You generally get what you pay for when it comes to bank stocks. As a result, if you're looking to invest in the nation's best-run banks, then you'll have to pay a substantial premium to book value in order to do so.
Three banks that immediately come to mind are US Bancorp (NYSE: USB), Wells Fargo (NYSE: WFC), and Huntington Bancshares (NASDAQ: HBAN). Of all the big bank stocks, these are the most expensive from a valuation perspective.
This matters because the price-to-book-value ratio is the most common metric that professional analysts and investors use to determine whether a bank 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, which is just another name for 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 governing when a 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 that -- say 2.0 times book value -- are considered expensive, while banks that trade for a discount to book value are generally considered to be inexpensive.
It's worth keeping in mind, of course, that there's generally a reason certain banks trade for more than others. The primary explanation is simply that expensive banks are more profitable than inexpensive banks. As such, the former generate higher shareholder returns than the latter.
This is illustrated in the chart above, which shows the direct relationship between a bank's profitability (i.e., return on equity) and its price-to-book-value ratio. It's no coincidence, in other words, that US Bancorp, Wells Fargo, and Huntington Bancshares have the three highest valuations as well as the three highest returns on equity.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends 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.