"Does P/E Mean Anything for Bank Stocks? May 6th, 2009
By David Goldman
What is a stock? According to the Nobel Prize winner Robert Merton a stock is a call option on the assets of the firm. It is undated, so that the option is perpetual. This makes equity valuation somewhat mystical when stock prices are very low and current earnings are neglible. In the case of Citigroup, for example, at yesterday’s close of $3.31 a share, a 10-year option at the money should have cost about $3 per share — almost the entire value of the stock price. A 10-year, at the money option on JPM at the money should have cost about $18, or slightly over half the stock price. And an at-the-money 10-year option on MSFT should have cost about $6, or a third of the stock price.
There are two components of the stock price, in short: the option value of possible future cash flows, and the discounted value of cash flows that are more or less predictable. Citigroup has no cash flows at the moment; JPM has some. MSFT has a lot. Ivolatility.com has a basic options calculator that will pull in data and allow the user to play with assumptions.
Citigroup will be a zombie for years. It won’t have a lot of cash flows. If it ever regains even a fraction of its former franchise, though, its stock price will be five or ten times what it is now. That’s pure option value. Price-earnings ratio means nothing.
Valuation of bank stocks, in short, is highly uncertain: it requires a set of assumptions about future earnings that cannot be extrapolated linearly from current data.
An interesting question is: why should Citigroup’s stock price rise as implied volatility on its options falls? If the stock is a call option on the company’s assets, shouldn’t it be worth more if volatility rises?
Volatility, as the above chart from ivolatility.com shows, has been plunging,
The answer is that short-term volatility has very little to do with the long-term, ten- to twenty-year volatility of the firm’s assets. The prospect for a big move up or down over the term adds to the option value of the stock."