Bank stocks are notorious for trading at prices below book value per share, even when a bank's revenue and earnings are on the rise. As banks grow larger and expand into nontraditional financial activities, especially trading, their risk profiles become multidimensional and more difficult to construct, increasing business and investment uncertainties. This is presumably the main reason why bank stocks tend to be conservatively valued by investors who must be concerned about a bank's hidden risk exposures. Trading for their own accounts as dealers in various financial derivatives markets exposes banks to potentially large-scale losses, something investors have decided to take into full consideration when valuing bank stocks.

Book Value Per Share

Book value per share is a good measure to value bank stocks. In this scenario, the so-called price-to-book (P/B) ratio is applied with a bank's stock price compared to equity book value per share. The alternative of comparing a stock's price to earnings, or price-to-earnings (P/E) ratio, may produce unreliable valuation results, as bank earnings can easily swing back and forth in large variations from one quarter to the next due to unpredictable, complex banking operations. Using book value per share, the valuation is referenced to equity that has less ongoing volatility than quarterly earnings in terms of percentage changes because equity has a much larger base, providing a more stable valuation measurement.

Banks with Discount P/B Ratio

P/B ratio can be above or below one, depending on whether a stock is trading at a price more than or less than equity book value per share. An above-one P/B ratio means the stock is being valued at a premium in the market to equity book value, whereas a below-one P/B ratio means the stock is being valued at a discount to equity book value. For instance, Capital One Financial (NYSE: COF) and Citigroup (NYSE: C) had P/B ratios of 0.92 and 0.91, respectively, as of Q3 of 2018.

Many banks rely on trading operations to boost core financial performance, with their annual dealer trading account profits all in the billions. However, trading activities present inherent risk exposures and could quickly turn to the downside. In contrast, Wells Fargo & Co. (NYSE: WFC), the largest U.S. bank by market capitalization, has seen its stock trading at a premium due to its equity book value per share, with a P/B ratio of 1.42 as of Q3 2018. One reason for this is Wells Fargo is relatively less focused on trading activities than its peers, potentially reducing its risk exposures. Bank of America (NYSE: BAC) had a book value per share as of Jun 30, 2018, of $17.19. Hence, Bank of America Corporation's price-to-book ratio for the period was 1.64.

Valuation Risks

While trading mostly derivatives can generate some of the biggest profits for banks, it also exposes them to potentially catastrophic risks. A bank's investments in trading account assets can reach hundreds of billions of dollars, taking a large chunk out of its total assets. For the fiscal quarter ending October 15, 2018, Bank of America saw its equity trading revenue up 3% to $1.0 billion, while its fixed-income trading fell by 5% to $2.1 billion over the same period. The bank with the most derivatives holdings is JPMorgan Chase (NYSE: JPM), at just over $200 billion in 2018. Moreover, trading investments are only part of a bank's total risk exposures when banks can leverage their derivatives trading to almost unimaginable amounts and keep them off the balance sheets.

For example, at the end of 2017, Bank of America had total derivatives risk exposure of more than $30 trillion, and Citigroup had more than $44 trillion. These stratospheric numbers in potential trading losses dwarf the total market caps of $282.2billion and $172.7 billion for the two banks, respectively. Faced with such a magnitude of risk uncertainty, investors are best served to discount any earnings coming out of a bank's derivatives trading. Despite being partly responsible for the extent of the 2008 market crash, banking regulation has been minimized over the past few years, leading banks to take on increasing risks, expand their trading books, and leverage their derivatives positions.

The Bottom Line

Banks and other financial companies may have attractive price-to-book ratios, putting them on the radar for some value investors. However, upon closer inspection, one should pay attention to the enormous amount of derivatives exposure that these banks carry. Of course, many of these derivatives positions offset each other, but a careful analysis should be undertaken nonetheless.