Can Banks Ever Trade Above their Book Value?
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Have investors become too accustomed to bank stocks' trading at a discount to book value, and thus are less demanding on the stocks' performance? Among major U.S. banks, Wells Fargo (NYSE: WFC) is the only stock that trades at a premium to its book value with a price-to-book ratio of about 1.35. The fourth largest bank by assets, Wells Fargo jumps to the top rank in terms of trading premium. Below Wells Fargo, I put the remaining large banks into three sub-tiers based on their stocks' price-to-book ratios. The first tier consists of JP Morgan (NYSE: JPM) and Goldman Sachs (NYSE: GS) with their respective P/B ratios at 0.92 and 0.82. Morgan Stanley (NYSE: MS) and Citigroup fall into the second tier that has a P/B ratio of about 0.58 for both banks. The third tier features Bank of America (NYSE: BAC) having the lowest P/B ratio of around 0.40. All the banks in the sub-tiers are trading at a discount to their reported equity book value.
Bank operations are known for their high expenses and thin profit margins. For shareholders, the earning power of a bank can be quite constrained sometimes. Many factors may limit shareholder returns, such as uncontrollable compensations for senior executives, traders, money managers, etc. After all, we investors claim our shares of earnings only after everyone else has been paid. Big banks may report earnings in the billions of dollars, given the massive amount of assets that they usually have at their disposal, but this seemingly high level of earnings may not translate into impressive shareholder returns relative to the amount of shareholder equity. The higher the profit margin and return on equity that a bank is able to achieve, the more commanding power it likely has over its stock price.
While other banks have had a relatively dismal return on equity all within single percentage points, Wells Fargo has consistently earned a return on equity of above 10 percent for the last three years, which undoubtedly has contributed to its premium stock price. First-tier JP Morgan and Goldman Sachs have their ROE reported at about 9 and 7 percent for the most recent year. ROE for second-tier Morgan Stanley and Citigroup is both at about 6 percent. Bank of America, the lone third-tier bank, reports its ROE as negligible. Thus, we can see that the level of return on equity for each bank corresponds quite well with the degree of the price discount for that bank's stock.
For this reason, I like banks that openly talk about their return on equity. For example, Morgan Stanley has set a goal of 15 percent for its return on equity, according to Bloomberg News. The bank hasn't seen its return on equity above 10 percent for the last five years, and any future improvements on that measure will most likely help advance its stock price. To increase return on equity, a bank must target its efforts on widening its profit margin. Again, it's no surprise that among all banks, Wells Fargo has the highest net profit margin of consistently above 20 percent, followed by JP Morgan and Goldman Sachs with their net profit margins both over 10 percent. Morgan Stanley is further down having its current net profit margin below 10 percent. CEO James Gorman has demanded some of the bank's units to deliver a profit margin of more than 20 percent going forward.
A better profit margin depends on both expense control and sustained revenue. For Morgan Stanley, there has been a solid expense downtrend not seen at the bank for a long time, and we all know that the bank has been chosen to lead the Facebook IPO, which will guarantee the bank handsome underwriting fees to boost its revenue. While JP Morgan and Goldman Sachs are trading close to their book value, Morgan Stanley still has enough room for a potential upside if future earnings reports show signs of continued improvements on profit margins and return on equity towards the bank's set goals.
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