1.1 Background and Motive
Valuations of businesses tend to be complicated and difficult to understand. However, Roger Montgomery details a fundamental valuation approach in his 2010 book, Value.ABLE, which is both intuitive and easy to use. The purpose of this paper is to expand upon the Roger
Montgomery valuation method which is heavily based on works done by Warren Buffet and Benjamin Graham and to apply it to American banks during the peaks of economic bubbles and to Chinese banks to determine if they are in the same situation. Gareth Cottam (2010) discovered in his paper entitled “The Measurement of Chinese Banks’ Intrinsic Value in its Developing Securities Market” that the large state owned banks (SOBs) were undervalued when compared to the non-state owned banks. This is largely attributed to large commercial bank’s stable intrinsic value from large capital inflows from the PRC government and the creation of asset management corporations (AMCs) to take possession and dispose of non-performing loans (NPLs) created during the 1990’s. However, Cottam didn’t take into account the effects of inflation and potential non-performing loans due to a large cash injection into the Chinese economy in the form of the 2009 economic stimulus package of 4 trillion yen (586 billion USD) and a 30% credit expansion from 2008 to 2009 (Shih, 2009) that could potentially lead to over investment and
over-leveraging.
Aspects of the economic environment faced by the Chinese banks are similar to those faced by the U.S economy prior to the 2000 dot com crash and the 2008 financial crises. This paper will attempt to quantitatively compare the three time periods by examining the price gap between the intrinsic value and share price of three of each country’s largest banks during those periods. The
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period prior to the 2000 US dot com crash was chosen because the operating activities of the American banks prior to the 2000 dot com crash is analogous the operating activities of the Chinese banks. Chinese banks’ revenues mostly comprise of interest earned from loans and are more comparable to the commercial banks of the US prior to the repeal of the Glass-Steagall act in 1999. The period before the 2008 US financial crisis was chosen because the loose monetary policy and proliferation of bank loans is comparable to the situation faced by the Chinese banks economy from 2008-2010. Interest rates dropped to an all-time low when Greenspan lowered interest rates to 1% in the US from 2001 to 2005 (Lee, 2009). This resulted in an explosion of house hold debt and subprime mortgages that the debtors were unable to repay. Similarly, the Chinese government injected over 700 billion USD into their economy while encouraging local governments to stimulate the economy by beginning construction projects. This led to a rise in local government debt, inflation, and property prices from 2008-2011.
1.2 Purpose of the Research
The purpose of this paper is threefold. First, the Roger Montgomery Value.Able method will be used to compare the Chinese banks with American banks during bubbles in 2000 and 2007. Next, the Chinese bank valuation will be adjusted for unexpected inflation. Finally, Chinese bank valuations will be adjusted to depict valuations for possible NPLs in the future and then compared with valuations of American banks during similar asset bubbles. The hypotheses of this paper are as follows.
H1. Bank shares during a bubble will be over-valued when compared to valuations after a bubble burst.
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H2a. The valuation of the Bank of China, Bank of Communications, and Minsheng Bank in 2011 using the Montgomery valuation method will show that the Chinese banks are undervalued compared the valuations of Morgan Stanley, Capital One, and Bank of America during the peak of the 2000 dot.com bubble and JP Morgan, Citibank, and Bank of America during the 2007 subprime crisis.
H2b. Unexpected inflation-adjusted valuations of the Chinese Banks in 2011 will show that the Chinese banks are overvalued intrinsically and when compared to US banks during the dot com bubble and 2007 subprime mortgage crisis.
H3. Valuation of Chinese banks in 2011 adjusted for possible levels of non-performing loans in China will show that the Chinese banks are actually overvalued when compared to American banks during the 2000 dot.com bubble and 2007 subprime mortgage crisis.
1.3 Research Scope and Target Banks
This study will focus on three American banks during the 2000 dot.com bubble, three American banks during the 2007 subprime crisis, and 3 Chinese banks from 2007 – 2011. Of the three Chinese banks, two are state owned banks and one is a privately owned bank. These are as follows:
United States 2000-2004: Bank of America, Capital One, and Morgan Stanley
United States 2007-2011: JP Morgan Chase & Co., Citibank, Bank of America
China 2007-2011: Bank of China (BOC), the Bank of Communications, and Minsheng Bank
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The primary valuation method will be the Montgomery Value.ABLE method. This study will assume that the financial statements of the Bank of China, the Bank of Communications, and Minsheng Bank adhere to IFRS and are equally as transparent as the financial statements obtained from the US banks used in this study. Also, it is assumed that all banks in this study operate under strong form efficiency to account for possible insider trading. These assumptions can be made because the three Chinese banks in question are cross listed on the Hong Kong Stock Exchange, a more mature stock market with tighter regulations than the Shanghai Stock Exchange.
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