Economy’s Shift Prompts Same in Valuation Models

Improving economic conditions have compelled Merrill Lynch & Co.’s lead bank and brokerage analyst to change the way he looks at valuation models, for now.

Judah S. Kraushaar said in a research note Thursday that he was shifting to a “relative” valuation model -- which compares a company’s price-to-earnings ratio against that of the Standard & Poor’s 500 index -- from an “absolute” model, which merely calculates P/E. And Mr. Kraushaar said he was lowering his intermediate-term ratings on several companies for price reasons, leaving regional banks among the casualties. Cincinnati’s Fifth Third Bancorp was downgraded to “neutral” from “buy,” while Huntington Bancshares Inc. of Columbus, Ohio, and Silicon Valley Bancshares of Santa Clara, Calif., were slapped with a “reduce/sell,” down from a “neutral” rating. San Francisco’s Charles Schwab Corp. was also downgraded to “reduce/sell” from “neutral.”

The recent rise in long-term Treasury yields has made many financial stocks look fully valued on an absolute basis, according to Mr. Kraushaar. With a better economy promising to diminish credit concerns and boost demand for financial services, a relative valuation model was warranted, he said Thursday in a report titled “Banks, Brokers and Asset Managers: Going Beyond Absolutism.”

Under relative valuation, the median regional bank stock offers a 12% prospective return on investment, while those using the absolute model seem about break-even, Mr. Kraushaar wrote.

Investors tend to rely on relative valuations during periods of healthy economic growth, but they turn to absolute valuations in tougher spells, Mr. Kraushaar noted. He said in his report that his decision to adopt a relative approach to valuations was justified “so long as the economy continues to improve steadily and short-term rates stay under reasonable control.”

But Mr. Kraushaar’s report showed just how much the thinking is open to interpretation. Should the economy head south again, relative valuation could go right back out the window. “In our mind, a ‘double-dip’ for the economy would pose the critical risk for the more expansive relative valuation approach,” he wrote.

Some analysts use both relative and absolute models, but most tend to base their assumptions on the relative models, said Jennifer Thompson, an analyst at Putnam Lovell. Ms. Thompson explained that an absolute model is limiting because it does not allow investors to see a company’s price-to-earnings ratio in the context of the broader market.

In setting relative price-to-earnings targets, Mr. Kraushaar used a long-term average of 60% for the median regional bank, 65% to 70% for broker-dealers and money center banks, and 80% to 85% median targets for asset managers. These targets are above each group’s average, but are justified for the market-sensitive sectors since those stocks appear to be most economy-sensitive over time, the report said.

In contrast, regional banks are generally more sensitive to interest rates and usually perform unevenly several months after interest rates stop falling, Mr. Kraushaar wrote.

However, should the Federal Reserve raise short-term interest rates significantly, regional banks would be hit first. “Under that scenario, we would consider more actively taking profits, especially in the mid-cap group,” Mr. Kraushaar wrote.