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Bank stocks are notorious for trading at prices below book value per share, even as a bank’s revenues and profits increase. As banks grow larger and expand into non-traditional financial activities, particularly trading, their risk profiles become multidimensional and more difficult to compile, increasing business and investment uncertainty.
This is probably the main reason bank stocks tend to be valued conservatively by investors worried about a bank’s hidden risks. Trading on own account as a dealer in various financial derivatives markets potentially exposes banks to large losses, which investors want to take full account of when evaluating bank stocks.
The central theses
- Book value per share is a company’s book value for each outstanding common share. Book value is the difference between total assets and liabilities.
- Bank stocks tend to trade at prices below their per-share book value because prices reflect the increased risks inherent in a bank’s trading activities.
- The price-to-book (P/B) ratio is used to compare a company’s market capitalization to its book value. This provides a comparison of stock price to assets and liabilities rather than earnings, which can fluctuate more frequently, particularly through trading activity.
- A P/B ratio above one means the stock is valued at a premium from market value to book value of equity, while a P/B ratio of less than one means the stock is valued at a discount to book value of equity.
- Companies with large trading activities typically have P/B ratios below one because the ratio takes into account the inherent risks of trading.
book value per share
Book value per share is a good benchmark for evaluating bank stocks. The price-to-book (P/B) ratio is applied using a bank’s stock price versus book value of equity per share, meaning the ratio looks at a company’s market capitalization versus its book value.
The alternative of comparing a stock’s price to earnings or price-to-earnings (P/E) ratios can lead to unreliable valuation results, as bank earnings can easily fluctuate back and forth from one quarter to the next in large swings due to unpredictability, complex banking transactions.
Using book value per share, the valuation relates to equity, which has less ongoing volatility in terms of percentage changes than quarterly earnings, as equity has a much larger basis and offers a more stable valuation measurement.
Banks with discount P/B ratio
The P/B ratio can be above or below one depending on whether a stock is trading at a price above or below its book value of equity per share. A P/B ratio above one means the stock is valued at a premium from market value to book value of equity, while a P/B ratio of less than one means the stock is valued at a discount to book value of equity.
For example, at the end of 2021, Capital One Financial (COF) and Citigroup (C) had P/B ratios of 0.99 and 0.71, respectively.
Proprietary trading at banks can yield substantial profits, but trading, particularly derivatives, involves significant risks, often leverage, that must be considered when evaluating a bank.
Many banks rely on trading operations to increase core financial performance, with their annual trading account profits in the billions of dollars. However, trading activity has inherent risks and could quickly turn down.
Wells Fargo & Co. (WFC) shares traded at a premium in 2021 based on its book value of equity per share with a P/B ratio of 1.24 at the end of 2021. One reason was that Wells Fargo was relatively less focused on trading activity than its peers, potentially reducing its exposure to risk.
valuation risks
While trading primarily in derivatives can generate some of the biggest profits for banks, it also exposes them to potentially catastrophic risks. A bank’s investments in trading accounts can reach hundreds of billions of dollars, making up a large portion of its total assets.
For the fourth quarter of 2021, Bank of America (BAC) reported equity trading revenue of $1.4 billion, while fixed income trading revenue was $1.6 billion for the same period. Furthermore, when banks can leverage their derivatives trading to near unimaginable amounts and keep them off balance sheets, trading investments are only part of a bank’s overall risk.
For example, at the end of 2021, Bank of America had more than $30 trillion in total derivative exposure and Citigroup more than $47 trillion. These stratospheric numbers of potential trade losses dwarf their combined market caps of $377 billion and $129 billion for the two banks, respectively.
With such levels of risk uncertainty, investors are best served by discounting any gains from a bank’s derivatives trading. Although bank regulation was partly responsible for the magnitude of the 2008 market crash, it has been minimized in recent years, leading banks to take increasing risks, expand their trading books and leverage their derivatives positions.
The final result
Banks and other financial firms can have attractive price-to-book ratios, putting them on the radar for some value investors. On closer inspection, however, one should note the huge exposure to derivatives held by these banks. Of course, many of these derivative positions offset each other, but careful analysis should be undertaken.
