In his legendary annual letters to Berkshire Hathaway (BRK.B 1.30%) shareholders, Warren Buffett has frequently stressed three words: margin of safety. Maintaining a margin of safety means buying companies at a discount. If you buy a company that is priced 20% below its real value, then you have yourself a 20% margin of safety on your investment. It's the essence of value investing.
We'll use this concept today to evaluate a potential investment in M&T Bank (MTB 2.93%). We've discussed the bank's income streams and its profitability. We know who leads the bank and how it grows. The question for today is whether this bank offers a sufficient margin of safety for an investment in 2015.
How to value a bank
The most common and arguably simplest method to value a bank is with the price-to-book-value ratio, or P/B. Banks earn profits based on the assets they hold on their balance sheet, and every bank is required to hold a certain level of tangible equity to support those assets. Therefore, comparing market cap to book value is a pretty good way to observe whether the market thinks the bank has strong, profit-earning assets worth a premium or dubious assets with a poor risk-reward balance.
As a rule of thumb, a bank that trades above two times P/B is considered expensive, and banks that trade for less than book value are considered cheap. That said,you should never follow rules of thumb blindly.
Buffett, the consummate independent thinker, emphasizes a bank's return on assets in his evaluation of bank values. Long story short, Buffett thinks that banks with strong ROA generally deserve a premium valuation.
Back to M&T Bank
To evaluate M&T Bank, we'll compare it with a few of its peers, using ROA and P/B as the two primary metrics. Here's the breakdown:
| Bank | Total Assets (Q3 2014, in millions) | ROA, Last 12 Months | P/B |
|---|---|---|---|
| US Bancorp (USB 2.56%) | $391,284 | 1.6% | 2.1 |
| SunTrust Banks (STI) | $186,818 | 1% | 1 |
| Regions Financial Corporation (RF -0.53%) | $119,226 | 1% | 0.9 |
| M&T Bank | $97,228 | 1.1% | 1.5 |
| KeyCorp (KEY 1.74%) | $89,784 | 1% | 1.2 |
Total assets and return on assets from S&P Capital IQ. Price to book value from YCharts.
Among these peers, M&T trails only US Bancorp in terms of ROA as well as price to book value. Based on this initial view, M&T Bank appears to be fairly valued or perhaps even slightly overvalued relative to the peer set.
There does not appear to be a significant margin of safety.
One final caveat
Currently, M&T Bank is investing hundreds of millions of dollars to enhance its regulatory compliance processes so that it can complete its acquisition of Hudson City Bancorp (NASDAQ: HCBK). There is an argument to be made that these expenses will be nonrecurring and that in a year or two, the bank will have an extra $100 million or so in annual profit just by getting past this regulatory challenge.
If that argument resonates with you, then perhaps M&T Bank's 1.5 P/B does represent a margin of safety. To me, though, that argument is difficult to get behind. Regulatory costs are up, and they will remain up. That's the new normal for banks of this size in the post-financial-crisis world.
Could I be wrong? Sure. I think M&T Bank is one of the best banks in the country, and I wouldn't sell its management team short by implying it can't achieve ROA of 1.5% or even higher. For me, though, the margin of safety is not enough to justify the risk at the market price offered today.
