In the shadow of a financial collapse that shook our system to its core, many big bank stocks look cheap. Really cheap.
On the basis of price-to-book value -- a good way to value banks -- the big banks in particular look like they're trading at bargain-basement prices.
|JPMorgan Chase (NYSE: JPM )||0.7|
|Bank of America (NYSE: BAC )||0.4|
|Citigroup (NYSE: C )||0.5|
|Wells Fargo (NYSE: WFC )||1.2|
Source: S&P Capital IQ.
Not all that long ago, buying any of these major banks at these valuations would have seemed like a no-brainer. Of course, these stocks weren't even sniffing valuations like these until we plunged into the financial meltdown.
Price-to-Book Value Today
Price-to-Book Value 2006
Price-to-Book Value 2000
|Bank of America||0.4||1.8||1.6|
Source: S&P Capital IQ.
This isn't an issue that applies only to the "too big to fail" banks. PNC Financial has a current P/BV of 0.9. In 2006, the multiple was a hair above 2, while it was well over 3 in 2000. US Bancorp (NYSE: USB ) , with a P/BV of 1.8, is valued much higher than many competitors, but that's significantly down as well -- at the turn of the century, USB traded at a P/BV of 3.6.
I'll stop there, but I could pretty much grab any bank stock at random and show the same thing.
Let's not fool ourselves, though. The banking environment of today isn't what it was in 2006 or 2000. And while Mr. Market does make mistakes that savvy investors can take advantage of, it's dangerous to blindly assume that any drop in valuation signals a stellar investment opportunity.
So how do we think about these bank valuations?
What are the returns?
Going back to Banking 101 -- a class that many banking chieftains apparently slept through -- a bank is a big pile of capital that the bankers deploy to earn returns for shareholders. For a given lump of equity, a bank can juice those returns by, for example, being more efficient in its operations, shifting capital to the most lucrative opportunities, or taking on more leverage to do more business with the same equity.
The equity in a bank that earns higher returns -- for example, Wells Fargo putting up a 20% return on equity back in 2006 -- is more valuable to investors than a bank that earns a lower return. Simple as that.
Fast-forward to today, and regulators are bearing down on banks. Leverage has come way down -- this is a good thing for Average Joe American who doesn't want to relive 2008/2009, but it's a drag on bank returns. At the same time, some banks are being forced out of certain once-lucrative businesses -- again, this may bolster the stability of the financial system, but it's no good for banks' bottom lines.
Investors are rightly concerned that banking returns may be permanently -- or, at least, semi-permanently -- lower. Lower returns would mean that the bank stocks shouldn't recapture the valuations of yore.
And what is on that balance sheet, anyway?
A more glaring concern for many investors is that they simply don't trust that the equity on banks' balance sheets is representative of the banks' actual equity position. That is, while the liabilities are the liabilities, what are the assets really worth? To the extent that banks are holding assets that aren't worth what it says on the books, their true equity could be lower, perhaps significantly lower.
The bad loan/asset concern could manifest in a couple of ways. If coming to terms with the real value of the assets is drawn out, then it would provide a drag on earnings. That would reduce banks' returns and exacerbate what we looked at above.
Alternatively, to the extent that there are big "come to Jesus" moments for banks where they swallow huge writedowns all at once, you end up with the denominator of the P/BV equation dropping and suddenly making a cheap bank look significantly less cheap.
Buy … or what?
Talking positively about big bank stocks leaves me with a feeling very similar to regurgitating regurgitation -- if you know what I mean.
But when I look at the numbers, the math makes a very attractive case. Take Bank of America, for instance. In 2006, investors were willing to pay 1.8 times book value for an 18% return on equity. If we say that lower leverage and crimped business cuts that potential ROE in half, we could reasonably say that investors should be willing to pay 0.9 times book value for shares (that would give them the same effective return as 2006).
Today, B of A shares change hands at 0.4 times book. This could make sense if there is the expectation that enough will be hacked off of B of A's book value that when the P/BV numerator is done falling the stock will sport a 0.9 multiple.
But that is a bleaker scenario than most investors probably give credit for. With a current market cap of around $81 billion, this implies that B of A's equity falls to around $90 billion. The bank's equity position at the end of March was $233 billion, so that thinking suggests a book value drop of $143 billion.
That's not going to happen. Why not? Because Bank of America losing $143 billion is Bank of America imploding and fading into nonexistence -- the bank simply wouldn't survive an equity loss of anything near that magnitude. Further, it's not terribly logical. If we tally B of A's cumulative bottom line from Q4 2008 -- its first unprofitable quarter -- to the most recent quarter, we get a profit of $4.3 billion.
So to say that a B of A valuation of 0.4 times book makes sense isn't simply saying that something bad is going to happen. Or even that we'll see a repeat of 2008/2009. It's suggesting that something truly cataclysmic is going to take place that will completely eclipse the global financial meltdown of a few years back. It's saying that Bank of America is going to go bankrupt.
The math isn't different for JPMorgan, Citigroup, and Goldman. And though Wells Fargo carries a higher valuation, similar logic can be applied.
I've put my money where my mouth is -- I own a number of banks in my portfolio. I've also rated a swath of banks -- including B of A, Citi, JPMorgan, and Wells Fargo -- as outperforms in my Motley Fool CAPS portfolio (because accountability is important).
And I'm not alone
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