapore's exposure as a trade and financial hub", explained. As a result, Singapore banks' margins have tended to rise when US rates rise and fall when they fall.
Loan growth shows how fast the balance sheet is expanding. Always read it against credit costs, because fast growth can mean lending standards have slipped. Credit costs are provisions for bad loans as a share of average loans, quoted in basis points. To work them out, take the provisions, divide by average loans and express the result in basis points. Provisions of S$200 million on S$100 billion of loans (example figures) give credit costs of 20 basis points, or 0.2%. A rise in credit costs comes straight out of profit, and these rises usually arrive in a downturn, when margins are falling too.
Capital ratios measure how much loss a bank can absorb. The main one is the common equity tier 1 (CET1) ratio, which compares core equity with risk-weighted assets. MAS sets the minimum CET1 ratio for Singapore banks. Check the current requirement on the MAS website instead of relying on a figure you read elsewhere.
Return on equity ties the other four measures together. Lesson 8.7 found that a bank's fair price to book depends on whether its return on equity beats its cost of equity through a credit cycle. You use the five measures to judge whether it does.
General insurers sell cover for cars, homes, travel and businesses, usually a year at a time. Their main measure is the combined ratio: claims plus expenses, divided by premiums earned. Say an insurer pays 65 cents in claims and 30 cents in expenses for every dollar of premium. Its combined ratio is 95%, so it makes 5 cents of underwriting profit per dollar before any investment income. Below 100%, the insurer makes an underwriting profit before it earns anything from investing the premiums. Above 100%, it loses money on the insurance itself and relies on investment income to cover the gap. One bad storm season can swing a single year, so look at the trend over several years.
Life insurers sell policies that last decades, so one year's profit tells you little. Analysts use embedded value instead: net assets plus the present value of future profits from policies already sold. They also watch the value of new business written each year. That figure shows whether the company is adding to its embedded value or living off policies it sold in the past.
Miners, oil producers and palm oil planters cannot set the price of what they sell, because the world market sets it. What they can control is cost, so the main question is where a producer sits on the industry cost curve. A producer in the cheapest quarter of the curve stays profitable when prices fall, while one in the most expensive quarter loses money first. Gold miners report a standard cost measure, all-in sustaining cost per ounce, and other industries have their own versions.
The second measure is reserve life: proven and probable reserves divided by yearly production. A miner with 120 million tonnes of reserves producing 8 million tonnes a year has a reserve life of 15 years at its current rate. When reserve life is short, the producer has to spend heavily to find or buy more reserves, which means its current free cash flow overstates what it can keep paying out. Lesson 9.2, "When each multiple misleads: cycles, leverage and accounting", applies in full here. Commodity producers are cyclical companies, and their P/E looks lowest at the top of the price cycle.
Subscription software companies spend heavily up front to win customers, then earn from those customers for years. Their income statement can show losses while the business underneath is healthy, or profits while it is quietly shrinking.
The first measure is annual recurring revenue (ARR), the yearly value of subscriptions in force. The second is retention, usually measured as net revenue retention. To calculate it, pick out the customers who were there a year ago. Take this year's revenue from them, after upgrades, downgrades and departures, and divide it by last year's revenue from the same customers. If those customers paid S$10 million last year and S$11.2 million this year, net revenue retention is 112%. Anything above 100% means existing customers are growing on their own.
The third measure compares the cost of winning a customer with the gross profit that customer brings in. Take a company that spends S$1,200 in sales and marketing to win a customer paying S$100 a month at a 75% gross margin (example figures). The customer brings in S$75 of gross profit a month, so the payback period is S$1,200 divided by S$75, or 16 months. If 2% of customers leave each month, average customer life is 1 divided by 2%, about 50 months. Lifetime gross profit is S$75 times 50, about S$3,750. That is a little over three times the cost to win the customer (S$3,750 / S$1,200 = about 3.1). Track this ratio over time. When it falls, growth is getting more expensive, even if revenue is still rising.
For any company outside ordinary manufacturing and services, find out which measures its industry's analysts watch before you trust a standard multiple. Results presentations from the large companies in the sector usually lead with these measures. You'll also find them in broker reports and in publications from industry bodies. Once you know what they are and how the company scores on them, you can decide whether a standard multiple tells you anything useful.
Choose one company from one of these four industries. Open its latest annual report or results presentation, ready to find the three measures its analysts would check first.
Pick a company in one of these four industries. Find its three main industry measures in its latest report.
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