Canadian banks have reached the unfortunate situation in which an asset can suddenly turn into a liability. In this global credit crisis, no lender can be sure of the value of many assets in the complex world of derivatives, securitized debt and collateralized debt obligations.

As the stock market’s recent performance shows, investors’ love affair with banks and other financial services institutions has ended. These stocks peaked in May 2007. Since then, the S&P/TSX financial subin-dex has dropped 14%, and the bank component of that has dropped 15%.

Last year, investors eagerly sought bank stocks for their dividend yields and ever-present growth. Now, because of the credit crisis, those same dividends are available at much better prices. Bank valuations, though, have entered the realm of hypothesis and guesswork. Downside derivative and securitized risks — although quantified in theory — are unknown because the worldwide ripple effect of asset losses continues.

All Canadian banks are exposed to derivatives, both as assets and as liabilities. The positions are roughly balanced, bank by bank. For the Big Six banks, derivatives account for a significant proportion of assets. (See accompanying table, near right.)

In addition to assets that may become worth far less than their cost, banks face the same problem every business confronts in a business contraction: lower sales. As a result, lower income and lower earnings are likely for this year and possibly for the longer term.

Banks usually run the stock market race in a bunch. But the credit crisis is separating the runners in Canada. CIBC, which burnt its fingers in the Enron Corp. scandal, has also burnt its hand in CDOs. It has arranged a $2.8-billion rescue package, which will dilute shareholder value by about 12%. National Bank of Canada has also been burnt by the collapse of asset-backed commercial paper.

As a result, CIBC shares have dropped 35% from their high. Bank of Montreal, National Bank and Royal Bank of Canada shares have dropped between 21% and 26%. Escaping the worst are Bank of Nova Scotia and TD Bank Financial Group, with losses of 14%-15%.

The real winner among this group, though, is Canada’s seventh-largest bank, Edmonton-based Canadian Western Bank. Its shares have dropped only 12% and its exposure to derivatives is nominal.

Canadian Western also scores better than the Big Six on growth — book value has gained 11.5% a year over the past five years — and balance-sheet strength. As a result of this, the market values Canadian Western highly. It trades at the highest multiple of current earnings, the lowest dividend yield and the highest relative to total income (price/sales).

The bottom-line question is: which banks have the strongest balance sheets? The calculation of their total capital ratio gives one array of answers. And for all its problems, CIBC ranks highest by this measure.

The ratio of equity to total assets offers another view of financial strength. This comparison places Canadian Western and TD at the top and CIBC at the bottom.

Assuming the avoidance of disaster in the world’s banking system, the question becomes: at what price point are bank shares buys?

From a balance-sheet view, stocks trading about one and a half times book value of shareholders’ equity have historically been viewed as cheap. At recent prices, Canadian bank shares were above that acid-test level.

Average return on equity provides a window on potential earnings. A “reversion to the mean” in ROE suggests possible earnings levels in the coming year or two, assuming no big writedowns of shareholders’ equity.

Average earnings power comes into play for analysis. Seven-year average earnings per share give a fair picture of long-term earnings power, so a multiple of that can suggest a purchase level. As price/earnings multiples drop in a bear market, investor expectations should drop, too. So, perhaps banks will be safe to buy at, say, 15 times their average long-term earnings.

Years ago, George Lasry, an investment manager in New York, developed a pair of formulas for estimating stock values using only current dividends, ROE and book value. These ultra-conservative valuation formulas have been useful in analysing bank stocks. Current calculations equate the stock price as roughly 15 times seven-year average earnings per share.

The last two methods disagree materially for only one stock: RBC. The Lasry formulas — using a 10% rate of return for possible alternative investments — suggest a value of $31-$33 a share for RBC, compared with the $26 suggested by the average earnings multiple. IE

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