At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
It's time to bail on Big Banking
When Bernstein announced its downgrades of Huntington Bancshares, BB&T
This morning, an analyst at UBS had harsh words for his banking compadres at Citigroup
But... but... aren't they cheap?!
UBS's pronouncement probably comes as a bit of a shock to investors who've heard that big banks have become cheaper than small banks as a result of a run-up in prices at the latter. And indeed, with shares of Citi selling for a mere 0.55 times book value, and Morgan Stanley and Goldman not much more expensive at 0.57 times book value and 0.87 times book, respectively, the stocks certainly look like bargains.
But here's the thing: UBS explains that "a more constructive environment" for capital markets could -- in theory -- improve returns on tangible equity for these banks to perhaps 10% next year. Problem is, if you assume a 12% "cost of equity," the bankers are actually destroying shareholder value with every move they make. Even at today's ultra-low interest rates, it costs them more to get access to capital than they can possibly make in profit by loaning that capital out to others.
This being the case, UBS argues that the big bank stocks can be fairly valued even when trading for below book value -- and all of this is even before you consider the risks of "regulatory/political uncertainty and impact of structural shifts in capital markets businesses" (or, put another way: "Europe.")
Uh-oh
Uh-oh is right. While UBS' argument uses metrics few investors are familiar with, the logic still seems sound. For those who prefer to look at these things in a more traditional way, though, let's run down the numbers from a pure P/E perspective and see if that sheds any light:
| P/E Ratio | Growth Rate | Dividend Yield | |
|---|---|---|---|
| SunTrust | 19.5 | 17.4% | 0.7% |
| BB&T | 14.0 | 10.5% | 2.4% |
| Citigroup | 9.8 | 9.7% | 0.1% |
| Morgan Stanley | 13.9 | 12.2% | 1.1% |
| Goldman Sachs | 17.5 | 13.8% | 1.5% |
As you can see, the regional bankers that Bernstein was bashing yesterday do in fact look a bit pricey. None of them boast P/E ratios lower than their combined growth rates and dividend yields (what value investor John Neff has called the "total return ratio." And now, UBS is pointing out that among the big banks, this key valuation metric is also largely lacking.
Among the three bigger bankers targeted for downgrade this morning, Citigroup comes closest to being a bargain, with a total return ratio of 1.0 on its stock. Conceivably, if Citi can eventually win approval from the Federal Reserve to increase its dividend payout, the stock could even turn into a bargain.
Foolish takeaway
Unfortunately, for Morgan Stanley and Goldman Sachs, both of which passed the last round of bank stress tests with flying colors, there's no such hope. Both already pay reasonable dividends. So unless they can grow their earnings quite a bit faster than most analysts think possible, their stocks will continue to look overpriced based on current P/E ratios and anticipated growth rates.
That said, not all hope is lost for investors who love to buy banks ... because "that's where the money is." In fact, according to our research, some of the smartest investors we know are buying banking stocks -- just not the ones named up above. Which ones are they buying, and which ones should you look at buying, too? Read our free report, and find out.
