The Universal Banks: Valuation and Profitability

In this clip, Industry Focus: Financials host Michael Douglass and Fool.com contributor Matt Frankel discuss how investors can interpret the valuation of bank stocks, and how the three biggest universal banks stack up. They also discuss the relative profitability of the three, and why the expensive one is so, well, expensive.

A full transcript follows the video.

This video was recorded on Jan. 29, 2018.

Michael Douglass: Let's go ahead and take a look at part two, which is, how expensive is the bank? When it comes down to it, valuation is really critical in banks, because as you mentioned, Matt, we're not seeing, for these big banks, a ton of growth. I mean, sure, listen, single-digit deposit growth and loan growth is great. And single-digit revenue growth is great, too. You're not going to tend to see double-digit growth here. So valuation becomes really important because these are large, mature companies.

Matt Frankel: Yeah. There's a couple of different ways you can value bank stocks. Price to earnings is the traditional valuation metric, it's used to pretty much for every sector of the market. And that's definitely helpful here. My favorite way to evaluate banks is the price to their tangible book value, or just their book value, depending on which one you're looking at. Price to tangible book value is how much a bank's stock is trading for relative to the value of its assets. In other words, if a bank decided to close its door today and sold off all of its assets, how much could it reasonably get? If you include things like goodwill and brand name, stuff like that, that's your price to book value. If you don't include any of those intangible items, as the name implies, that's your tangible book value.

As far as these three banks go, this is where it starts to get a little bit different. Citigroup (C -0.85%)is by far the cheapest of the three. They trade at just over 1.1 times their book value, 1.3 times their tangible book value. Bank of America (BAC -0.29%) is the middle one here. They trade at about 1.35 times their book value, 1.9 times their tangible book. JPMorgan [Chase] (JPM -0.48%) is the expensive one, about 1.75 times their book value and 2.2 times their tangible book. With banks, though, you have to remember, you're getting what you pay for. Citigroup has a lot of risky assets on its balance sheet, mainly left over from the financial crisis. And you see that, as your valuations go up among these three, you see less and less of that risky stuff on there.

Douglass: One of the key things to think about when investing is not just returns. Everyone talks about returns. But also, risk-adjusted returns. I don't personally view risk as volatility. I view risk as the likelihood that everything goes belly up. Because, for me, I'm not concerned about volatility, because I'm 28, so I have plenty of time to ride out lots of volatility. But for me, the really key question is, what's the risk that things don't pan out well? And so, I will tend toward safer businesses for exactly that reason. Now, to be clear, Citigroup is perfectly fine. But, you do tend to get, when you adjust your potential returns for risk, that does sometimes create a different picture than what you had when you were just looking at potential returns. So, I would throw that out there as a caution for anyone, particularly some growth-minded investors like me, to think about.

But yeah, as you pointed out, you get what you pay for, and I think that actually segues us very nicely to part three, which is, what is the bank's earning power? And here is where JPMorgan certainly starts to pull away from the pack a little bit. Return on equity, you want to see 10%. JPMorgan's was 11%. Citigroup's was 7.3% and Bank of America is around 8%.

Frankel: Yeah, same goes for return on assets. You want to see around 1% here. JPMorgan's was 1.04%. Citigroup's was 0.87%, Bank of America's was 0.93% for the year. Like I said, efficiency, they're all pretty much evenly matched. But JPMorgan really stands out from the pack here. That means they're earning more than enough money to cover their cost of capital. Bank of America is getting there. They're improving very rapidly, which is why I think they command a premium valuation to Citigroup, even though the metrics don't really justify trading for a 30% premium or whatever it is. JPMorgan is definitely the most profitable today. Bank of America is the most rapidly improving of the three, is the way I put it. That's where you get the three levels of valuation that you see between these.