Citigroup Inc. (C), JPMorgan Chase & Co. (JPM): Forget the Stress Test When Buying Banks

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Bank capital is not nearly as important as asset diversification when it comes to shareholder protection. Larger banks have a big advantage over smaller ones as long as they stay diversified and don’t face a significant economic downturn. Here are a few large banks I find interesting:

Regions Financial

Regions Financial Corporation (NYSE:RF), has over $121 billion in assets and is one of the nation’s largest consumer and commercial banks. It serves customers in 16 states across the South and the Midwest. The company has a decently diversified asset pool with 22% in commercial and industrial lending, 22% in securities, 20% in consumer real estate-related loans, and 15% in commercial real estate lending.

Regions looks to have a reasonable fair value, calculated by estimated normalized cash earnings times a market value multiplier, of around $9 to $10 a share. This assumes an annual pre-tax return on assets of 1.34% on an asset level of $121 billion, a corresponding average adjusted earnings amount of $978 million with an industry standard market capitalization multiplier of 14.

Capital One Financial

Capital One Financial Corp. (NYSE:COF) is a financial institution with $212.5 billion in deposits and $312.9 billion in total assets. It offers a broad spectrum of financial products and services to consumers, small businesses and commercial clients. It is a major credit card lender, which accounted for about 62% of 2012 revenues. Capital One has 28% of its asset pool in credit card loans. It also has 20% in bank-held securities, 25% in consumer related loans, and 13% in commercial lending.

Based on a pre-tax return of 1.70% on $313 billion in assets, resulting in average adjusted profits of $3.2 billion, it looks to have a fair intrinsic value of around $66 a share. Since the firm has a meaningful exposure to unsecured credit card loans, a discounted market multiplier of 12 was used.

JPMorgan Chase

JPMorgan Chase & Co. (NYSE:JPM) is a leading global financial services firm with assets of $2.4 trillion and operations worldwide. The firm is a leader in investment banking, financial services for consumers and small businesses, commercial banking, financial transaction processing, asset management, and private equity. The company has a large well-diversified book of business. It has 31% of its assets in a mix of consumer and commercial loans, 16% in bank-held securities, and 19% in trading investments.

Assuming JP Morgan gets a pre-tax return of 1.26% on assets of $2.4 trillion and an average adjusted earnings amount of $18.2 billion, its reasonable business value looks to be around $59 a share. This is calculated with a discounted market multiplier of 12 that seems warranted due to the firm’s investment banking exposure.

Conclusion

The Fed’s stress test is a useful exercise in measuring a bank’s capital, but a higher bank capital level does not necessarily lessen shareholder risk. Large institutions with well-diversified portfolios, purchased at reasonable prices, might be the best way for investors to reduce risk and increase the chance for reward when buying banks.

The article Forget the Stress Test When Buying Banks originally appeared on Fool.com and is written by Bob Chandler.

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