EUFN: European Financial Stocks Remain Cheap

EUFN: European Financial Stocks Remain Cheap

KanawatTH/iStock via Getty Images iShares MSCI Europe Financials ETF (NASDAQ: EUFN ) is an exchange-traded fund that offers exposure to financial companies in Europe. The fund’s benchmark is the MSCI Europe Financials Index, and carries an expense ratio of 0.48% (in line with plenty of other niche funds offered by iShares, but not cheap by any means). The fund is popular, with $1.38 billion in assets under management as of March 11, 2022. That is in light of net inflows over the past year, although most recently EUFN has seen significant outflows. ETFDB.com As illustrated above, net inflows over the past year sum to circa +$377 million, however, in the two weeks commencing February 28 and March 7, net outflows were -$222 million and -$211 million, respectively. These outflows are not especially particular, though; the broader market has sold off, and EUFN has suffered similarly.

Yet EUFN is not expensive. The fund’s price/book ratio was 0.85x as of March 10, 2022, i.e., the average share price across EUFN’s portfolio was below net asset value (1.00x). Usually discounts to net asset value arise from poor returns on equity, and European banks are generally not expected to generate high returns on equity.

Still, if we look to the most recent factsheet for EUFN’s benchmark index, reported as of February 28, 2022, the price/book ratio then of 0.88x compares to the forward price/earnings ratio (estimated) of 9.43x. Dividing the former into the latter gives us an estimated return on equity of 9.33% at the portfolio level.

Professor Damodaran published his most recent estimate of the mature market equity risk premium of 5.37% as of March 1, 2022. That is elevated as compared to history, and reflects recent risk aversion as stocks have sold off amid various risks I have discussed in the past. These include inflationary pressures, a contracting fiscal impulse (government spending relative to GDP), a contracting credit impulse (bank lending to the private non-financial sector), and you could also add supply chain disruptions post COVID-19, plus the recent significant escalation in the Russo-Ukrainian War. Altogether, the world looks risky at the moment, so it makes sense that the equity risk premium (or ERP for short) is elevated.

Nevertheless, 5.37% is still below EUFN’s forward return on equity of 9.33%. Additionally, European bond yields are low. Using 5.37% as an ERP base, I calculate the full cost of equity by finding the regionally-weighted 10-year bond yield for EUFN’s portfolio, and adding that to our ERP base. I also include country risk premiums wherever available, as provided by Damodaran. Author’s Calculations I arrive at an estimated cost of equity of 6.79% here. This is still safely below the estimated forward ROE of EUFN’s portfolio of 9.33%. What’s more, Morningstar analysts’ consensus estimates for three- to five-year earnings growth rates for EUFN are currently set to 18.03%. Recent announcements from the ECB to scale back stimulus may also be supportive for commercial interest rate margins, and thus European financial companies, as well as for the euro (in which over 45% of EUFN’s holdings are denominated at the time of writing).

However, in spite of the recent earnings growth estimate, in light of inflationary risks and the escalation in the Russo-Ukrainian War, it would be a better idea to instead base our short-term forecast (for valuation purposes) on an ROE target, let’s say of 9% after year one. Additionally, we could assume portfolio-level dividend distributions (relative to portfolio earnings) of one third, which is just under the actual 34.6% per EUFN’s recent benchmark factsheet. That is, if I divide the dividend yield by the trailing earnings yield.

Following this trajectory takes us to a smoothed 6% earnings growth rate, after an initial dip in year one which is implied from data provided by MSCI (the benchmark index provider, whose results I prefer as they tend to be less forgiving than Morningstar and other providers). In spite of this “conservative” scenario (which may well not be conservative, but it would seem less optimistic than the consensus), the suggested valuation would imply that EUFN is deeply discounted. Author’s Calculations The uplift potential of over 100% is probably unrealistic. However, based on these inputs, an alternative way of expressing EUFN’s valuation is that the current share price would seem to lend to a cost of equity of 13.75%. That is high; far higher than risk-free rates across Europe (EUFN’s weighted average risk-free rate on the 10-year is just 0.93%). If I revise my ROE estimate down to just 5% after the initial year, […]

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