While the financial crisis of 2008-09 isn't something that most us want to live through again, one of its enduring legacies has been the opportunity to buy bank stocks at discounts to book value.
Three banks that come immediately to mind are Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Regions Financial (NYSE:RF). These are the only big bank stocks that still trade for less than their respective book values.
The price-to-book-value ratio is the most common metric that professional analysts and investors use to determine whether a bank stock is cheap or expensive.
To calculate it, the first thing you need is a bank's book value per share. By subtracting a bank's liabilities from its assets, you get its equity, or book value. By then dividing this by a bank's outstanding share count, you get its book value per share.
If you then divide its current share price by its book value per share, you get the bank's price-to-book-value ratio.
Generally speaking, bank stocks fluctuate between 0.5 and 2.5 times book value, depending on where we're at in the business cycle. When the economy is steaming ahead, banks make more money and their shares are more expensive. But when the economy takes a turn for the worse, valuations fall as loan losses erode earnings.
There is no hard and fast rule regarding when a specific bank stock is cheap or expensive, but a handy rule of thumb is 1.0 times book value. Banks that trade far in excess of this threshold -- say 2.0 times book value, or more -- are considered expensive, while banks that trade for a discount to that are generally considered to be inexpensive.
In Bank of America's case, its price-to-book value is 0.81. This means that its shares trade for a 19% discount to the bank's own estimate of its net worth. The same is true with Citigroup and Regions Financial, which trade for 16% and 14% less than their book values, respectively.
It's worth keeping in mind, of course, that there are generally reasons that certain banks trade at lower valuations than others. One is simply that cheap banks tend to be less profitable than expensive banks. As such, the former generate lower shareholder returns than the latter.
Another reason is simply a lack of confidence in the bank -- this often goes hand in hand with profitability. Both of these points are reflected in the chart above, which illustrates the direct relationship between a bank's profitability (i.e., return on equity) and its price-to-book-value ratio.
In sum, it's no coincidence that Bank of America, Citigroup, and Regions Financial have the three lowest valuations as well as the three lowest returns on equity.
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.