Amazon.com, Inc. (AMZN), Yelp Inc (YELP): Great Ways To Lose Good Money

3. Valuing financials based on P/B only

Warren Buffett has implemented a share repurchase policy in his company, which allows the company to buy-back stock of Berkshire Hathaway Inc. (NYSE:BRK.B) at no more than 120% of book value. However, that doesn’t mean that Buffett uses the P/B ratio to value financial names.

Financial stocks are usually valued by investors and analysts with the Price/Book ratio, or a more prudent approach–the Price-to-Tangible Book ratio. However, the Oracle of Omaha gave out his methodology of valuing banks in a recent interview with CNBC. Buffett’s chosen method of valuing banks is return on assets and earnings power, and not book value.

His preferred method of valuing banks is Return on Assets (ROA), and he stated that banks that earn 1.3% or 1.4% will end up selling above their tangible book value. As the earnings flow through to book value over time, banks that earn decent returns will do well and sell above book value.

Buffett’s favorite bank Wells Fargo & Co (NYSE:WFC) has a ROA of more than 1.46%, and the conservatively run bank trades at a much higher P/B multiple of 1.47, compared to peers. Whereas, Bank of America Corp (NYSE:BAC) earns a much lower ROA of only 0.23%, and as a result it is trading well below book value. Bank of America has a current P/B of only 0.64, which is widely expected to go north, as the company is still unwinding its troubled mortgage assets.

The Takeaway

Valuing a company solely based on book value or a P/E multiple is not the most correct or accurate approach. A company’s earnings capabilities and competitive positioning should be assessed as well in order to develop a big picture view.

Ishfaque Faruk has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Bank of America, Berkshire Hathaway, and Wells Fargo (NYSE:WFC). The Motley Fool owns shares of Amazon.com, Bank of America, Berkshire Hathaway, and Wells Fargo.

The article Great Ways To Lose Good Money originally appeared on Fool.com and is written by Ishfaque Faruk.

Ishfaque is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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