Banks are frequently valued based on multiples of tangible book value. This multiple essentially compares a bank's stock price to the amount of tangible assets -- loans, cash, investments, etc. -- that underlie the value of each share.
Among large banks, valuations are all over the map. Bank of America trades at just more than 1.1 times tangible book, whereas Royal Bank of Canada trades at roughly 3.3 times tangible book value, according to S&P Capital IQ. The disparity is attributed to quality -- the greater the bank's return on tangible book value, the greater the multiple investors will pay.
Here are two expensive, big-bank stocks that justify an above-average valuation.
The world's largest community bank
Wells Fargo (WFC 2.74%) is often called "the world's largest community bank." Despite its $1.6 trillion balance sheet, the company maintains the most basic of banking models -- taking deposits and making loans. It isn't all that different from a small bank you might find on a suburban street corner.
Investors appreciate the simplicity of the company. Today, the stock trades at more than two times tangible book value, according to S&P Capital IQ. But don't get sticker shock; Wells Fargo offers more than meets the eye.
An excellent operator
Wells Fargo's national deposit franchise is one of the country's best. The company last reported that its $1.1 trillion in deposits cost the company just 0.1% annually. That balance sheet funding allows the company to earn superb net interest margins, even with a safer, higher-quality loan book. As of last quarter, Wells Fargo reported net interest margin of 3.15%.
Lending is only half the business. Fees on checking and savings accounts, asset management income, and card-related revenue make up the other half of the pie. Fee-based revenue is a premium asset for any bank because it doesn't subject the bank to credit risk -- the risk its borrowers default.
When it comes to costs, the company matches below-average interest expenses with below-average overhead. The bank's efficiency ratio, which measures overhead relative to banking revenue, has trended less than 60%.
What does this mean for shareholders? In the last 12 months, the bank earned roughly 17% on tangible book value, placing it in the upper tier of bank stocks. Said another way, Wells Fargo is compounding shareholder wealth at a 17% clip.
Generally speaking, financial companies earn a valuation of one times book value for 10% returns, and two times for 15% returns on equity. By that rule of thumb, you're getting Wells Fargo at a fair price for an average bank. Wells Fargo isn't your average bank; low-cost deposits, efficient operations, and superior loan quality put it squarely in the above-average category. But investors are letting it go for an average price, necessitating a second look.
A northeastern banking king
When any business generates a profit in every quarter since the 1970s, it should demand more attention. M&T Bank (MTB 2.93%) is one such company, having generated excess returns for shareholders for decades.
That legacy leaves M&T Bank to trade at a premium to most bank stocks, earning a valuation of 2.2 times tangible book value according to S&P Capital IQ. Alas, even at that price, M&T Bank is an excellent stock for a long-term investor.
Behind the numbers
M&T Bank understands that excellent returns don't necessarily come from size or scale. The bank operates mostly in the northeastern United States, with a handful of branches in Florida. M&T shines bright where it really matters: holding down costs, paying a pittance on deposits, and having some of the best historical underwriting standards in the industry.
Its sterling balance sheet offers an incredible asset: roughly one-third of deposits are non-interest bearing. Should rates rise, M&T bank becomes an immediate beneficiary, as it will generate higher returns on loans while paying no more on its non-interest bearing deposits.
Recent cost concerns have plagued the company. Compliance costs have hit the company dearly, sending its efficiency ratio from its normal range of 50% to closer to 60%. Despite these temporary problems, M&T bank reported earning nearly 15% on tangible book value in recent quarters. A return to normal expenses would put returns on tangible book value closer to 20% per year.
In a tip of the hat to the bank's quality, investors haven't let temporary cost concerns impact its valuation. M&T Bank still trades at a premium to most banks in the United States.
At roughly two times tangible book value, it's hard to make a case against M&T. Over the long haul, the company's low-cost model and growing balance of non-interest bearing deposits should provide patient shareholders with an excellent return.
The foolish takeaway
Wells Fargo and M&T Bank trade at higher multiples than their peers, but for good reason. Both banks used opportunistic acquisitions to grow their balance sheets during the financial crisis, pay paltry sums on their deposits, and have above-average underwriting histories compared to their peers.
Over long periods of time, a high valuation does not stand in the way of market-beating returns. If these two banks continue to earn double-digit returns on tangible book value, they'll sustain their above-average multiples on growing tangible book values per share. That's all a bank investor could ever wish for.
