Are Bank Stocks Cheap?

Are bank stocks cheap?

By one measure, they sure look that way. And if you're a "value investor," for example, a disciple of Benjamin Graham and Warren Buffett, and an aficionado of buying stocks at a discount to their book value, you're probably feeling tempted to hop on the banking train. Tempted to bet that concerns over Europe are overblown, and that once this crisis blows over, banking stocks will bounce right back.

Don't do that.

Don't judge a book value by its cover
Right now, stocks of most major U.S. banks sell for sizable discounts to their book value. In fact, only the Buffett-blessed Wells Fargo (NYSE: WFC  ) currently costs more than its own net asset value. And I admit, some of the valuations we're seeing today seem very attractive:

Stock

Price-to-Book Value

Wells Fargo 1.0
Goldman Sachs (NYSE: GS  ) 0.7
JPMorgan Chase (NYSE: JPM  ) 0.7
Morgan Stanley (NYSE: MS  ) 0.5
Citigroup (NYSE: C  ) 0.5
Bank of America (NYSE: BAC  ) 0.3 (!)

When you consider that the average stock trading on the Dow Jones Industrial Average (INDEX: ^DJI  ) costs not less than its book value, but 2.5 times its book, investing in banking stocks seems almost a no-brainer. But that's just the problem. Buying banking stocks today is not something you want to rush into without thinking.

It depends on what the  meaning of "are" is
Are banks cheap? Are they -- as the above table certainly makes it appear -- so cheap that it's now ridiculously easy to make money by investing in them? If this were a simple matter of "buy at 0.5 times book value, wait until the stock rises to the average Dow valuation of 2.5 times book value... and collect a 400% profit," then the answer would clearly be yes.

But consider: What is it really that goes into a bank's book value that makes the company's net asset value look so high while its stock price is so low? Net asset value, as you know, is what you get if you take a bank's assets and subtract its liabilities. Therein lies the problem -- those "assets" may not be all they're cracked up to be, and those "liabilities" may be greater than they seem.

Danger in the details
Last week, Goldman Sachs shares dropped below $100, and Morgan Stanley suffered a one-day 9% drop on fears these banks had "exposure" to European sovereign debt, which could default. To allay such fears, Goldman, Morgan Stanley, and B of A and JPMorgan, too, published details on their lending to Portugal, Ireland, Italy, Greece, and Spain -- Europe's so called "PIIGS." The upshot of the reports was that while the banks had about $70 billion in combined exposure to troubled government debt, their net exposure was only about $40 billion.

How does that work?

Consider: When a bank issues a loan -- for example, by buying $1 million worth of Greek government bonds -- it's entitled to repayment of that $1 million plus interest. As you may have heard, though, there's a certain non-zero chance that Greece will default on its bonds. To mitigate this risk, many banks buy insurance against the risk of Greece defaulting on its loan, a credit default swap, in which they pay "some anonymous person" (SAP) a fee in exchange for a promise that if Greece does default on its bond, the SAP will make good on the debt.

Result: The thus-insured bank gets to book the value of the bond, minus the small fee it pays this poor SAP, as its asset value.

Poor SAPs
And here's where things get dicey. Sure, if everything goes as planned, the calculation is accurate. The bank's "book value" is what it says it is. But what happens if something goes wrong? What happens if, for some awful reason, the SAP who sold the bank a CDS turns out to be too poor to pay up? What if said SAP turns out to be named AIG? Or Lehman Brothers? Or... MF Global?

Alternatively, what if the European government in question works a deal with the EU to arrange a voluntary "haircut" on the value of its debt, such that no "default" technically takes place, and the CDS that the bank purchased never kicks in? 

Why, in that case, dear Fool, it's not the poor SAP left holding the bag, but the supposedly smart bank that bought the CDS. In that case, the bank's asset is worth far less than the bank says it is. The bank's book value isn't what it says it is -- and the bank's stock isn't a cheap as we think it is.

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Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 325 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup. The Fool owns shares of and has created a covered strangle position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of The Goldman Sachs Group.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


Read/Post Comments (4) | Recommend This Article (10)

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  • Report this Comment On November 17, 2011, at 6:26 PM, xetn wrote:

    I believe most bank stocks are expensive because they are not required to mark to market in regard to their real estate loans where the "real value" of the collateral is grossly over valued.

  • Report this Comment On November 20, 2011, at 8:09 PM, iamnik77 wrote:

    Your timing on this article is wrong. Had you posted this article prior to the market crash from a couple of years ago, people could have made money (or avoided losing it) from your advice. But due to the dreadfully bad timing of this article, people will only leave money on the table by believing it. The current market situation with banks is more of a "be greedy when others are fearful situation" in my opinion.

  • Report this Comment On November 30, 2011, at 9:31 PM, YBoon wrote:

    xetn,

    that is where you are wrong. the real estate loans are the assets of the bank, while the collateral is just used to support the loan application. as long as the borrowers did not default on the loans, why do the banks need to MTM the loans just because the collateral depreciated? you have gotten it mixed up.

    bank stocks expensive? that is your opinion. i believe the fear factor and the 'embargo' in restricting the banks from paying higher dividends and distributing capital are what causing the current low valuation of banks.

  • Report this Comment On November 30, 2011, at 9:33 PM, YBoon wrote:

    If the stress tests on the banks turn out fine (which i believe they would), and the Fed allows more dividend payment and capital distribution by the banks, i am sure the bank stocks will take off. also assuming that no additional european nonsense happening from here.

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