Bank stocks are traditionally valued by comparing a bank's book value -- the difference between its assets and liabilities -- to its market capitalization -- a bank's current share price multiplied by the number of shares outstanding.
This is an effective measure because it reveals the market's sentiment toward a specific bank. If investors believe a particular bank's book value will rise over the foreseeable future, then they'll pay more for its shares relative to book value. But if a bank's book value is projected to stall or fall, then its shares will generally trade for a discount to book value.
This works great as a blunt instrument, but it comes up short in one important regard: It doesn't take profitability directly into the equation -- I say "directly" because the direction of a bank's book value is, of course, influenced by a bank's profitability.
It's for this reason that bank analyst Richard Bove, who recently issued a note to his clients on this point, prefers to use a measure that directly compares a bank's profitability to its valuation. I'm by no means not authorized to speak for him, but Bove's thought process seems to be that a bank with higher profitability and lower valuation is, at least compared to other banks, the best bet for investors seeking to maximize their return.
The metric that he uses comes from dividing a bank's book value per share by its return on equity. The goal is to identify banks with the lowest ratio, as that implies high earnings relative to valuation.
It's in this regard that Bank of America and Citigroup shine. As you can see, Bank of America's valuation-to-profitability ratio is 8.7, Citigroup's is 9.1, and the average of the nation's 12 largest traditional lenders comes out to 12.2 -- in each case, I'm using an annualized figure based off each bank's second-quarter earnings.
What this tells us is that Bank of America and Citigroup have much higher earnings relative to their valuations than any other big bank. "Clearly this is a mechanistic way of looking at these stocks," Bove wrote. "However, it may make sense to heed its message."
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. 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.