After hitting all-time highs in 2021, Capital One Financial (COF 0.71%) has seen its stock plummet roughly 22% this year, as high inflation, aggressive rate hikes by the Federal Reserve, and concerns over a severe economic downturn have scared away investors.

While there are some headwinds -- including a potentially deteriorating macro outlook which could lead to higher loan losses -- the business is operating well right now, and management seems acutely aware of the risks they face. All of this sets up a good risk-reward proposition when you look at Capital One's valuation. Here's why.

Looming risks

While Capital One's return on equity has come down since its peak in late 2021, it is still generating returns that are well above pre-pandemic levels. In the second quarter, Capital One made a return on equity of roughly 15.8%. Prior to the pandemic, the best return Capital One generated was around 12%. Loan growth continued to come in strong in the second quarter, with period-end loan balances up 6%. Margins have also continued to expand, and Capital One has been repurchasing stock.

Person paying for something with credit card.

Image source: Getty Images.

But investors have been justifiably concerned because Capital One serves a less affluent customer base with lower FICO scores. At the end of the second quarter, roughly 70% of Capital One's credit card customers had FICO scores greater than 660, while 30% were below, meaning Capital One has a lot of subprime exposure.

In the company's auto portfolio, it's even worse. While more than half of the auto originations in Q2 went to borrowers with a FICO score above 660, 20% of originations went to borrowers with FICO scores between 621 and 660, and 28% to borrowers with FICO scores below 621.

While consumers across the board are coming from a place of strength, credit card lending can see higher default rates than other lending categories. Investors are also very concerned about auto loans because car prices have been so elevated thanks to a shortage of inventory brought on by pandemic-induced supply chain issues. But everyone expects those prices to come down eventually. 

Capital One is taking all of this into account. At the end of the second quarter, it had set aside enough money to cover losses on 6.76% of its total credit card book and 2.5% of its total consumer banking loan book, which is mostly auto loans. At the end of Q2, current charge-offs, which is debt unlikely to be collected and a good indicator of actual loan losses, were 2.34% in the company's credit card portfolio and 0.67% in the consumer banking portfolio. Management also said they are currently pulling back in auto lending significantly, as funding costs rise and as the space remains competitive.

Furthermore, Capital One has a tremendous amount of excess capital it could lean on if losses and defaults fare worse than expected. The Federal Reserve requires Capital One to maintain a common equity tier 1 (CET1) ratio, which measures a bank's core capital as a percentage of risk-weighted assets such as loans, of 7.6%. Capital One ended the second quarter with a CET1 ratio of 12.1%, and management has an internal long-term CET1 target of 11%.

Attractive valuation

Capital One has long traded at the bottom of its peer group and currently trades at 132% of its tangible book value or net worth. While I understand the concerns given the macro outlook, this is an experienced management team with discipline and that seems to be reserving prudently. The company also has lots of excess capital. If it can successfully navigate the potential difficult economic conditions to come, the stock has upside.