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World's problems analysed
Sep. 19th, 2008 03:23 pmYou know what the problem with the financial system comes from?
A share in a company is generally valued by multiplying its expected profits by some factor - quite what that factor is can be a little arbitrary, but there normally is one.
When you take a bank, which has huge assets and huge liabiilties, the profits are very very small compared to the groos amounts of the assets and liabilities. So a very small movement in the value of those assets or liabilities has an enormous effect on the profits. Which then has a huge effect on the share price.
Indeed, to take a simple model: say we have assets of 1,000 and liabilities of 900, and being cunning fund managers we average 10% on our assets but 9% on debts. That means we have income of 100, costs of 81, and a profit of 19.
If our assets go down in value by say 1%, then we've apparently lost 10. So our profits are now only 9 - less that half what they were! So, applying a multiple to earnings (ceteris paribus), our share price will halve - the company is apparently worth half what it was, because its net assets have gone down by 10%. Now if you were to apply a net assets valuation then the share price would have barely moved.
So the whole problem is analysts applying short-term formulae when valuing shares rather than looking at the underlying health of the business. You'll note that HBOS's capital base is regarded as healthy - it only needs help because of a short-term dip in profits. It's like saying a house used to be worth £200,000, but the cost of repairs this year has used up all the rent and left no profit, so the house is worthless and if we sell it for a song we'll be better off.
What we need is more volatility in the markets, then people would have to look below the surface to make valuation decisions :-) Or else go back to historic cost accounting ;-)
A share in a company is generally valued by multiplying its expected profits by some factor - quite what that factor is can be a little arbitrary, but there normally is one.
When you take a bank, which has huge assets and huge liabiilties, the profits are very very small compared to the groos amounts of the assets and liabilities. So a very small movement in the value of those assets or liabilities has an enormous effect on the profits. Which then has a huge effect on the share price.
Indeed, to take a simple model: say we have assets of 1,000 and liabilities of 900, and being cunning fund managers we average 10% on our assets but 9% on debts. That means we have income of 100, costs of 81, and a profit of 19.
If our assets go down in value by say 1%, then we've apparently lost 10. So our profits are now only 9 - less that half what they were! So, applying a multiple to earnings (ceteris paribus), our share price will halve - the company is apparently worth half what it was, because its net assets have gone down by 10%. Now if you were to apply a net assets valuation then the share price would have barely moved.
So the whole problem is analysts applying short-term formulae when valuing shares rather than looking at the underlying health of the business. You'll note that HBOS's capital base is regarded as healthy - it only needs help because of a short-term dip in profits. It's like saying a house used to be worth £200,000, but the cost of repairs this year has used up all the rent and left no profit, so the house is worthless and if we sell it for a song we'll be better off.
What we need is more volatility in the markets, then people would have to look below the surface to make valuation decisions :-) Or else go back to historic cost accounting ;-)
Anyway, no real point to this post, just venting slightly :-) I'm looking forward to going to Canary Wharf again to see the sheep panicking :-)
