Financial Markets Are Dangerous Places!

Friday, June 13, 2008

It has now become clear why financial companies trade at very low multiples relative to other market stocks. Banks and brokers have traded between nine and twelve times earnings for years while other market stocks average around sixteen times earnings. We now, once again, realize why these companies trade at such low multiples.

Companies trade at multiples relative to their earnings based on their expected future growth as well as the potential risk to that expected growth. Previously, I had never really considered the fact that price-to-earnings ratios are based not only on growth but also the standard deviation of potential growth. A company with a ten percent growth rate with a two percent standard deviation should clearly trade at a higher multiple than a company with a ten percent growth rate and a ten percent standard deviation. I have now realized that this concept must be calculated when considering a company's accurate valuation.

Case in point: James Cayne, we assume speaking faithfully, asserted publicly that Bear Sterns would turn a profit in the first quarter of 2008. Within a week, Bear Sterns was negotiating a two dollar purchase price for its shares with JP Morgan as the acquirer. This unbelievable collapse of the fifth largest investment bank in the world shook financial markets around the globe. The incredible quickness of Bear Sterns' fall makes clear that financial markets are dangerous places. Bear Sterns' ill-fated bets on collateralized debt obligations with subprime mortgages as the collateral produced spectacular loses as home values fell and interest rates were raised. The swiftness of the fall stunned investors. A once twenty billion dollar company less than a year prior was now offered to JP Morgan for less than one half of one billion dollars. Eventually, Bear Sterns was acquired for $1.7 billion by JP Morgan.

The Bear Sterns collapse and the roiling of all financial company stocks sheds light on why we choose to price companies not only relative to their growth but the risk to their expected growth. This concept must always be remembered by the investor.


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