4 Bank Stocks That May Be Overvalued

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Back in the spring of 2013, Warren Buffett appeared on CNBC. Among other topics discussed, Buffett explained how he values bank stocks:

Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you're required to hold a certain amount of tangible equity compared to the assets you have. But you've got banks like Wells Fargo and USB that earn very high returns on assets, and they at a good price to tangible book. You've got other banks ... that are earning lower returns on tangible assets, and they're going to sell -- they're going to sell [for less]."

This answer at first seems to fly in the face of the conventional wisdom in bank valuation.

Many bank investors look to the price to book ratio as the primary valuation metric when analyzing banks. If a bank trades at less than book value, then it's cheap. If it trades higher than three times book value, then it's expensive.

Buffett turns this logic on its head, arguing that a bank's earnings engine, measured by its return on average assets, dictates its valuation, not its book value.

Let's take a minute today to look at four bank stocks with high price-to-book ratios and see whether they're overvalued by Buffett's logic.

4 bank stocks that may be overvalued

Company NamePrice to Tangible Book Value (Last 12 Months)*Return on Average Assets**
Prosperity Bancshares 3.6 1.55%
The Bank of New York Mellon Corporation 3.5 0.49%
U.S. Bancorp 2.8 1.53%
The Toronto-Dominion Bank (TSX: TD) 3.1 0.63% 

Sources: * S&P Capital IQ, ** BankRegData.com

It's immediately apparent that in these four instances, the return on average assets results swing considerably even with relatively consistent price to tangible book value metrics. There are a couple of reasons why.

Source: Company website

On one hand, we have Prosperity Bancshares and U.S. Bancorp with very strong return on average assets, which aligns with Buffett's explanation above. These two banks are among the strongest, best performing in the country. 

On the other hand we have The Bank of New York Mellon, which trades at a robust price multiple despite having the lowest return on average assets of this group.

It isn't quite fair to include BNY Mellon in a comparison with these other banks. BNY Mellon is a custodian bank and is not actually in the traditional banking business at all. The bank avoids high-yield, risky assets like loans and instead produces the vast majority of its income from transactional services like settlements, treasury services, and deposit accounts. BNY Mellon is the largest custodian bank in the world, and quite a strong institution in its own right.

For the purposes of this article, then, BNY Mellon's valuation gets a pass. Just because this bank's return on assets are low relative to other traditional banks, does not imply that its stock is overvalued.

TD Bank, on the other hand, raises an eyebrow. The bank has posted very strong return on equity in recent quarters, including an eye-popping 15.5% in the second quarter of this year. The trick to that impressive return on equity is, of course, leverage. TD Bank currently sports an assets to equity ratio of over 17 (the industry average is around 9.5).

Investors today seem happy with TD Bank's performance, but based on the bank's lagging return on average assets, that happiness could be short lived. By Warren Buffett's logic anyway, TD Bank looks to be overvalued.

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The article 4 Bank Stocks That May Be Overvalued originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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