The 5 Cheapest Big Bank Stocks Right Now

If you're in the market for a bank stock, then valuation is one thing you should keep in mind. Holding all else equal, the cheaper you can buy a stock, the bigger your return is likely to be.

It's for this reason that I intermittently check bank stock valuations on the KBW Bank Index, the leading index of large-cap bank stocks headquartered in the United States. The average stock on the index trades for 15.5 times the bank's projected earnings per share over the next 12 months. That's not cheap, but it's far from expensive when you consider that the average stock on the S&P 500 is valued at 35 times forward earnings.

But while bank stocks in general are valued at a lower multiple to earnings than the typical large-cap stock, some banks are still cheaper than others. Based on the forward P/E ratio, here are the five cheapest big bank stocks right now:

Data source: YCharts.com.

Aside from Capital One, which is heavily concentrated in credit card loans and thus exposed to elevated credit risk, as credit card loans tend to default at higher rates than other types of loans, the four other cheapest big bank stocks have something in common: They're the largest banks in the country.

Citigroup is the smallest of the four, yet it still has $1.8 trillion worth of assets on its balance sheet. JPMorgan Chase, meanwhile, is the largest, overseeing $2.6 trillion in assets. And Bank of America and Wells Fargo fall in between these two.

Why would these banks trade at lower valuations than smaller banks? It seems to me that there are four reasons.

First, under the Dodd-Frank Act of 2010, global systemically important banks like JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup can't operate with as much leverage as their smaller, simpler peers can. This is because they're subject to higher capital requirements, which necessarily reduces leverage and profitability.

Second, all of these banks are effectively shut out of the market for mergers and acquisitions of other depository institutions. JPMorgan Chase, Bank of America, and Wells Fargo each hold more than 10% of the nation's deposits. Therefore, they're prohibited under federal law from acquiring other banks. Citigroup doesn't face the same constraint, as its depositary base is weighted more heavily toward international deposits. But given the New York-based bank's strategy over the past few years of shrinking its balance sheet as opposed to growing it, it's safe to say that Citigroup is not in the market to acquire other banks, either.

The net result is that these four banks are all largely confined to organic growth, which could weigh on their returns in the future relative to banks that aren't similarly prohibited from merging with or acquiring other banks.

Image source: Getty Images.

The third reason is that these four banks are especially difficult to analyze. Much of this comes from their sheer size and the extent of their operations. Furthermore, JPMorgan Chase, Bank of America, and Citigroup are all universal banks, meaning that they run both investment and commercial banking businesses.

Commercial banking is straightforward, consisting of taking deposits and making loans. This yields recurring revenue that doesn't fluctuate widely on a quarterly or annual basis. Investment banking operations are much harder to understand and forecast into the future. This is primarily because an investment bank's top line is influenced by volume and volatility in the credit markets, both of which are all but impossible to predict in advance.

Finally, while I've touched on this already, the biggest banks in the country are all subject to much more robust regulatory requirements than smaller banks. Their compliance exams are more intense. They face additional hurdles on the annual stress tests. And the way they structure their balance sheets is much more closely scrutinized by industry overseers.

Does this mean you should avoid buying shares of JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup? Not necessarily because, remember, while they may face more headwinds than smaller banks, their shares can also be picked up at much lower valuations. That said, as I've written in the past, given the towering heights of the stock market today, I think investors have more to gain than lose from waiting for a potential pullback in the market before diving deeper into stocks.