Why Do State Street and Bank of New York Mellon Trade for Such High Multiples to Book Value?

Their balance sheets are better insulated from credit risk. Image source: DigitalVision/Thinkstock.

Although Bank of New York Mellon (BK -1.98%) and State Street (STT -2.55%) may not appear expensive at first glance, they do after you consider their subpar profitability. This begs the question: Why do shares of these two banks trade for double-digit premiums to their respective book values even though they return less than 1% on their assets?

Most bank investors use the price-to-book-value ratio, or some variation thereof, to gauge the value of bank stocks. This is calculated by dividing a bank's share price by its book value per share. The larger the number, the higher the valuation.

The typical bank stock trades for between 0.5 times book value and 2.0 times book value. Many variables play into where a specific stock falls on this continuum, but the most important is profitability. A bank that generates net income equal to 1% or more of its assets each year tends to trade for a premium to book value, while a bank that earns less than 1% on its assets generally trades for a discount thereto.

This is why it's hard at first to reconcile Bank of New York Mellon and State Street's valuations. Their returns on assets last year were 0.78% and 0.75%, respectively, while their shares are currently priced at 1.18 and 1.25 times book value. The former puts them closer to ne're-do-wells like Bank of America and Citigroup, while the latter makes them seem more like JPMorgan Chase and Wells Fargo, two of the best-run banks in America.

*Return on assets calculated using net income available to common stockholders divided by year-end 2015 assets. Data sources: Yahoo! Finance and company filings.

How does one explain the fact that Bank of New York Mellon and State Street trade for premiums to book value despite the fact that they earn less than 1% on their assets? The answer is that these two banks expose investors to less credit risk than your traditional bank. This is the risk that borrowers will default, and it's the thing that most often causes a bank to lose money, or even fail outright.

"Banks get in trouble for one reason," successful bank investor Carl Webb once said. "They make bad loans."

The Bank of New York Mellon and State Street are custodial banks (click here to see the five different types of banks you can invest in). Instead of focusing on taking deposits and making loans, they act primarily as custodians over other institutions' assets, such as mortgage-backed securities. This becomes clear when you look at their own assets, of which only 16.2% and 7.6%, respectively, consist of loans. By contrast, half of Wells Fargo's assets are loans, as are roughly 40% of Bank of America's assets.

What they lack in profitability, then, Bank of New York Mellon and State Street make up for in peace of mind. And it's that peace of mind that helps explain why their stocks trade for premiums to book value.