This Bank Is Cheap According to Ben Graham

I am always on the hunt for cheap companies, and one of the means of identifying "cheap" I like to use is the Graham number.

Its formula is pretty straightforward: Multiply earnings per share by book value per share, then multiply that by 22.5, and finally, take the square root. As with any valuation, the Graham number only tells part of the story, and it's important to look at the story behind the numbers to see if there are underlying reasons why the company appears so cheap.

Last week, I discovered that the financial sector is among the cheapest sectors out there when it comes to the Graham number. The reasons for this are varied, so I will be taking a deeper look at the 27 financial companies that currently trade below their Graham valuations to see if there is real value in the company, or if there is an underlying reason investors should avoid the stock in question. I will then make a CAPScall on the future performance of the company. Up next will be SunTrust Banks (STI).

What is it?
Atlanta-based SunTrust is a "traditional" bank that operates primarily throughout the Southeast United States. With over 1,600 branches and 2,800 ATMs, SunTrust serves over 5 million clients and has over $170 billion in assets. As with other banks of similar size, SunTrust is required to pass annual stress tests run by the Federal Reserve. During last year's test, SunTrust was near the bottom with a Tier 1 capital ratio of 5.5% when simulated "stressors" were placed on the bank.

At the end of last year, however, SunTrust reported a Tier 1 capital ratio of 11.1%, showing great improvement over the course of the year. We'll know for sure how well this improved ratio stands up when the latest round of stress test results are published on Thursday afternoon.

How cheap is it?
Compared to some other banks of similar size, SunTrust comes out on top as the cheapest by a wide margin:

Source: Yahoo! Finance and author's calculations. 

Why does a company like SunTrust have over 95% of upside from its current price to its Graham valuation? Part of the reason could be its poor performance in last year's stress test, as mentioned above. Its share price was also one of the worst performers during 2011, though it did recover nicely during 2012 as financials rallied. Third-quarter results also drove down the price a bit during the past six months, as the bank saw a large one-time gain from the sale of Coca-Cola shares and not from an improvement in banking quality.

Other banks on the list could also be attractive options even if they don't have as much room to grow. BB&T is a personal favorite of mine because of its focus on community banking and strong leadership. Unlike SunTrust, BB&T actually performed well during last year's stress test, and promptly boosted its dividend 25% shortly after the results were released. Fifth Third performed even better than BB&T in the stress tests, and despite trading near its 52-week high, it has plenty of room to grow into its Graham valuation. In the meantime, investors can benefit from a sizable 2.5% dividend yield and its position as a leading bank in the Midwest.

Accountability time
A stock's valuation, regardless of the method used, only tells part of the story when evaluating a company. However, by going beyond its Graham number valuation, it is easy to see why SunTrust might appear so "cheap" at its current price. Like many other banks, it's still recovering from the financial crisis, and it could be years before it's back to pre-crisis levels. Nevertheless, I will be giving the stock a "thumbs up" over on my CAPS page in order to track this call and keep myself accountable.