If you follow bank stocks at all you’ve probably been reading a good deal about stress tests and low tangible common equity ratios at the nation’s largest financial institutions.
Tangible common equity is the capital surplus left once all liabilities, preferred stock, goodwill, and intangibles are removed from a company’s balance sheet.
You then divide this number by the tangible assets a firm has to determine the firm’s tangible common equity ratio.
From what I have been reading bank analysts like banks with a tangible common equity ratio between 3-5%.
For some financial institutions the number is in the 1-2% range which has apparently caused great alarm.
For example, by my calculations at the end of the 4th quarter of 2008 Citigroup had a tangible common equity ratio of 1.2%, Bank of America 2.1%, Wells Fargo 2.3%, and JP Morgan Chase 3.4%.
But exactly how important is this ratio in determining a company’s financial health and more importantly, future prospects?
For example, Proctor & Gamble, a stalwart of the Dow Jones Industrials, has a tangible common equity ratio of -54.9% (that’s right, minus).
Yet no one is talking about P&G’s precariously low tangible common equity ratio.
Why?
Because investors feel Proctor & Gamble’s goodwill & intangibles have enduring economic value and that the company’s future earning power is much greater than it’s current balance sheet reflects (why else would you buy common shares with a tangible book value of -$9.28).
Tangible common equity ratio’s are a good tool and should not be ignored, but they provide no information about the single most important factor when investing: a company’s future prospects.
As such, the real key is not what a company’s tangible common equity ratio is but which way it’s headed: think AIG, which had a tangible common equity ratio of 8.3% at the end of 2007.
(Disclaimer: the author of this article owns positions in the securities discussed above).
