Years after the great financial crisis, interest rates are heading even lower. From Japan to Germany, interest rates are so low that they're negative -- that's right, negative! Some investors are actually choosing to lose money by investing in government bonds.
But this week's episode of Industry Focus: Financials has it all. Join us as The Motley Fool's Gaby Lapera and Jordan Wathen discuss accounting ratios, negative interest rate policy, and why it's so darn hard to make accurate predictions about the future.
A full transcript follows the video.
This podcast was recorded on March 7, 2016.
Gaby Lapera: Financial metrics, negative interest rates, and forecasting. Welcome to Industry Focus!
Welcome to Industry Focus: Financials edition. This is Gaby Lapera. Joining me on the phone is Jordan Wathen. Today is March 7th, 2016, and I am very excited today. We have a three-part show. Normally, we pick one topic, but I think I kind of miss the old format, where we covered a plethora of topics. Today, we're going to start with a couple metrics, which are book value per share and return on equity. We had a reader write in -- I guess he would be a listener, wouldn't he? We had a listener write in, named Lucas Coffey. Thank you very much for the get-well email I got last week, Lucas. And, he wanted us to talk about different metrics, so I figured we'd cover one or two a week until we got through his entire list. This week, we're going to start with book value per share and return on equity.
Jordan, do you want to go ahead and start talking about book value per share?
Jordan Wathen: Sure. So, when you think about book value, book value is essentially shareholders' equity. And you get to shareholders' equity by looking at the balance sheet. You look at assets and you subtract the liabilities from the assets to get to shareholders' equity. And then, from there, of course, you divide shareholders' equity by the number of shares to get your book value per share.
And this is a really valuable thing to understand. Essentially, what shareholders own of a company, once all the liabilities, the bondholders, the people who have given you inventories, for example, on credit, once they're paid off, what do shareholders have left over for them? And so, understanding that value on a per-share basis can really help you understand the value that underlies an individual share you might own. So, if you own 100 shares, and you can know what the book value per share is, you know, basically, the net value of those shares for accounting purposes.
Lapera: I have a question for you. What about intangible book value?
Wathen: Intangible book value, especially -- this is a financials show, so with banks, it's an important one. Intangible book value, especially for banks, is usually goodwill. So, it's the value that exceeds the tangible value of assets from an acquisition. So, if a bank buys another bank, they're not just going to pay 1x equity. They'll usually pay something like 1.5x equity, and the extra 0.5 times equity has to be applied to an asset after an acquisition. And usually, that's ascribed to goodwill, which is basically the value of customer relationships, the value of the brand, things that necessarily couldn't be sold, if you had to sell them.
Lapera: Right, it's not a printer. It's more of a feeling.
Wathen: Right, it's something that doesn't really exist, but it does. It's hard to explain. (laughs)
Lapera: Yeah, absolutely. But it still factors in to book value per share, so it's just something you kind of want to keep in mind. You could, of course, do tangible book value per share. And tangible, of course, means things you can touch. So, it's literally the assets the company has, excluding any sort of goodwill that might be factored into the books.
Wathen: Right. When people look at banks, they usually like to look at tangible book value because it gives you a very good understanding of what the actual real liquidation value of a bank is. Also, when you're measuring return on equity, which we're going to get to, if you measure return on tangible equity, that's kind of like a measure of how fast a bank could grow organically, instead of acquisitively.
Lapera: OK. You kind of teed yourself up there, do you want to talk about return on equity now?
Wathen: So, return on equity, once you've calculated book value -- so, you take your assets, you subtract liabilities, now you have your book value. Return on equity is, you take the company's net income, then you divide it by the book value. So, if a company makes $100 million on a book value of $1 billion, the return on equity for this company would be 10%.
Lapera: OK. That's a very simple, straightforward definition. Thank you very much. If anyone has any questions about how any of these work, feel free to write in. I think we should just move right along to the next segment of our show, which is a segment that I'm pretty excited to talk about. We had another listener write in and ask about negative interest rates, which actually coincides with some articles I've been editing. So, negative interest rates, what are they?
Wathen: Negative interest rates, probably the scariest thing in the world, right? Imagine the idea that you give someone -- you loan someone money under the promise that they're going to pay you back less in the future. So, let's say, Gaby, that you're such a good credit, and I'm so worried about the global economy that I'm going to loan you $10,000 under the promise that you're going to pay me, say, $9,500 back in the future.
Lapera: Yeah. And the idea is that I will definitely pay you back. But, you're right, this is something that's never been seen before in financial history. Up until a couple decades ago, this whole concept was theoretical.
Wathen: Right, and it's still kind of theoretical. If you go to the curriculum to become a chartered financial analyst, the curriculum basically says, "Oh, negative interest rates can't happen, so don't worry about it." And this is a designation that's super highly respected on Wall Street, probably 50% of bond fund managers out there have one, and they've all studied under this premise that negative interest rates simply don't happen -- it's something that's just theoretical, it's an idea. And now, of course, it's a reality in a lot of places around the world.
Lapera: Well, as of right now, three major economies have negative interest rates, which are Japan, Switzerland, and Sweden.
Lapera: You're right, it's a reality now. So, part of the reason people thought that negative interest rates were completely theoretical is because, say you have your money in a bank, and you have that tiny interest portion back every month, right? Right now you do, and right now, it's super low. But when you have negative interest rates, you actually have to pay the bank to hold on to your money. So, everyone thought, negative interest rates will never happen because people will just withdraw their money from the bank and leave.
Wathen: Right, exactly. And there's a lot of talk now, especially around the world, people are talking about, they need to print more big dollar denomination bank notes because people are just sitting on them. Because, when your option is to go loan money to the German government for 10 years and get less back, it's preferable to just keep the cash hidden underneath the mattress. And luckily, so far, at least as far as I can tell, that I've seen, and maybe someone out there can prove me wrong, but this hasn't yet affected individuals. So, banks in Europe are still paying one basis point, so, 0.01% on your money. But, for institutions, it's certainly a problem, because they have so much, there's so much capital, that they can't just go put it in a storage shed. Right?
Lapera: And they're international organizations, so they need to be able to keep their money in a place where they can access it easily and send it across the world easily.
Wathen: Right, exactly. Bloomberg reported, actually, that $7 trillion of government debt around the world is actually currently yielding an interest rate of less than 0%. So, investors are willing to lose money on $7 trillion capital, essentially, to have a safe place to store it.
Lapera: Yeah. So, not only is it just having a safe place to store it, but some people are saying that part of the reason people aren't moving it is that it's just convenient to have it in your bank as opposed to underneath your mattress.
Wathen: Right, that's one of the things. It's kind of weird, as we think about it, as individuals, you wonder, why would anyone ever go out and buy a bond that pays a negative interest rate, right? It's just so asinine to even think about, that you might give someone the opportunity to use your money for short amount of time and get less back. But, one of the things you have to understand is, there's actually away to make money from this. You could buy a bond at a -1% interest rate and sell it at a -2% yield, and actually make money because the bond will go up in value. The basic premise behind bonds is, if interest rates go down further, the bond value goes up.
Lapera: Ooh. That makes a lot of sense, I hadn't actually even thought about it that far, I was just like, "Let's talk about negative interest rates." That is really interesting.
Wathen: It's kind of speculative. Obviously, you're still taking that risk that interest rates don't go lower and you end up losing money, so you end up getting paid off and you've accepted that negative yield.
Lapera: You know what would be really interesting? Is if negative interest rates stayed low for long enough, and then they continued to become more negative, I think it would have to change payment structures, wouldn't it? People would say, you can't pay up front, you have to wait 60 days to pay.
Wathen: (laughs) That's the interesting thing, right? If you lose money in a negative-interest rate world, you might have done better than you should have.
Wathen: It's completely asinine. And normally, negative interest rates are something that's associated with deflation, so, prices going down. So, maybe in nominal terms, you've lost money, but not in real terms. So, prices are going down faster that you're losing money on your investment. But, that's kind of scary, too, because, let's say you run a business, and prices go down by 5%. So, you paid your employee $100,000 last year, and this year, you say, "Hey, you're getting a raise, buddy! We're going to pay you $98,000 -- because prices went down by 5%, this is technically a raise."
Lapera: Oh my gosh. I feel...
Wathen: Yeah, just, beyond financial reasons, there's so many social costs that come with this. And economists call this sticky wages, that businesses would prefer to cut people than cut people's wages, because it's a horrible thing to try to convince people that this is better for them.
Lapera: Right. This is crazy. I feel like -- I don't know if it's just being leftover-sick. I don't know. I feel like I've eaten a substance that is not legal.
Wathen: Right. Totally Fantasyland, right?
Lapera: Yeah, it's crazy. So, the big news recently is that the Fed is stress testing for negative interest rates. This doesn't necessarily mean that these are going to happen, but it's a scenario that they're seeing what would happen. Right?
Wathen: Right. They're basically saying it could be a reality here, and that's the concern is, let's say a recession comes. And typically, a recession comes, what you do, at least for monetary policy, is you start cutting rates. Well, we're already close to 0% or at 0%. So the only place to go from there is negative. And obviously, there's a big concern now, the biggest banks are only bigger. And so, what would this do to their income statements and balance sheets if rates actually go negative? It's one of those things where they're just trying to be responsible and get ahead of the problem, should it become one.
Lapera: Right. So, if we get to the point where this is occurring, there are a lot of other problems happening. This isn't going to come out of the blue. Janet Yellen isn't going to wake up one day and be like, "You know what? Today, we're going to have negative interest rates." That's not going to happen. We're going to see it coming.
Wathen: Right, things have already gone terribly wrong. Especially for the banks, because, the point at which we have negative interest rates, they would already be paying a positive yield, likely, on deposits, and investing into securities at negative interest rates. So they're already losing money. This is so ... this is like problem No. 5 that you encounter. This isn't like, oh, you just wake up one day, and interest rates are suddenly negative. This is, things have really gone badly.
Lapera: Yeah, and it's kind of doubtful right now anyway. The job market is pretty strong. The Bureau of Labor Statistics released its job report. The labor market is pretty strong, unemployment is hovering around ideal levels. Some people say we're going into another recession right now. I don't know, it's kind of hard to tell.
Wathen: That's the thing too, you have to put everything into perspective. One of the things that's kind of difficult to consider is, things seem to be fairly rosy in the United States, and we've never had things to be this rosy in the United States and rates to be this low, it's kind of weird. But interest rates are kind of a global issue. So, if rates are super low in Japan, they're not going to be very high in the United States, because investors are going to say, "Well, forget Japan, I'll take my money to the United States." Right?
Lapera: Right. The other interesting thing about negative interest rates is that they're not even sure if it's legal to have negative interest rates in the United States. Like, according to the Federal Reserve Act, which kind of established the Federal Reserve Board's authority, they're not sure if they can declare negative interest rates anyway. But it's just kind of one of those things that they're like, "Eh, I guess we should test for it, just in case it turns out it is legal."
Wathen: That's fascinating. I hadn't even encountered that, I hadn't even pondered the fact that it might not be legal. That's a whole 'nother slew of issues, great. So, now you throw politicians in the mix, too, fantastic. (laughs)
Lapera: (laughs) Yeah, because that always goes great with fiscal policy. So, what would this mean for consumers, if a negative interest rate environment did happen in the United States? Which, as we've established, is not hugely likely. I'm not going to say 100% unlikely, because as we'll get to, forecasting is hard. But, what would consumers want to do?
Wathen: It's hard to say. We're dealing totally in theoretical territory here, so, all bets are off. But, at least so far, if we use foreign countries as an example, I don't think that if we have negative interest rates here in the United States, that consumers will have to deal with the negative interest rate on their bank account. So, although this will be an issue for banks, will be an issue for a lot of huge corporations -- Apple, they have $100 billion or whatever overseas, they have to deal with the effects of this. But for individuals, I don't think that it will come to an issue where you have to tolerate the idea of having $10,000 in your bank account today and next year only having $9,900 because of a -1% interest rate. I don't think that is within the realm of possibility. At least, I hope not. (laughs)
Lapera: Yeah, and if it is, we're probably both fired anyway. So, we'll get what's coming to us. (laughs)
Wathen: Yeah, all bets off. I'll have bigger problems to deal with, everyone will have bigger problems to deal with than that. And, another thing, too, that you have to think about is that banks are fairly resilient. That's kind of a joke.
Wathen: But, they are fairly resilient in a sense of that, say a Wells Fargo, they make 50% of their income from interest rates. But they also make 50% of it from fees and stuff like that. So, there's some give and take.
Lapera: Right. So, after having asked you to guess what will happen and what consumer ought to do if negative interest rates do occur, I found this article on The Wall Street Journal about how forecasters did over the course of 2015. So, it provided what the average forecaster guessed what would happen for some kind of metric, and then it said what actually happened. And I thought it was kind of funny. So, do you want to talk about that?
Wathen: Sure. Can we start with the big one? We'll start with the big miss first, because this makes me feel better about how my crazy predictions might not come to pass, and you might actually get a negative interest rate on your bank account. So, crude oil, December 2015, the average economist put it at $63 a barrel, and the actual as of Dec. 29th was about $38 a barrel, which is a critically massive miss.
Lapera: Yeah, it's so big. (laughs)
Wathen: Yeah, it doesn't seem big, whatever, $25, I guess.
Lapera: But, people all year -- so, these are guesses people make in January of 2015. So, people all year were saying, "There's no way oil's going to get below $40 a barrel. I can't remember the last time that even happened." And here we are. What is it now? I think I read somewhere that the oil is actually cheaper than the container it is put inside of. The barrel costs more money. (laughs)
Wathen: Right, the oil barrel costs more than the oil that's in it, yes, that's true.
Lapera: (laughs) That's just crazy. So, this one is fun: the interest rate, since we were just talking about interest rates, the average forecaster said it was going to be at 1.6%, and the actual interest rate on December 16th, 2015, was 0.5%.
Wathen: Big miss.
Lapera: Yeah, people thought the economy was going to rally more, but we had so much global uncertainty, plus the oil, that it didn't really quite get back up to where they thought it was going to.
Wathen: Right. Predicting interest rates ... talk about something that's just pulling numbers out of a hat. It's not easy to do. And for a long time -- actually, anyone listening should go online and google predictions about where interest rates were going to be since the Great Recession. In every single year, the expectation was that rates would go higher, and then by the end of the year, it was like, "No, we missed, interest rates are staying low forever, apparently." And then, in January, I guess bonus time comes back around, and all the analysts are happy again, so then they predict, yet again, that interest rates will go higher, and they don't. (laughs) Not easy.
Lapera: No, it's definitely... I don't mean, if you're an analyst out there and you're listening to this and you're like, "These guys should go walk off a short dock," (laughs) we're not making fun of you, we promise. We know it's really, really hard. It's just, it sucks, this is the nature of the job, you're going to be wrong. (laughs)
Wathen: Right. I mean, I'm sure if a lot of these guys could, they'd just love to write, "You know what? I don't know." And that would be the most honest answer. But that's not what you get paid to do. Your job description isn't, "Hey, just tell us that you don't know because we know you don't," it's, "Hey, give us a best guess. Just guess."
Lapera: Yeah. And if you get it right, I'm sure you must get a bonus, right?
Wathen: Right. If you get it right, you totally nail it, you get to go on CNBC and talk about how great you were, and then the next year you get to be proven wrong again. It's ... (laughs)
Lapera: Exactly. Well, at least someone will buy you drinks that first time. (laughs)
Wathen: Right, exactly.
Lapera: Then, the Fed funds rate average forecast was 0.89%, and the actual as of December, 2015 was 0.375%. And the Fed funds rate, for our listeners who don't know, is the rate at which the Fed will give these very short overnight loans to banks.
Wathen: So, this is basically Yellen.
Lapera: Right. And the higher they are, the more expensive it is for banks to borrow money from the central banking agency. However, unemployment they got pretty much on the nose.
Wathen: Right. Unemployment, they almost nailed it. Let's see... they said average forecast 5.2%, and actual as of November was 5%. I think we're below 5% now.
Lapera: I looked it up, we're barely, barely below 5% for 2016. But in December of 2015, it was 5% exactly.
Wathen: Nailed it.
Lapera: Good job, guys. Whoever picked that one, really good job. And, for wage growth, which is average hourly wages, the percent change over last year, they had forecast 2.6%, and the actual for Dec. 2015 was 2.3%. Good job.
Wathen: It's not so surprising, actually. I thought about that a little bit, and if you get the unemployment rate right, you're probably going to nail wage growth, because if...
Lapera: That's true.
Wathen: ... unemployment is low, you expect wage growth to be x%.
Lapera: Yeah. They were pretty good at a lot of the jobs metrics in general.
Wathen: Right, yeah. Luckily, that's kind of been a thing where you can just say, "Unemployment will go a little higher, wages might go a little higher." There's a lot of industries right now that are really hurting from higher labor costs, which is, I guess, good if you're a worker, not so great if you're an investor.
Lapera: Yeah (laughs). But, yeah, standards of living, that's nice. I don't miss those minimum wage days.
Wathen: (laughs) No.
Lapera: And, I was in high school and I had parents supporting me. So, I can't even imagine what it would be like...
Wathen: Right. In high school, I worked at a golf course for all of about a month before I was promptly fired, and making minimum wage for that month was not fun.
Lapera: Yeah. I guess I made minimum wage through most of college, too. Ugh. And, back then, it was low. Back then it was like $5.25 or something like that.
Wathen: Right, yeah, no. Back when I was in college, it would have been something like that. I owned my own business in college. I was probably making minimum wage, though, because I was working way too much.
Lapera: (laughs) And then, the last one we have for you guys is the real GDP. Forecast was 3%, and then I went and looked it up and the actual one was 2%.
Wathen: Which, not too bad. That's kind of a hard one to nail, because, if you get the oil price wrong, you're going to miss that.
Lapera: Yeah. So, all things considered, it wasn't a bad guess.
Wathen: No, it wasn't really. I mean, you could throw darts, probably, as long as you had a number between 1-4%, you might be pretty close. (laughs)
Lapera: Yeah. There you go. (laughs) Job advice from Jordan Wathen for all the forecasters out there. (laughs)
Wathen: (laughs) Yeah, let me teach you how to do an analyst's job: just throw darts at numbers. It's fantastic.
Lapera: OK, everyone. Well, that's all we have time for this week. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at IndustryFocus@Fool.com, or by tweeting us @MFIndustryFocus. Thank you to that guy who tweeted me and told me I used too many filler words. I hope I used fewer this week. Thanks everyone, and have a great week. Bye!