Bank stocks are known to trade at prices below book value per share, even when a bank’s revenue and earnings are up. As banks grow and expand into non-traditional financial activities, particularly trading, their risk profiles become multidimensional and more difficult to construct, increasing business and investment uncertainties.
This is probably the main reason why bank stocks tend to be valued conservatively by investors who need to be concerned about a bank’s hidden risks. Trading on their own account as brokers in various financial derivatives markets exposes banks to potentially large losses, which investors have decided to take into full consideration when evaluating bank stocks.
Key points to remember
- Book value per share is a company’s book value for each 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 reflect the increased risks associated with 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 allows the stock price to be compared to assets and liabilities rather than earnings, which may fluctuate more often, especially due to trading activity.
- A P/E ratio greater than one means the stock is valued at a premium to market book value over equity, while a P/E ratio less than one means the stock is valued at a premium. discount to the carrying amount of equity.
- Firms that have significant trading activities typically have P/B ratios below one, because the ratio takes into account the risks inherent in trading.
Book value per share
Book value per share is a good metric for valuing bank stocks. The price-to-book (P/B) ratio is applied with a bank’s stock price against the book value of equity per share, meaning the ratio looks at a company’s market capitalization. compared to its book value.
The alternative of comparing a stock’s price to earnings, or the price-to-earnings (P/E) ratio, can produce unreliable valuation results, as bank earnings can easily swing back and forth with large variations from quarter to quarter due to unpredictable events. , complex banking operations.
Using book value per share, valuation refers to stocks that have less ongoing volatility than quarterly earnings in terms of percentage changes, because stocks have a much broader base, providing a more stable valuation measure .
Banks with discount P/B ratio
The P/E ratio can be greater or less than one, depending on whether a stock is trading at a price above or below the book value of equity per share. A P/E ratio greater than one means the stock is valued at a premium to market book value over equity, while a P/E ratio less than one means the stock is valued at a premium. discount to the carrying amount of equity.
For example, Capital One Financial (COF) and Citigroup (C) had P/E ratios of 0.99 and 0.71, respectively, at the end of 2021.
Proprietary trading in banks can generate substantial profits, but trading, especially derivatives, involves significant risks, often related to leverage, which must be taken into account when evaluating ‘a bank.
Many banks rely on trading operations to improve their core financial performance, with their annual trading account profits running into the billions. However, trading activities have inherent risks and could quickly turn negative.
Wells Fargo & Co. (WFC) in 2021 saw its shares trading at a premium due to its book value of equity per share, with a P/E 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 exposure.
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 account assets can run into the hundreds of billions of dollars, which eats up a large portion of its total assets.
For the fourth quarter of 2021, Bank of America (BAC) recorded its equity trading revenue at $1.4 billion, while its fixed income trading revenue was $1.6 billion on the same period. Moreover, commercial investments are only a fraction of a bank’s total risk exposure when banks can leverage their derivatives transactions to almost unimaginable amounts and keep them off balance sheets.
For example, at the end of 2021, Bank of America had total derivatives risk exposure of over $30 trillion, and Citigroup had over $47 trillion. These stratospheric numbers of potential business losses dwarf their total market capitalizations at the time of $377 billion and $129 billion for the two banks, respectively.
Faced with such a magnitude of risk uncertainty, investors are better served to discount any profit from trading a bank’s derivatives. Although partly responsible for the scale of the stock market crash of 2008, banking regulation has been minimized in recent years, causing banks to take on increasing risks, expand their trading portfolios and take advantage of their derivative positions.
Banks and other financial companies can have attractive price-to-book ratios, putting them on the radar of some value-oriented investors. However, on closer inspection, it is worth paying attention to the huge exposure to derivatives that these banks carry. Of course, many of these derivative positions offset each other, but careful analysis should still be undertaken.