In a broad sense, a bank's share price is affected by the same forces that affect the share prices of other public companies. Major, abstract factors can impact a bank's share price. These include overall market sentiment, expectations about the future, fundamental valuation, and the demand for banking services. Banks, however, are somewhat unique because central bank activity (such as Federal Reserve policy in the United States) plays a truly significant role in bank operations.

A stock's valuation should always reflect the current health of the underlying business and its future growth potential. For banks, this means being able to make healthy loans, to receive interest and fees on other accounts, and to limit counterparty risk.

Key Takeaways

  • Abstract factors that can affect a bank's share price include overall market sentiment, expectations about the future, and the demand for banking services.
  • Investors look at a bank's growth potential as a key valuation factor when determining a fair value for the stock.
  • A bank's share price can be affected by three types of risk: interest rate risk, counterparty risk, and regulatory risk.
  • A bank's share price can also be impacted by its price-to-earnings (P/E) ratio and price-to-book (P/B) value.

Common Valuation Factors Affecting Bank Share Prices

Investors use a wide variety of valuation factors to determine the value of a stock. This is particularly true for those investors who rely upon fundamental analysis to determine a fair value of the stock they're evaluating. The goal is to determine whether a stock is overvalued, undervalued, or priced correctly.

While there are many valuation factors, there are some that are more universal and widely used. These include expected growth, banking risks, earnings potential, and the cost of capital. Investors can use all of these valuation factors when evaluating the share price of a bank stock.

Growth

Investors and analysts pay particular attention for signs that a company's revenue is growing and that this growth is sustainable. They'll review a company's annual and quarterly income statements, comparing bottom-line growth versus top-line growth.

Most fundamental and value investors also look for dividends and various other accounting metrics to show growth potential. For banks, in particular, monetary policy and changing interest rates influence growth and profitability. Sometimes—such as after the financial crisis of 2007-2008—governments will issue extra capital to banks to prop up the financial sector.

Banks are likely to grow and produce profits by attracting depositors, making sustainable loans, issuing credit in other forms, or making investments. Because the Federal Deposit Insurance Corporation (FDIC) guarantees depositors up to $250,000, much of the inherent risk for banks is alleviated.

Risks

Bank stocks are heavily influenced by three types of risk: interest rate risk, counterparty risk, and regulatory risk.

A large majority of bank assets and liabilities are interest-rate sensitive. Generally speaking, banks look to maximize the amount of interest they generate from loans and minimize the interest they pay out on deposits. Keep in mind that deposits are liabilities for banks, while loans are assets for banks.

A bank's assets are only as good as the debtors that it transacts with. A bank's counterparty risk refers to the likelihood that the party receiving a loan from the bank will default on that loan. When a mortgage or car loan is made, banks perform underwriting to ensure that the borrower can repay the loan. However, it can be difficult for an investor to evaluate whether a bank's underwriting policies are effective. Two banks, each with $100 million in loan receivables, may have very different counterparty risk exposure.

Bank regulation is a controversial topic. Many blame bank regulations for the vulnerability of U.S. banks before the Great Depression. On the other hand, some people blame deregulation for the financial crisis of 2007-2008. Either way, bank share prices are sensitive to the perceived impact of changing government influence.

Earnings and Future Returns

Investors interested in buying bank stocks should review the stock's price-to-earnings (P/E) ratio and price-to-book (P/B) value when trying to determine a fair value for the shares. Companies with higher P/E ratios tend to have higher share prices. A high P/E ratio can also mean investors anticipate higher future earnings.

Value investors want to discover companies that are undervalued since this represents an opportunity to buy a stock at a low price and realize a profit when the price goes up. For this reason, they will evaluate a company's P/B ratio to find a low-priced stock that has the potential to trade for a higher price in the future.

Cost of Capital

Cost of capital is difficult to assess with banks, so it isn't entirely clear how much cost of capital is actually reflected in bank valuations. This is because most banks have a lot of off-balance sheet (OBS) instruments and, in the U.S., a special lending relationship with the Federal Reserve.

The major source of bank capital comes from depositor accounts. During times when interest rates are low, banks have to balance the cost of capital with the relative difficulty of attracting new deposits.

The Bottom Line

Bank shares are sometimes a favorite of investors who follow a value investing strategy. This is because banks have an easy-to-understand business model and provide a service that is critical for society. When evaluating a bank as an investment opportunity, you'll want to carefully review those factors that drive share price, such as current growth and the potential for future growth, risk factors inherent to banking, future earnings potential, and the cost of capital.