When it comes to buying bank stocks, valuation is one of the most important things an investor should consider. But this raises an important question for investors new to the banking space: How are bank stocks valued?
The short answer is that bank stocks are valued by the price-to-book-value ratio or some derivation thereof. This is calculated by dividing a bank's share price by its book value per share -- the higher the number, the dearer the valuation.
Bank stocks tend to be considered cheap when they trade for less than book value -- i.e., their price-to-book value ratio is less than 1.0 -- because that suggests that investors can buy the bank for less than its stated net worth. Alternatively, once a bank's share price approaches or surpasses two times its book value per share, it's considered expensive.
This is why savvy bank investors have piled so much money into Bank of America's (BAC 1.64%) stock over the past few years. At its low point in 2009, shares of the North Carolina-based bank traded for less than a quarter of its book value per share, according to data from YCharts.com. Since then, they've climbed to around one times book value, helping to explain why Bank of America has been one of the industry's best-performing bank stocks over the past five years.
Yet, while this shows how bank stocks are valued, it doesn't answer the question of why some bank stocks carry higher valuations than others. That's where the chart I referenced in the title comes into play. It reveals an obvious correlation between a bank's profitability, which tends to be measured by return on equity, and the valuation of its of stock. In other words, the higher the profitability, the higher the valuation, and vice versa.
This should make sense. After all, a bank's profitability is the most important determinant of shareholder return. A bank that earns more money than its peers, is not only in a position to grow its book value per share faster than less profitable banks, but it can also distribute more capital via dividends and share buybacks, both of which supplement shareholder return.
In the above example, then, the reason that Bank of America's shares trade for a discount to most other big bank stocks is because it has one of the lowest returns on equity among the nation's biggest banks. Its return on equity over the last 12 months comes in at only 6.9%, according to YCharts.com. That's meaningfully below the peer group average of 9.1%, and less than half of industry leader U.S. Bancorp's (USB 1.12%) return on equity, which comes in at 14.2%.
The takeaway for investors is that, as with most other things in life, you tend to get what you pay for when it comes to bank stocks.