Risk Reduction Part 2 – Industry’s Financial Dynamics
Every industry has different financial dynamics. Some industries utilize leverage ratios to perform well – think airlines. Other industries are physical asset-based – REITs, transportation, and utilities. Some industries are location-driven – fast food, shipbuilding, and retail. Others are investment holdings such as finance, banking, and insurance.
Every industrial sector has its unique financial dynamics, and when investing in these industries, knowledge of these financial matrices provides a greater chance of success and reduces risk exposure dramatically.
A perfect example of this knowledge requirement is banking. Most people don’t know this, but banks have two book values. The first is the traditional definition of book value, and the second is the tangible book value of the company. Both value points play a pivotal role in assessing intrinsic value along with an introspection into the bank’s balance sheet. One of the standing rules of thumb with bank stocks’ buy point is to never pay more than 1.25 times of traditional book value. This is because a bank’s underlying assets are loans. Loans are highly susceptible to interest rate changes. If interest rates jump 750 basis points over a year, current loans on the books of the bank become less valuable because their interest rate earnings are lower than current market rates. A portfolio of loans of $500 billion could drop six to nine billion in value. This would dramatically reduce the bank’s total value, greatly impacting intrinsic and market value per share. By limiting the buy point to 125% of traditional book value, a value investor reduces their risk exposure tied to the loan portfolio of the bank. This Wells Fargo illustration explains it well:
On July 25, 2025, Wells Fargo’s market price was $84 per share. Wells Fargo’s traditional book value is about $49 per share. Using the above rule of thumb, the maximum price a value investor would pay is $60 per share. From the 12/31/24 balance sheet, the loan portfolio is $1.75 trillion. The total interest earnings on this portfolio were $91 billion, generating an average interest earnings rate of 5.2%. The bank paid out an average interest rate of 2.47% to earn a net interest rate average of 2.7%.
If the interest rate in the market jumps 250 basis points, then the average overall cost will jump to 2.72% and net interest rate earnings will decrease to 2.5% costing the bank, on average, a little more than $4 billion. For practical purposes, this doesn’t happen immediately, but the cost of interest will increase over time for the bank, and without offsetting this cost via the loan portfolio’s structure, it will cost the bank additional interest, reducing its primary revenue source of net interest income. To give the reader some perspective, $4 billion changes the earnings per share by about $1.16 per year. Using a traditional banking PE of 12, this would reduce the value per share by $15. Thus, the bank’s underlying assets are at extreme risk of significant value change in a very short period. This is why value investors do not pay more than 1.25 times of book value for a bank’s securities.
The banking industry has three key financial matrices that greatly impact the value of this industry’s securities. The traditional book value pricing is just one of them. Other industries have their own set of fundamental rules when it comes to investing. For example, with REIT’s which are income tax-free operations under IRS Code Section 856, an investor looks to a REIT’s physical asset portfolio and values the portfolio on the average price per unit from sales over the last three years. Valuation isn’t driven by earnings; it is driven by the value of the underlying properties held. Just as with banks, there are several unique valuation tools and corresponding financial matrices that determine intrinsic value for a REIT.
Knowledge of these investment matrices by industry dramatically reduces risk exposure when a value investor desires to purchase securities. In addition to understanding the industry’s financial dynamics, knowledge of the company’s financial depth also plays a key role in risk reduction. Act on Knowledge.