Since last year, the Federal Reserve has raised interest rates by 5.25 percentage points, the fastest pace of monetary tightening since the 1980s. The rapid increase has pushed interest rates to levels not seen in a decade and a half, putting pressure on some banks and casting a storm cloud over the industry.
Capital One Financial (COF 0.16%) is one bank stock bucking the trend, gaining nearly 13% since January. Despite the run-up, Capital One remains down 41% since it peaked at $178 per share about two years ago and is at a cheap valuation relative to history. There are several factors to consider, so should investors buy, sell, or hold Capital One today?
Credit cards are Capital One's bread and butter
Capital One provides financial services to clients, including checking, savings, and money market accounts. Its $465 billion in assets makes it the ninth-largest bank in the U.S. While banking is one component of the business, credit cards are the bread and butter that propel its earnings.
The company works with Visa and Mastercard to provide credit cards for its customers and holds on to those credit card loans to generate fee and interest income. According to the Nilson Report, Capital One was the fourth-largest credit card issuer in the U.S.
It earns service charges and interchange fees (the fees merchants pay when customers use their debit or credit card to make purchases). Last year, it earned $7.1 billion in these fees, but they represent only a small part of the business. Net interest income, or the difference between interest earned on loans and interest paid on deposits, was $21.3 billion in comparison.
Rising deposit costs put pressure on its net interest margin
High interest rates can benefit banks like Capital One because they result in a wider net interest margin, or the difference between interest earned and paid out. However, the rapid increase in interest rates has put pressure on banks, which hold a sizable amount of loans made during a time of ultra-low interest rates.
When customer deposits flowed out of Silicon Valley Bank earlier this year (a subsidiary of SVB Financial), the bank was put in a position where it would have to raise funds through equity or debt or take a sizable loss selling loans and other investments from its portfolio to fund the outflows. Since then, banks have increased the interest rates paid on deposits, putting pressure on their net interest margins.
Image source: Getty Images.
Capital One's average deposit interest rate on consumer accounts went from 0.79% last year to 2.85% in its most recent quarter. So, even though net interest income was up 9% from last year, its net interest margin has narrowed from last year.
The good news is that Capital One doesn't face the deposit outflow risk that Silicon Valley Bank or other failed banks did. In fact, its total deposits of $346 billion are up 4% from last year.
Why investors will want to keep an eye on its credit metrics
While Capital One doesn't face risk of deposit flight, investors will want to pay attention to its credit situation. This year, U.S. credit card balances topped $1 trillion for the first time, and consumers are beginning to show cracks. According to the Federal Reserve, the delinquency rate on credit card loans at all commercial banks was 2.77% in the recent quarter, the highest rate in more than a decade.
Data source: Board of Governors of the Federal Reserve System. Chart by author.
Capital One is in a vulnerable position if delinquencies continue to pick up because many of its borrowers have a less-than-prime credit score (a FICO score below 660) -- 48% of Capital One's auto loans and 31% of its credit card loans were made to these subprime borrowers, who could be more vulnerable in an economic downturn, leading to higher charge-offs for the bank.
Capital One charged off 4.4% of its credit card loans in the third quarter, double its charge-off rate last year. Its charge-offs on consumer auto loans also increased from 1.1% last year to 1.8% in the third quarter.
Is it a buy, hold, or sell?
Down 41% since its peak price in 2021, the stock has a price-to-sales (P/S) ratio of 1.1 and price-to-tangible-book-value of 1.03, both of which are below its historical average and near a decade low.
Data source: YCharts.
Its low valuation could be an intriguing opportunity for value investors. But the low valuation might be warranted, considering the potential downside to the stock if there's a slowdown in consumer spending that leads to a recession sometime next year.
The company could face headwinds due to its consumer base and seems reasonably valued considering those risks. However, I think these headwinds limit its upside in the near term; therefore, I would give the stock a hold recommendation for now.
