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 banking 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, whereby 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 to equity book value, whereas a below-one P/B ratio means the stock is being valued at a discount to equity book value. Bank of America and Citigroup had the deepest discounts at 43 and 40% respectively, as of April 29, 2016.

All those five banks rely on trading operations to boost 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 of 28% as of April 29, 2016. One reason for that is Wells Fargo is less focused on trading activities than the other five banks, potentially reducing its risk exposures. Wells Fargo's dealer trading account profit was only $614 million in 2015 compared to a respective $6.5 billion and $6 billion trading profit for Bank of America and Citigroup during the same year.

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. As of March 31, 2016, Bank of America had $179 billion in its trading account assets, and Citigroup had $273.7 billion. The bank with the most of such holdings is JPMorgan Chase, at $366.2 billion. 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 2015, Bank of America had a total derivatives risk exposure of more than $39 trillion, and Citigroup had more than $48 trillion. These stratospheric numbers in potential trading losses dwarf the total shareholders' equities of $262.8 billion and $227.5 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.

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