Here's Why Big Bank Stocks Look Cheaper Than They Really Are

Big bank stocks have surged over the past eight months, yet they still look relatively cheap when compared with regional bank stocks. Is this a sign you should buy the former and sell the latter? Not necessarily.

The easiest way to see the difference in valuation between banks based on size is to compare the median valuation on the KBW Bank Index, which tracks the two dozen biggest banks in the country, with the KBW Regional Banking Index, which tracks 50 banks with between $5 billion and $40 billion worth of assets on their balance sheets.

Data source: YCharts.com.

It doesn't matter which of the three primary valuation metrics you use: Regional banks such as Glacier Bancorp (GBCI -0.14%) and Bank of the Ozarks (OZK 0.10%) generally trade at a higher multiple compared with big banks such as Bank of America (BAC 1.59%) and JPMorgan Chase (JPM -0.40%).

Based on earnings, which is the metric that should take the lead in an analysis today, the median regional bank on the KBW Regional Banking Index trades for 17.41 times earnings per share over the next 12 months. The figure on the KBW Bank Index is 14.88.

The story is the same when you look at valuation as a function of book value. The median regional bank stock trades for 2.18 times tangible book value, while the median big bank trades for a multiple of 1.92.

Investors need to appreciate that these figures alone don't mean big banks are better buys than regional banks. A better interpretation of the difference is that regional banks have more opportunities to grow.

Regional and community banks are growing like weeds. Image source: Getty Images.

There are two ways to grow in the bank industry. The first is through organic growth -- attracting new customers through marketing efforts and gaining more of each customer's overall financial business, be it a mortgage, credit card, car loan, whatever. The second avenue is through mergers and acquisitions.

Holding all else equal, a bank that can use both avenues can grow faster than a bank that can use only one. Herein lies the difference in valuation between the nation's biggest banks, such as Bank of America and JPMorgan Chase, and regional banks, such as Glacier Bancorp and Bank of the Ozarks.

As I've discussed in the past, the nation's three biggest banks, which are weighted heavily on KBW's large-cap bank index, are all shut out of the acquisition game, at least insofar as other depository institutions are concerned. That's because Bank of America, JPMorgan Chase, and Wells Fargo each already hold more than 10% of the nation's deposits. As such, these three banks are legally prohibited from acquiring other banks.

Regional banks aren't similarly proscribed. Because none of the banks on the KBW Regional Banking Index come even close to the 10% deposit threshold, they can still merge with or acquire other banks, thereby supercharging growth.

That's exactly what they've been doing. To cite just two examples, Glacier Bancorp has acquired nine banks since the beginning of 2009, and that's on top of 15 other deals it has completed since 1990. The same is true at Bank of the Ozarks, which has purchased a total of 16 other banks since the financial crisis.

OZRK Total Assets (Quarterly) data by YCharts.

The net result is that these two banks have seen their balance sheets expand rapidly over the past decade. Bank of the Ozarks went from $2.5 billion in assets 10 years ago to more than $19 billion today. And while Glacier Bancorp's recent ascent hasn't been as steep, the Montana-based bank has nevertheless more than doubled in size over the same stretch.

Thus, the reason big bank stocks seem cheap is that their ability to grow is tightly constrained compared with their smaller, simpler counterparts in the regional banking space.