Since the beginning of the credit crisis last summer, bank stocks have been absolutely murdered -- the KBW Bank index, which tracks 24 of the most prominent U.S. commercial banks (including Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase (NYSE:JPM)) is down more than 40% from a year ago, at levels not seen in almost a decade.

However, I’ve learned it can pay to be contrarian. Distressed sectors needn’t repel you; when I sense that sentiment is unanimously negative, it’s like a dinner bell ringing in Pavlov’s kennel!

What was happening in the market 10 years ago?
Prior to 2008, the last time the Bank index was at this level was the fourth quarter of 1998. Russia had defaulted on its debt over the summer, precipitating the meltdown of hedge fund LTCM. In response, the Fed organized a private rescue of LTCM by a consortium of 14 banks and broker-dealers -- the fund’s massive positions were thought to threaten the stability of the financial system.

If that sounds familiar, it should -- the summer of 1998 offers direct parallels with the current environment. In March, for example, the Treasury facilitated JPMorgan Chase’s rescue of Bear Stearns on the assumption that the troubled broker’s failure posed an unacceptable risk to the financial system.

Cut to the chase: What’s it worth?
As serious as the current problems are, when a bubble deflates, it’s common for sentiment to shift from unbridled optimism to exaggerated pessimism. That spurred my curiosity: What is a fair value for the KBW Bank Index?

To figure that out, I used the justified Price-to-Book Value multiple. (The Price-to-Book Value (P/BV) multiple is commonly used to compare stock valuations; it’s calculated by dividing the stock price by the company’s book value-per-share. P/BV values for any stock can be found on Yahoo! Finance.)

Banks: Justify yourselves!
Instead of starting with the stock price, the justified P/BV is calculated based on the company’s fundamentals -- it’s the multiple at which the stock ought to be valued in light of those fundamentals. Specifically:

Justified P/BV = (Return on Equity - Expected Growth Rate in Earnings per Share )/(Cost of Equity - Expected Growth Rate in Earnings per Share )

Multiplying the justified P/BV by the company’s book value per share produces an estimate of the stock’s fair value. Calculating a justified P/BV for the index is no different; you simply use the fundamentals of the index.

The following table contains the results of these calculations for the KBW Bank index and six of its component stocks. The six stocks include three well-run banks that are riding out the crisis rather better than their peers (BB&T (NYSE:BBT), M&T Bancorp, and Wells Fargo (NYSE:WFC)) and three that are suffering tremendously (Citigroup, Wachovia, and Washington Mutual (NYSE:WM)).

 

Justified P/BV

Fair Value

Current Price (08/26/2008)

BB&T

16.38

n/m*

$28.21

M&T Bancorp

3.50

$206.81

$68.41

Wells Fargo

(3.86)

n/m

$28.69

Citigroup

3.13

$62.72

$17.84

Wachovia

2.41

$73.80

$14.04

Washington Mutual

1.94

$25.90

$3.59

KBW Bank Index

0.84

$57.76

$62.26

*n/m = not meaningful. Sources: Capital IQ, Yahoo! Finance.

I made conservative assumptions at all steps of the calculation. My fair value estimate for the index should be thought of as a lower bound for the fair value; it represents a level at which the index is attractively priced. (If you would like to know more about the assumptions behind these numbers, I discuss them in my CAPS blog.) That said, what does the table tell us?

First, the multiples for individual banks are plainly useless, with some values negative and others that are off the chart. As a ratio, the price/book multiple is very sensitive to its three inputs (ROE, cost of equity, and EPS growth).

The multiple for the index, on the other hand, is derived as an average across 24 banks, so it’s much more stable. Another argument in support of its legitimacy: Its value jibes with my practical observations of the bank sector in July.

Capitulation in bank stocks: a diary
During the week of July 7, Fannie Mae and Freddie Mac were in the market’s crosshairs as investors wrestled with heightened fear concerning the financial position of the mortgage giants. These fears spilled over onto all financial stocks, including banks and broker-dealers.

By Friday, July 11, the fear felt all-encompassing. I bought shares of two U.S. banks that day, taking my exposure to bank stocks from zero to 14% of my portfolio. The KBW Bank Index closed at 54.67 on Friday, down more than 50% from a year earlier.

On Sunday, July 13, the Treasury and the Fed announced a raft of measures in support of the GSEs. Despite this, bank stocks continued lower during Monday’s session.

On Tuesday, July 15, in testimony before the Senate Banking committee, SEC Chairman Chris Cox said the SEC would implement an emergency measure to restrict the short selling of stocks of 19 financials, including Fannie and Freddie. The KBW Bank Index closed the day’s trading session at 48.47, recovering some ground from an intraday low of 46.52. The following day, the index soared, with a gain of 17%.

My point here is that my conservative fair value for the KBW Bank index (57.76) is only a bit higher than the values observed during the capitulation in bank stocks. That period (July 9-15) will go down as an extreme buying opportunity. For those who didn’t participate at the time, all is not lost. The index -- now priced at approximately 8% above my fair value -- doesn’t look overvalued.

My fair value estimate for the index may be a helpful benchmark, but I’m a bottom-up investor. I buy individual stocks; I don’t make bets on the KBW Bank ETF (AMEX:KBE). In the second part of this two-part article, I’ll describe which banks investors should focus on as they comb through the sector.

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo and BB&T, but not in any of the other companies mentioned in this article. JPMorgan Chase, BB&T, and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy, which has suffered no impairments to its book value.