Is Jefferies, the pint-size investment bank, really a more valuable franchise than the mighty Goldman Sachs?
The Leucadia National Corporation announced Monday that it planned to acquire Jefferies for $3.6 billion. At that price, Leucadia is paying 1.2 times the firm's tangible book value, a measure of a company's worth. The important point is that a large financial company is willing put down real money to acquire a brokerage firm, paying more than its tangible book value.
Right now, firms like Goldman and Morgan Stanley would be happy just to see their shares trade above book. The stock market values Goldman at 0.9 times its tangible book value. Investors are even less sanguine about Morgan Stanley, awarding it a price to book value of only 0.6 times.
There seems to be little reason for Jefferies to have a superior valuation. It has a credit rating of Baa3 from Moody's, three notches below Goldman's rating of A3. Jefferies is paying around 6.2 percent w hen it borrows for longer periods in the market, whereas Goldman is paying only 2.1 percent. Solid credit ratings and a low cost of borrowing are critical for investment banks, which rely on markets for their financing.
Small investment banks like Jefferies are clearly vulnerable to market angst. Last year, the company's stock price plunged 60 percent on fears over its holdings of European sovereign debt.
So what explains the valuation gap?
One theory is that the market is unduly pessimistic about the health of Morgan Stanley and Goldman. The companies' valuations have actually improved as their stock prices have risen. That could continue until they trade about tangible book, especially if global markets continue to stabilize, economic growth strengthens and the uncertainty surrounding new Wall Street regulations lifts.
The alternative view is that the market doesn't like the size and complexity of Goldman and Morgan Stanley, which also have higher l everage than smaller investment banks.
With their “too big to fail†status, firms like Goldman and Morgan Stanley have had to hold more capital since the financial crisis of 2008. That depresses metrics like “return on equity,†which investors track when deciding whether to buy stock in investment banks.
If investors believe regulations permanently cap returns at lackluster levels, they will be loath to pay more than book value. The big Wall Street firms may then decide to exit certain businesses and downsize. UBS recently announced plans to do this, causing its shares to leap.
All this suggests that the government's soft-handed approach to the “too big to fail†problem may be working. Instead of forcing size explicit limitations on large banks, the overhaul focused on rules that effectively gave financial firms incentives to opt for simpler businesses and avoid excessive growth.
A simple, small balance sheet meant Jefferies could sell its elf for a premium price. Given the current valuations, Goldman and Morgan Stanley may want to pay attention.
