How to Value a Bank Stock

Banks have been on a roll this year. Hence, I think this is a good time to find out what we, as investors, need to know about analysing a bank’s stock. This is the third and final part of this series.

In the first two parts of the series, I looked at how to analyse a bank’s balance sheet and how to analyse a bank’s profitability.

In this final part of the series, I will look into three metrics that we can use to see if a bank is reasonably priced.

Even if a bank is performing well, we need to make sure that we are getting good value for the price we pay.

Price-to-Earnings Ratio

A bank’s profitability plays a huge part in its valuation. Therefore, comparing its price to its earnings makes a lot of sense.

There is no hard and fast rule as to what a good price-to-earnings multiple is but in general, the lower the multiple, the more bang you are getting for the price paid. Having said that, there can be some reasons why banks may trade at premiums to their counterparts. This can be due to greater future earnings potential, a long history of growth over the years, better return on equity, etc.

Even though the price-to-earnings ratio can vary widely between banks, this is still a good metric to start with when assessing if the valuation is enticing. To give a rough idea of what sort of ranges you should be looking at, the current average price-to-earnings ratio for banks in the US is 15.9 times.

Price-to-Book Value

The other metric that most investors use to analyse bank stocks is the price-to-book value. The book value is another term to describe shareholder’s equity. In essence, a stock that is trading at a discount to its book value can be considered cheap.

However, some investors go one step further by removing intangibles out of the equation. Intangibles include assets that cannot be sold or are difficult to value like brand value (goodwill), or premiums paid to acquire other companies. This leaves us with just the tangible book value. If a bank is trading below its tangible book value, it is possible that it is cheap at the moment.

Having said that, there are sometimes good reasons for stocks to be trading below tangible book value. This could be because the company is unable to generate good returns on its equity or is facing future headwinds that can affect business profitability.

Dividend Yield and Dividend Payout Ratio

When deciding which stock is a good income stock to hold, we need to consider three aspects of dividends.

First, is dividend yield attractive? By dividing the price of the stock with the yearly dividend payout, we are able to calculate the percentage of dividends earned from our capital.

The next important aspect of dividends is if the dividends are growing and sustainable. By looking at previous years’ dividend payouts and profits, we can assess if the bank will be able to consistently grow its dividend.

Finally, to measure the sustainability of dividend, we use the dividend payout ratio. This metric looks at how much of the profit generated by a company is being paid out to shareholders. The lower the percentage, the better it is as it means that the dividends paid out is justified and the company can sustain the level of dividends even if it faces future headwinds.

The Foolish Bottom Line

Valuing a bank is the final part of the investment decision that we need to make. After identifying a great company, it is important that we analyse the price we are paying to be a shareholder. These three metrics can give us a good idea if we are getting a good “bank” for our buck.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.