Are Banks Still a Buy at Dow 14,000?

The Dow Jones Industrial Average closed above the psychologically important 14,000-point threshold on Friday for the first time since October 2007, roughly one year before the calamitous downfall of Lehman Brothers. While the financial media widely celebrated the occasion, it's a much more sanguine affair for investors with money on the sidelines.

With stocks trading near historic highs, it's natural to wonder whether you've missed the boat. And this is particularly true for bank stocks, which notched some of their best performances last year after investors gained confidence that the worst of the financial crisis was in the rearview mirror. To name only the most noteworthy performance, which my colleague Anand Chokkavelu foretold here, shares of Bank of America doubled in 2012, starting the year out at $5.80 and crossing the finish line at $11.30.

For those of you facing this quandary, I have both good and bad news. The good news is that many banks continue to offer attractive upside potential. The bad news is that a roughly equal number are now trading at valuations that limit significant share price appreciation over the foreseeable future. The trick is to know which is which.

The best way to gauge a bank's valuation is to look at the ratio of its share price to tangible book value -- the latter measures the quantity of shareholders' equity less intangible assets like goodwill that's attributable to each of a bank's outstanding shares. The general rule is to "buy at half and sell at two," meaning to buy at half of tangible book value and sell at a multiple of two times the same figure. While this doesn't always work out, as few banks that you'd want to invest in nowadays are still trading at half their tangible book value, it serves as a useful guide for possible entry and exit points.

With this in mind, we can develop a general feeling for the lay of the land. On one end of the spectrum are the proverbial top-shelf banks, including regional lenders US Bancorp and M&T Bank, which sell for 2.6 and 2.3 times tangible book value, respectively. On the other end are banks that remain mired in litigation and toxic mortgages from the financial crisis, including Bank of America and Citigroup, which are priced at between 0.8 and 0.9 times tangible book. And in the middle are a range of respectable lenders, including Wells Fargo and Huntington Bancshares , which trade for multiples of 1.5 and 1.2, respectively.

At first glance, in turn, it's tempting to conclude that one should only invest in, say, Bank of America and Citigroup and avoid buying shares of US Bancorp and M&T Bank. While there is some legitimacy to this conclusion, the reality is that it also depends on what exactly you're looking for in an investment. If you're on the hunt for share-price appreciation exclusively, then by all means this is the appropriate takeaway, as I strongly believe that Bank of America in particular still offers considerable upside potential for investors comfortable with the risk. But if you're looking for, say, a dividend play with less upside potential, then you could do a lot worse than New York Community Bancshares , which yields a generous 7.7% and a proven record of responsible leadership and consistent profitability.

Alternatively, for those of you with an affinity for Goldilocks bank stocks -- that is, stocks that offer a little of everything -- then you'd be better suited to go with Wells Fargo and Huntington Bancshares. While Wells Fargo trades for a dear 1.5 times tangible book, its shares yield a decent 2.8% and its management has clearly expressed a desire to increase this further. And as I discuss in a recent in-depth report, Huntington Bancshares offers a healthy portion of both, trading for a reasonable 1.2 times tangible book while yielding a respectable 2.3%.

Thus, the answer to the question of whether banks are still a buy is both yes and no. It just depends on what you're looking for.

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John Maxfield owns shares of Bank of America. The Motley Fool recommends Wells Fargo and owns shares of Bank of America, Huntington Bancshares, and 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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