Capital One Stock

Capital One Financial (NYSE:COF) is among the most intriguing companies in the banking sector. It was at the forefront of direct-to-consumer banking, building and acquiring an online banking presence before most traditional banks had even considered it.

In recent years, the company has turned from a small credit card issuer to a formidable banking operation. Shares might have upside. Here are three reasons why.

1. It has built on a top-shelf deposit franchise

It seems most banks do only one thing well. For some, it's gathering deposits. Others are excellent lenders.

Capital One Financial is both. And over time it has proven its ability to gather and retain deposits through acquisitions like that of ING's online banking unit, now known as Capital One 360. A cursory glance of its balance sheet reveals that its deposits are simply cheap.

Category

Total Deposits

Average Cost

Consumer banking

$169.7 billion

0.57%

Commercial banking

$31.2 billion

0.24%

All interest-bearing liabilities

$217.7 billion

0.73%

Source: SEC filings.

The company's relatively low-cost deposits are the direct result of their source. A majority are savings and checking balances. Less than 5% are sourced from time deposits (CDs), which tend to be the most expensive deposits on a bank's balance sheet.

2. Its competitive position in lending

While most banks take deposits to make primarily mortgage loans, Capital One Financial has the benefit of being the No. 4 credit card and automotive lender. Credit cards, as one can imagine, generate substantially larger net interest spreads than other forms of lending. So, too, do auto loans, which also offer the benefit of being quick to amortize -- a boon should rates rise.

To put its competitive position in perspective, one only needs to look at Capital One's asset yields relative to its average cost of funds. As of June 30, 2014, Capital One paid an average of 0.73% on its interest-bearing liabilities, while earning 7.15% on its interest-earning assets.

And unlike many lenders, Capital One keeps a substantial share of its interest income. The company reported an efficiency ratio of less than 55% in the second quarter, which is seven percentage points lower than the banking industry average.

3. Valuation

Capital One is not a cheap stock. Investors have come to recognize the quality of its deposit franchise, its above-average loan yields, and its lean operations. Shares now trade at about 1.7 times tangible book value.

That's fair, but it's far from excessive. Consider this: in the past three years, returns on tangible book value have run as high as 21% and as low as 13% in any given quarter. The midpoint of 17% is conveniently in line with its return on tangible book value in the quarter ended in June, and for much of its history.

What should you pay for a 17% return on tangible book value? I think a price of up to two times tangible book value is more than reasonable, and in line with other big banks. That would price shares as high $94, for 16% upside at the current price of $81 per share.

Although a 16% return sound nice, I think this is a bank you want to hold for a very long time. Its recent performance is no outlier -- Capital One has put up impressive results from inception through the financial crisis. In fact, it was just a hair shy of profitability in 2008, despite its riskier than average credit card book. This isn't your average bank. It's a well-oiled, profit-generating machine trading at a reasonable price.

 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of Capital One Financial.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.