Are Banks Cheap?

If you sort the stocks on the S&P 500 (SNPINDEX: ^GSPC  ) by price-to-earnings ratio, one thing becomes immediately obvious: Financial companies are some of the cheapest stocks in the market right now. Of the 20 stocks with the lowest P/E multiples, five are insurance companies and three are banks.

While I'm not as well versed in insurance stocks, there are a couple of important things to note here with respect to banks. These companies appear cheap for a reason. Many, like S&P component SunTrust Banks (NYSE: STI  ) , are still atoning for sins committed in the lead up to the financial crisis. Their costs are high because of heightened mortgage-servicing standards and loan-loss provisions while their revenues are down thanks to the compression of interest rates.

The more traditional way to assess this is through the price-to-tangible-book-value ratio -- which is analogous to the P/E ratio, but the denominator contains a bank's tangible book value and not its earnings. The story is the same if viewed from this perspective. Since 1994, the average P/TBV of the nation's four largest banks by assets comes in at 2.69. Right now, it's 1.17, or less than half of its recent historical average.

Source: Standard & Poor's Capital IQ.

So are banks actually cheap? It's one thing to say that they're inexpensive on a relative basis compared with, say, the rest of the stocks on the S&P 500 -- which they are. But it's a whole other thing to say they're cheap on an absolute basis.

Valuation multiples are a mixture of current and past data with future projections; they're two parts astronomy and one part astrology. Looking forward, in turn, there are a number of ominous signals. There's the ongoing debate about too-big-to-fail banks, which threatens to stymie the growth aspirations of megalenders such as JPMorgan Chase (NYSE: JPM  ) and Wells Fargo (NYSE: WFC  ) . There's the increased regulatory oversight of everything from mortgage underwriting standards to debit card interchange and overdraft fees. And finally, there's simply an understandable mistrust of large financial institutions thanks to the havoc they fueled five years ago.

Yet it's critical to appreciate how much the banking industry has changed since 2008 and how this works in certain banks' favors. For example, Wells Fargo's 2008 acquisition of Wachovia gives it a much-coveted nationwide footprint. And while Bank of America (NYSE: BAC  ) and others retreated from the mortgage market to lick their wounds, Wells Fargo stepped in to fill the void. It now originates or services a staggering one in three mortgages.

The same can be said about JPMorgan. Its distressed purchase of Bear Stearns gave it an industry-leading prime brokerage to further service its institutional clients, and its acquisition of Washington Mutual completed its own transcontinental branch network.

The moral of this story is that, from a historical perspective, there's reason to believe that certain lenders are indeed cheap for good reason. Bank of America and SunTrust Banks fit this description. Meanwhile, others seem to have suffered by association. Wells Fargo and JPMorgan are obvious inclusions here.

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