I recently read that bank-stock expert Douglas Hughes had called two bank buyouts in the past couple of weeks that had resulted in some of the largest premiums in years. Intrigued, I dug deeper into Hughes' value-investing background, and then called him up to see what I and fellow Fool readers could learn from his methods. (Notes in italics are my own commentary.)

Emil Lee: Can you provide me with a little background information?

Douglas Hughes: Yes, we manage money and also put out a newsletter on small- and mid-cap banks at banknewsletter.com.

EL: Describe what you look for in a bank.

DH: We look for great valuation, a great management team, and a bank that has returned 15%-25% on their money every year for a long period of time. Recently two of the biggest premiums in history were on two banks in the newsletter -- Commercial Bankshares (NASDAQ:CLBK) got a 30% premium, and Premier Community Bankshares (NASDAQ:PREM) got a 65% premium. These are the highest premiums in 7-8 years.

EL: What about First Republic (NYSE:FRC)?

First Republic jumped roughly 40% when Merrill Lynch (NYSE:MER) bought the bank out.

DH: First Republic's been in our newsletter five or 10 times, but due to valuation we never had tremendous size in it.

EL: How do you generate investment ideas?

DH: We've researched every bank out there, about 2,000-3,000 banks. We wait for them to get to an entry point that minimizes downside risk, but maximizes upside. It's like buying a car or house: As long as you buy at the right price, you don't have too much downside. There's always something mispriced -- in the current bank environment, there's some at highs, some at lows. It's a stock-by-stock basis -- we have to know the company, and the asset quality. For Commercial Bankshares -- everyone was worried about their Florida loans, but they have zero bad loans. Not having bad loans is always the most important thing. Any banker can ruin a bank by running up costs and making stupid loans.

EL: How do you feel about Corus Bankshares (NASDAQ:CORS)?

Corus is another bank with heavy Florida exposure that seems to be trading at a low valuation.

DH: Corus is big in new construction condos; they also invest in 30 other banks. The guys there are definitely smart guys. Is it foolish for them to be doing what they're doing? I can't say, there are too many variables -- the portfolio of bank stocks ... there's too many unknowns. We want to buy something with minimal downside. Our downside has to be 5%-10%.

EL: How do you judge asset quality when reading a financial statement?

DH: We look for a smart management team with 5-15 years experience -- a couple cycles without any problem loans.

EL: What about asset quality in terms of metrics?

DH: Good banks never loan more than 70% LTV and then drop their LTVs to 50%-60% as markets deteriorate -- they're ahead of the game, a couple banks [you'll see them do this before the credit cycle goes bad].

LTV stands for loan to value -- a 70% LTV means that the loan equals 70% of the estimated value of the collateral. Thus, for a loan with a 70% LTV, the collateral would have to decrease 30% in value before the bank suffers credit losses. Obviously, the lower the LTV, the more secure the loan is.

EL: How do you do your valuation models?

DH: Banks are valued on P/B [price-to-book], asset quality, and how long the bank has been around. The most important criteria are asset quality, how much growth is ahead of [the bank]. With banking you're buying a group of smart people.

A bank's assets and liabilities are loans, securities, debt, and deposits -- all highly liquid and easily convertible to cash. A bank's tangible book value (which excludes intangibles such as goodwill) -- can be considered its base case valuation -- the premium to tangible book can be attributed to the value investors place on future earnings the bank can be expected to earn. Thus, the higher the price-to-book multiple, the more value investors believe the bank can earn over its cost of capital.

EL: In terms of the price-to-book multiple, do you say "The bank is worth this price-to-book ratio today, this is how fast we think book value will grow, this is the price-to-book multiple we think the bank is worth, so the bank will be worth X in the future?"

DH: Exactly.

That's enough bank talk for today -- in the follow-up to this article, Hughes discusses which of his current picks in the small- and mid-cap bank space are undervalued and possible takeover candidates.

For some more reading on banking, check out:

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.