Source: Company website.
There are only a handful of institutions in the U.S. banking system that match the size, financial soundness, and conservative management of PNC Financial Services Group (PNC 2.79%). The bank brings strong financial results without the baggage, culture, or complexity of a large Wall Street bank.
The question then, is if now is the time to buy PNC stock? To me, the answer is no.
In my view, the issue with an investment in PNC today is the same as it's been since 2009 -- the bank trails its peers in problem loan management. Until that trend reverses, there are other bank stocks with higher upside.
Let's start with the bank's value compared to a few peers
The most common method for valuing a bank is to use the price to tangible book value ratio. Tangible book value is akin to the bank's net worth, except that we subtract out items without clear tangible value like goodwill, preferred equity, and other intangible assets. Bank investors generally consider a price to tangible book value of less than one to be cheap, and more than three to be expensive.
Currently, PNC trades at a ratio of 1.4 times price to tangible book value. Compare that to competitors Wells Fargo, BB&T, and U.S. Bancorp which trade at 2.3 times, 2.1 times, and 3.0 times, respectively.
Looking at a chart of these numbers over the past 10 years adds much-needed context to these numbers, especially in light of the financial crisis in 2008 and 2009.
PNC Price to Tangible Book Value data by YCharts.
First and foremost, it is painfully clear that during 2005 through 2007, these banks were massively overvalued. The five, six, and even seven times price to book value ratios are painful reminders of just how frothy the markets had become leading up to the financial crisis.
For PNC though, there is another noteworthy observation: The bank was valued in the middle of these peers prior to the crisis, and yet today trades notably lower. Our conclusion then will be based on what caused that change and how effectively the bank is reversing it.
Why does PNC Financial trade at a lower valuation than other banks?
Banking, at its most fundamental level, really is a simple business. That's particularly true for traditional banks like PNC. The bank gathers deposits and extends loans. The spread on those two functions is the bank's core driver of earnings, which is then supplemented with fees for other value-added services like wealth management, trust, or treasury services.
What this means for us today is that a bank is only successful if it makes good, high-quality loans that are paid back. More often than not, poor financial performance is a symptom of problems linked back to bad loans. For a current example, look no farther than PNC over the past six years.
To measure the quality of PNC's loans, we can use the bank's level of non-performing assets relative to its total assets. Non-performing assets, or NPAs, are loans that are severely delinquent plus property in foreclosure.
The chart below shows PNC's non-performing assets ratio as of the second quarter in each of the past 10 years. Just like the price to tangible book value chart above, there is a clear change in 2009 that persists today.
The blue and red bars in the chart show PNC's level of NPAs over time, and the black line is the average of the 100 most similar U.S. banks to PNC by total assets.
Source: BankRegData.com.
For the five to six years preceding the financial crisis, PNC's level of NPAs was consistent with or lower than the peer set represented by the black line. During and then following the financial crisis, that trend reversed, with PNC having a clearly higher level of NPAs.
That means, for PNC's stock to rise relative to other banks, then the company must solve its remaining credit quality issues. Unfortunately, that is not yet happening.
Since the third quarter of 2011, PNC's 100 closest peers by assets have reduced their NPA ratio on average by 55%. Over the same period, PNC's non performing assets ratio has declined by just 47%. That means even today, PNC's not keeping pace with its competitors in reducing these credit quality problems.
Foolish takeaway
The core of my view today is one of opportunity cost. PNC Financial Services Group has a lot of very positive things going for it. The bank has strong profits, good return on equity, and is very well positioned for a change in interest rates.
However, PNC's problems with asset quality are real, and they justify the bank's current low valuation relative to peers. Until PNC is able to lower the level of NPAs on its books to a level more in line with the rest of the industry, then your investment dollars are likely better put to use at a different bank.
The stock very well may ride the tide of an improving banking industry overall and see its stock price move higher. However, if that happens, it is my view that other banks will see even greater upside and will outperform PNC.
