What do we do with this?
Now that we know that Chase and Wells Fargo & Co (NYSE:WFC) earn high and consistent returns on equity due to prudence and conservatism, and that Bank of America Corp (NYSE:BAC) and Citigroup have historically had unpredictable earnings due to cultures of risk-taking, we can start to make investment decisions.
The first thing to do is to toss out Bank of America Corp (NYSE:BAC) and Citigroup Inc (NYSE:C) — how can we value companies without having any idea what their earnings are likely to be? Bank of America Corp (NYSE:BAC) may have averaged an 8.6% return on equity over the last 10 years, but that average is not useful due to the high degree of variability year to year.
So now we are left with just Chase and Wells Fargo & Co (NYSE:WFC) as possible investments. Both banks have historically earned stable returns on equity, and nothing that has happened in the last few years makes me think that is likely to change.
A good bank is probably worth 15 times normal earnings, but I only want to pay 10 times earnings. Chase averaged a 9.6% return on equity over the last 10 years, so I would pay close to 1 times book value and expect a 10% annualized return on investment. The stock currently trades for 1.1 times book — slightly higher than my buy range.
Wells Fargo averaged a 14.5% return on equity over the last 10 years, so I want to pay no more than 1.4 times book. The stock trades for 1.6 times book.
Both Chase and Wells Fargo trade at reasonable valuations and are probably a little undervalued. But, especially when investing in banks, I want to buy really cheap stocks. So I will sit and wait for them to get cheaper.
Investing in banks does not have to be a complicated task — you just have to be smart about it. Some banks do not lend themselves to valuation — at least not of the sort offered in this article. Focus on buying banks that you can value, and do it only when they are cheap.
The article A Simple Way to Value Banks originally appeared on Fool.com and is written by Ted Cooper.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc (NYSE:C) , JPMorgan Chase & Co (NYSE:JPM)., and Wells Fargo. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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