Bank stocks are notorious for trading at prices below book value per share, even when a bank's revenue and earnings are on the rise. As banks grow larger and expand into nontraditional financial activities, especially trading, their risk profiles become multidimensional and more difficult to construct. This increases business and investment uncertainties.
This is presumably the main reason why bank stocks tend to be conservatively valued by investors who must be concerned about a bank's hidden risk exposures. Trading for their own accounts as dealers in various financial derivatives markets exposes banks to potentially large-scale losses, something investors have decided to take into full consideration when valuing bank stocks.
- The book value per share is a company's book value for every common share outstanding. The book value is the difference between total assets and liabilities.
- Bank stocks tend to trade at prices below their book value per share as the prices consider the increased risks from a bank's trading activities.
- The price-to-book (P/B) ratio can be used to compare a company's market cap to its book value. This provides a comparison of market price to shareholders' equity rather than earnings, which can fluctuate more often, particularly through trading activities.
- An above-one P/B ratio means the stock is being valued at a premium in the market to equity book value, whereas a below-one P/B ratio means the stock is being valued at a discount to equity book value.
- Companies with large trading activities usually have P/B ratios below one because the ratio considers the inherent risks of trading.
It Is More Accurate Than Price-To-Earnings
Book value per share—or total shareholders' equity divided by total outstanding shares—is a way to value bank stocks. The price-to-book (P/B) ratio is applied with a bank's stock price compared to equity book value per share, meaning that the ratio looks at a company's market cap compared to its book value.
The alternative of comparing a stock's price to earnings, or price-to-earnings (P/E) ratio, may produce unreliable valuation results, as bank earnings can easily swing back and forth in large variations from one quarter to the next due to unpredictable, complex banking operations.
Using book value per share, the valuation is referenced to equity with less ongoing volatility than quarterly earnings in terms of percentage changes because equity has a much larger base, providing a more stable valuation measurement.
Price-To-Book Shows Discount or Premium
The P/B ratio can be above or below one, depending on whether a stock trades at a price more than or less than equity book value per share. An above-one P/B ratio means the stock is being valued at a premium in the market to equity book value, whereas a below-one P/B ratio means the stock is being valued at a discount to equity book value.
Proprietary trading in banks can lead to substantial profits, but trading, particularly derivatives, comes with significant amounts of risk, often through leverage, that must be considered when evaluating a bank.
Many banks rely on trading operations to boost core financial performance, with their annual dealer trading account profits all in the billions. However, trading activities present inherent risk exposures and could quickly turn to the downside.
Wells Fargo & Co. (WFC) in 2021 saw its stock trading at a premium due to its equity book value per share, with a P/B ratio of 1.24 at the end of 2021. One reason for this was that Wells Fargo was relatively less focused on trading activities than its peers, potentially reducing its risk exposures.
Price-To-Book Valuation Risks
While trading mostly derivatives can generate some of the biggest profits for banks, it also exposes them to potentially catastrophic risks. A bank's investments in trading account assets can reach hundreds of billions of dollars, taking a large chunk out of its total assets.
For Q4 2021, Bank of America (BAC) recorded its equity trading revenue at $1.4 billion, while its fixed-income trading revenue was $1.6 billion over the same period. Moreover, trading investments are only part of a bank's total risk exposures when banks can leverage their derivatives trading to almost unimaginable amounts and keep them off the balance sheets.
For example, at the end of 2021, Bank of America had total derivatives risk exposure of more than $18 trillion, and Citigroup had more than $47 trillion. These stratospheric numbers in potential trading losses dwarfed their total market caps at the time of $377.8 billion and $122.8 billion for the two banks, respectively.
Faced with such a magnitude of risk uncertainty, investors are best served to discount any earnings coming out of a bank's derivatives trading. Despite being partly responsible for the extent of the 2008 market crash, banking regulation has been minimized over the past few years, leading banks to take on increasing risks, expand their trading books, and leverage their derivatives positions.
What Is a Good Price to Book Value for Banks?
It depends on your risk tolerance, but generally, a ratio close to 1.0 is ideal. If it gets too far below or above one, it might indicate that you should investigate further before investing.
What Is the Best Ratio To Value Banks?
There are several ratios used, but one of the most popular is the price to book. Some examples are the gross non-performing asset, net non-performing asset ratios, and the net interest margin ratio in your evaluation. Whichever you choose, make sure you compare it to industry averages for similar banks.
What Is the Largest Bank by Value?
If you prefer market cap to look at total value, JP Morgan & Chase is usually at the top of the list of largest banks.
The Bottom Line
Banks and other financial companies may have attractive price-to-book ratios, putting them on the radar for some value investors. However, upon closer inspection, one should pay attention to the enormous amount of derivatives exposure that these banks carry. Of course, many of these derivatives positions offset each other, but a careful analysis should be undertaken nonetheless.