In this Industry Focus: Financials clip, host Michael Douglass and banking specialist Matt Frankel discuss the valuation of commercial banking giants Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB). Then, they compare valuation and risks to give investors a better picture of what they're getting for their money.

A full transcript follows the video.

This video was recorded on Feb. 2, 2018.

Michael Douglass: OK, let's turn now to part two of the framework, which is, how expensive is the bank? Of course, there are a few different ways to approach that, but our preferred is price to tangible book value.

Matt Frankel: Right. This is how much a bank trades for relative to the actual assets, excluding intangible items like goodwill that are on its balance sheet. Kind of the short way to say it is that U.S. Bancorp is expensive.

Douglass: [laughs] Yes, that would definitely be how to say it.

Frankel: They trade for a little over 3X tangible book, which is, if you've been following the first two parts of our series, is the highest of the seven banks we've discussed. Wells Fargo is right around 2X tangible book. It's interesting to note, though, that if you value these in the traditional way, price-to-earnings ratio, both are almost right around 16X earnings. And if you look at some of the other banks, they all trade between 15-17X earnings, despite the fact that their price to tangible book varies considerably, from Citigroup's just over 1X tangible book to U.S. Bank over 3X tangible book. That's a metric you want to look at to differentiate between all the banks, even though their price to earnings ratios may look about the same.

Douglass: And what's one of the interesting things to me about the price to earnings ratio here is, it tells us, in some ways, a different story. When you have a bank that's expensive from a book value perspective, but is, let's say cheap, or in line, at least, from a price to earnings perspective, that's usually a sign that you have a high return on equity. As a reminder, generally speaking with banks, you want to see return on equity of over 10%. Over 12% is awesome, but at least over 10%. And U.S. Bank's ROE is just under 14%. So, that's one of the reasons why, even though it's expensive from a book value perspective, it actually looks in line from a price-to-earnings perspective.

Frankel: Definitely. This is a return on equity that would be reasonably good for a bank without branches. That's almost unheard of for a branch-based bank, especially one that size. Just to give you the comparison, Wells Fargo's is 11.3%. And that's very good. Most of the other banks are right around 10% or even a little bit less. Return on assets is another one. You want to see about 1% return on assets. U.S. Bank is almost 1.4%. So, the quick way to say this is, you get what you pay for. You're paying a premium valuation for the bank, but you're getting a much higher quality banking institution. Not to say Wells Fargo is low-quality. U.S. Bank is just in a class by itself.

Douglass: Indeed. And I have to admit here that we have slipped into part three, which is, what is the bank's earnings power. But it was such a natural conversation that I couldn't resist. One of the other pieces to look at is efficiency ratio. You always want to see an efficiency ratio under 60% if possible. U.S. Bank clears that at 58.8%, and Wells Fargo doesn't, they're 66.2%. Now, there are some particular reasons for Wells Fargo's to be so high recently, we'll get to that in a bit. That's certainly something to keep an eye on. The other piece I'll throw out there is, net interest margin, almost 3.1% at U.S. Bank, which is a really, really good spread. And it's 2.9% at Wells Fargo, which is also a really good spread. Generally speaking, if you're seeing over 1.5%, I start getting pretty happy. To see them both at or near double that is a good spot to be, particularly because as interest rates continue to hopefully rise, knock on wood, there is a lot of opportunity for that interest margin to expand further.

Frankel: Yeah, definitely. To give you a comparison, Bank of America is about 2.25%, which we think is pretty good. If you have anything over 1.5%, it's nice. Another thing you want to watch for is margin expansion. Wells Fargo is a special case, we'll get to why in a minute.

Douglass: We'll just keep burying that lede.

Frankel: Yeah, we'll kick the can down the road on that one. U.S. Bank, their margins have expanded by 10 basis points over the past year. So, you can see the effect of rising interest rates at work. Just, generally, the rates banks charge for loans, outpaces the rates they're paying for deposits. So, you'll see margins expand as interest rates, hopefully, like you said, knock on wood, continue to rise.

Douglass: Absolutely. And of course, this takes us to part four, which is, what risk is the bank taking on to achieve those earnings? To some extent, when you see a lot of growth and you see a lot of good metrics with a bank, one of the first questions you really have to ask is, what's the flip side of this? Have they really found a way to build a better mousetrap? Or is this a case of loaning out money too aggressively to people who may not be a good credit risk? So, think about it this way. If you're putting out a risky loan, chances are good you're putting it out for a good interest rate -- from the bank's perspective, of course not so much from the consumer's perspective -- because you're able to charge more for someone who's higher risk. The flip side of that is, when the tide goes out and the credit cycle turns and the economy goes bad, those tend to be loans that are going to default first, which is not so great from a bank earnings perspective. So that's something you really, really have to keep an eye on. Both Wells and U.S. Bank, their net charge-offs are pretty low. Wells' is at 0.31%, U.S. Bank's is at 0.46%. Of course, cautionary point here, everything tends to look good when the credit cycle is doing well. But they both did pretty well, even through the Great Recession, comparatively speaking.

Frankel: Yeah, both of these banks have historically been known for having top-notch asset portfolios. One thing you do want to keep an eye on, both have substantial credit card businesses, especially Wells Fargo. And these tend to be, like Michael just said, riskier loans, but banks are willing to make them because, what's the interest rate on your credit card? 20%? 22%?

Douglass: Something like that.

Frankel: That's why they're willing to do it. But, those are the loans that tend to turn first when the credit cycle gets bad. So, like you said, the numbers look great right now, they look great across the board. I can't think of a bank that has a high net charge-off ratio right now. But, keep an eye on these when the tide goes out. Wells especially looks great right now, but they have a gigantic credit card business, so keep an eye on it.

Douglass: Yeah. I think one of the other things to pay attention to as well is assets over equity. Basically what that tells us is how hard is the bank levering to achieve its earnings power. Usually, if you see around 10X, you're pretty happy. Wells and U.S. Bank are right between 10-11X. So, no really big concerns there, from my perspective, at least. So, that's how that looks.

Generally speaking, returns have looked pretty good, particularly when you adjust for risk, given that their asset portfolio has been historically good. But, there are other parts to this story.

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