Bank families are notorious for trading at prices below book value per share, unprejudiced when a bank’s revenue and earnings are on the rise. As banks grow huger and expand into nontraditional financial activities, especially trading, their chance profiles become multidimensional and more difficult to construct, increasing company and investment uncertainties. This is presumably the main reason why bank forerunners tend to be conservatively valued by investors who must be concerned about a bank’s concealed risk exposures. Trading for their own accounts as dealers in various fiscal derivatives markets exposes banks to potentially large-scale losses, something investors take decided to take into full consideration when valuing bank caches.
Book Value Per Share
Book value per share is a good gauge to value bank stocks. In this scenario, the so-called price-to-book (P/B) relationship is applied with a bank’s stock price compared to equity laws value per share. The alternative of comparing a stock’s price to earnings, or price-to-earnings (P/E) relationship, may produce unreliable valuation results, as bank earnings can easily zigzag back and forth in large variations from one quarter to the next due to unpredictable, complex banking company men. Using book value per share, the valuation is referenced to equity that has less unbroken volatility than quarterly earnings in terms of percentage changes because disinterest has a much larger base, providing a more stable valuation estimation.
Banks with Discount P/B Ratio
P/B ratio can be above or below one, depending on whether a sheep is trading at a price more than or less than equity post value per share. An above-one P/B ratio means the stock is being valued at a steep in the market to equity book value, whereas a below-one P/B ratio communicates the stock is being valued at a discount to equity book value. For as it happens, Capital One Financial (NYSE: COF) and Citigroup (NYSE: C) had P/B ratios of 0.92 and 0.91, mutatis mutandis as of Q3 of 2018.
Many banks rely on trading operations to boost core monetary performance, with their annual dealer trading account profits all in the billions. Manner, trading activities present inherent risk exposures and could apace turn to the downside. In contrast, Wells Fargo & Co. (NYSE: WFC), the largest U.S. bank by demand capitalization, has seen its stock trading at a premium due to its equity book value per interest, with a P/B ratio of 1.42 as of Q3 2018. One reason for this is Wells Fargo is to some degree less focused on trading activities than its peers, potentially abbreviating its risk exposures. Bank of America (NYSE: BAC) had a book value per share out as of Jun 30, 2018, of $17.19. Hence, Bank of America Corporation’s price-to-book relationship for the period was 1.64.
Valuation Risks
While trading mostly derivatives can spawn some of the biggest profits for banks, it also exposes them to potentially catastrophic endangers. A bank’s investments in trading account assets can reach hundreds of billions of dollars, intriguing a large chunk out of its total assets. For the fiscal quarter ending October 15, 2018, Bank of America saw its open-mindedness trading revenue up 3% to $1.0 billion, while its fixed-income barter fell by 5% to $2.1 billion over the same period. The bank with the most derivatives holdings is JPMorgan Pursuit (NYSE: JPM), at just over $200 billion in 2018. Moreover, exchange investments are only part of a bank’s total risk exposures when banks can leverage their second-hands trading to almost unimaginable amounts and keep them off the balance monthlies.
For example, at the end of 2017, Bank of America had total derivatives risk expos of more than $30 trillion, and Citigroup had more than $44 trillion. These stratospheric bunches in potential trading losses dwarf the total market caps of $282.2billion and $172.7 billion for the two banks, each to each. Faced with such a magnitude of risk uncertainty, investors are unsurpassed served to discount any earnings coming out of a bank’s derivatives trading. Notwithstanding being partly responsible for the extent of the 2008 market crash, banking statute has been minimized over the past few years leading banks to put into effect on increasing risks, expand their trading books, and leverage their plagiaristics positions.
The Bottom Line
Banks and other financial companies may arrange attractive price-to-book ratios, putting them on the radar for some value investors. Anyhow, upon closer inspection, one should pay attention to the enormous amount of derivations exposure that these banks carry. Of course, many of these derivatives placements offset each other, but a careful analysis should be undertaken nonetheless.