What metrics can be used to evaluate companies in the financial services sector?

Two of the best metrics for evaluating companies in the financial services sector are the price-to-book (P/B) ratio and the price-to-earnings (P/E) ratio.

The financial services sector includes the stocks of a variety of companies that provide financial services to retail and commercial consumers. The three primary industries within this sector are banks, investment firms and insurance companies. Investment banks are key in driving the overall financial markets, since they provide the capital that enables new corporations to begin operations and existing corporations to expand. Several financial service firms are expanding operations into emerging market economies such as India, Brazil and China.

Though the basic fundamentals of evaluation are applicable to nearly every type of firm, some critical and unique aspects of the financial services sector affect how it is valued. Companies within this sector operate under much stricter government regulations than the average corporation. Also, a key variable in the evaluation of a company's soundness is debt, but a financial service firm's debt is not always easily measured or defined, thus making the firm's value and its cost of capital difficult to estimate.

The P/B ratio, also referred to as the price-to-equity ratio, is utilized by traders and investors to compare the book value of a stock to its market value. The P/B ratio is a formula that uses the most recent quarter's book value per share to divide the present closing price of a stock. Low P/B ratios can be an indication of stock undervaluation. This metric is suited to the evaluation of the financial services sector specifically because historical analysis has shown the ratio to very accurately track the intrinsic value of financial service firms. (For related reading, see "How Are Book Value and Market Value Different?")

The P/E ratio shows the relation of a company's stock price to its earnings and is also a favored metric for evaluating financial service firms. A high P/E ratio is interpreted as signaling increasingly higher earnings for investors. This ratio is useful in the evaluation of the financial services sector because it indicates the likely future growth rate of a company. Investors should be careful, however, when employing both the P/B ratio and the P/E ratio to compare similar companies within the sector, such as comparing small banks to other small banks or one auto insurance company to another.

Discounted cash flow, although favored by some analysts, is a metric that is not considered particularly appropriate for evaluating companies in the financial services sector. This is because the nature of financial sector businesses often makes it difficult to specifically identify what constitutes capital expenditures and to accurately measure cash flow. More preferred evaluation metrics beyond the P/B ratio and the P/E ratio include return on equity (ROE) and the price-to-earnings growth (PEG) ratio. (For related reading, see "What Metrics Can Be Used to Evaluate Companies in the Banking Sector?")