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What causes bank stocks like Wells Fargo (NYSE:WFC) to trade for significantly higher valuations than bank stocks like Bank of America (NYSE:BAC)?

The easy answer is that because Wells Fargo has a long history of shrewder management and higher profitability than Bank of America, it seems reasonable to expect the former to earn more money than the latter, and to thus produce a higher shareholder return going forward.

While this answer captures the essence of why some banks trade at valuations that are twice or three times the valuation of other banks, this explanation is too general. A more precise answer is that different things drive bank stock valuations at different times.

This is a point that Richard Bove of Rafferty Capital Markets discussed in a recent note to clients. His breakdown is excellent and well worth sharing with the broader investing world.

A brief primer on book value
The difference between a bank's assets and liabilities is its equity, or book value. This is the amount of money that, theoretically speaking, would be left over to distribute to shareholders after a bank sells its assets and pays its liabilities.

Importantly, however, this is not what a bank is "worth" on the public markets. This estimate comes instead from a bank's market capitalization, which is its current share price multiplied by the number of outstanding shares.

As you can see in the table below, there can be large differences between banks' market capitalizations and their book values. Wells Fargo's market capitalization exceeds its book value by $107 billion, or 57%. Alternatively, Bank of America's market capitalization is $65 billion, or 26%, less than its stated book value.

Metric 

Wells Fargo

Bank of America

Outstanding shares

5.15 billion

10.47 billion

Current price per share

$57.50

$17.66

Market capitalization

$296 billion

$185 billion

Book value

$189 billion

$250 billion

Valuation

1.57 times book value

0.74 times book value

Data source: Yahoo! Finance.

What drives these differences? The answer is that investors aren't looking simply at a bank's current book value; they're projecting it into the future. A bank expected to grow its book value at a fast pace will trade for a higher valuation than a bank expected to boost book value at a slow pace, or perhaps even see its book value decline.

What drives book value?
The key to the entire analysis is to determine which factors have the biggest impact on the expansion or contraction of a bank's book value. And it's here where Bove's analysis is so insightful.

Bove argues that the most important factors impacting a bank's book value are a moving target, alternating between three options:

  • When the economy is headed into a recession, and thereby triggering higher loan losses, a bank's loan quality is the most important factor in its valuation. This is because loan charge-offs come directly out of a bank's book value.
  • When loan quality is stable, as it is now, then the onus switches to the direction of interest rates. Although climbing rates have a tendency to depress book value in the short run, as the value of a bank's assets generally goes down when rates rise, the exact opposite is true over the long run, as asset-sensitive banks are positioned to earn more net interest income when rates are high.
  • Finally, when both loan quality and interest rates are stable, then a bank's earnings has the biggest impact on book value, and thus becomes the most important variable for bank investors to analyze.

If you think about where we are right now, this all starts to make sense. As credit losses from the financial crisis have bottomed out, most bank analysts and commentators (me included) have shifted to talking about the impact of higher interest rates on banks' book values and bottom lines. When I've been interviewed of late, this is always one of, if not the, principal questions I'm asked.

The lesson for bank investors is accordingly twofold. First, you have to be flexible in your analysis to account for the evolving impact of credit losses, interest rates, and earnings on bank valuations. And second, you need to have a rough idea of where we're at in the credit and interest rate cycles, as that will tell you where to focus your energy and analysis.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Wells Fargo. 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.