Deutsche Bank: Low Valuation Meets High Risk

One of the world's cheapest banks should perk up investors' ears and risk awareness.

Jul 7, 2014 at 10:58AM

Value investing involves considering a host of factors to find stocks selling for below their fair value. Among the measurements value investors use is price to book value, which involves determining how a company is valued based upon its stated assets and liabilities.

Today, Deutsche Bank (NYSE:DB) looks like a bargain based on a price to book valuation -- but investors should look further and consider the risks in investing in this German bank.

How cheap is it?
For a major bank, Deutsche Bank trades at a low valuation, even when compared to peers that themselves trade below average historical valuations. A look at the following table shows how Deutsche Bank compares in valuation to Bank of America and Barclays.

BankPrice to BookPrice to FY2014 EarningsPrice to FY2015 Earnings
Deutsche Bank 0.47 9.5 7.5
Bank of America 0.76 17.4 10.6
Barclays 0.63 10.6 8.5

earnings estimates source: NASDAQ.com

While I would argue that Bank of America and Barclays are themselves undervalued, Deutsche Bank looks even cheaper using price to book and forward price to earnings measurements.

Trading at only half its book value, Germany's largest bank is being valued like Bank of America was a couple years ago before B of A rose to trade at 0.76 times, where it trades today.

Why is it cheap?
Just because a stock is trading at a low price to book value doesn't necessarily mean you should buy. Oftentimes there are other factors to consider including whether to book value remains accurate and what risks lay ahead for the company.

As to the first concern, there is some risk as to how valuable Deutsche Bank's book value really is considering its heavy exposure to peripheral debt and European derivatives. Although the value of peripheral economy debt is recovering, these economies are still at an elevated degree of risk and the true value of these assets will remain difficult to sort out for years to come.

Deutsche Bank also carries higher risks than most major banks due to its business strategy and upcoming european banking events.

As other banks have moved away from fixed income and parts of investment banking, Deutsche Bank wants to fill the void. In its recent 8 billion euro capital raise, the bank noted that some of the capital was to help take market share and become a stronger global investment bank.

While this strategy does have the potential to open up a new line of business, it also has both execution and operational risks associated with entering a business rivals are so quickly leaving.

The upcoming European stress tests represent another risk that Deutsche Bank shareholders should watch for. If regulators determine a need for extra capital, the bank may be forced to cut its dividend or even issue new shares. The most recent capital raise provides a degree of protection against a capital issue but the bank's exposure to peripheral economies will have regulators giving it a close look.

Investors should also watch for any more downward revisions of Deutsche Bank's estimated earnings. These estimates have been trending down for the past few months as more analysts have factored in the recent capital raise and the consequential dilution.

Is it a bargain?
Deutsche Bank is one of Europe's most powerful financial institutions but the financial crisis and subsequent recession show that major risks still exist at the largest banks. Having survived the worst of the crisis and remained a key part of the global financial system, Deutsche Bank is unlikely to completely collapse but remains at the risk of share dilution and dividend cuts.

But stocks tend to trade cheapest when the most risk is involved. For risk tolerant investors bullish on a recovery in the peripheral economies, Deutsche Bank can be considered a cheap but risky pick.

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Alexander MacLennan has the following options: long January 2016 $40 calls on Deutsche Bank AG (USA) and Bank of America Class B warrants. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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