The financial services sector includes 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 have operations globally, as well as an ever-growing presence in emerging market countries.

Insurance companies are an integral part of any society as they protect people against unexpected losses in a variety of areas. Investment firms, such as mutual funds and hedge funds, provide an opportunity for individuals to put their money to good use and grow their wealth.

Though the fundamentals of evaluation apply 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.

Many different financial ratios can help evaluate a company in the financial services sector, two of the best metrics are the price-to-book (P/B) ratio and the price-to-earnings (P/E) ratio.

Key Takeaways

  • The financial services sector includes companies that provide financial services to retail and commercial clients.
  • Traditional companies in this sector include insurance companies, banks, and investment firms.
  • The financial services sector has certain attributes that make evaluating the companies within it unique, such as higher government regulation and their organization of debt.
  • Two important ratios in evaluating the financial services sector are the price-to-book (P/B) ratio and the price-to-earnings (P/E) ratio.
  • The P/B ratio compares the book value of a company to its market capitalization.
  • The P/E ratio shows the relation of the company's stock price to its earnings.

Price-To-Book (P/B) Ratio

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 that the ratio can accurately track the intrinsic value of financial service firms.

Price-To-Earnings (P/E) Ratio

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 of a company.

Other Ratios to Use and Not to Use

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-to-growth (PEG) ratio.

Discounted cash flow is an excellent tool for corporations when choosing to invest in a new project as it considers the time value of money.

The Bottom Line

Financial ratios are an important tool in evaluating a company to determine whether or not it is a sound investment. Though most financial ratios provide insight, specific ratios work better for different sectors, due to the specific characteristics that define that sector. When evaluating a company it is critical to utilize the ratios that suit it the best and that will shine the most light on it as an investment.

Investors should be careful, however, when employing any ratio to compare companies within a sector, such as a small bank to an auto insurance company, as it would not be an apples-to-apples comparison.