It is a heavy week of earnings reporting, particularly by the financial sector, therefore we want to provide you some analysis about banks. Morgan Stanley reports their Q4 2021 earnings before the opening bell today, we will be out with an analysis later in the week.

While you certainly have heard about Price-to-Earnings multiple, it is not necessarily appropriate for all sectors. In particular, the banks are looked at through a different lens, and that is a Price-to-Book multiple. In today's post, let's delve into P/B multiple and compare between banks in our portfolio.

What Is P/B Ratio?

P/B stands for Price-to-Book, a valuation multiple. This is a ratio that shows how many times the stock's valuation is higher than the net assets of the business (recorded on the financial statements). For example, currently the P/B ratio of Morgan Stanley (MS) is 1.79; that means to own MS shares, investors are currently paying 2 times the underlying assets that Morgan Stanley company has.

P/B ratios would not be found on the company's financial statement, but rather calculated in financial analysis websites. Certainly when you view individual stocks on our website, you can see a lot of valuation multiples, including P/B ratio (a courtesy of TradingView). The formula to calculate P/B is as below:

P/B As A Valuation Multiple For The Financial Sector

The P/B ratio is often used in valuation for the financial sector because of the nature of the business of banks, that is earning money based on their assets. When there is a change in the quality of the assets, for example, changes in interest rates, the returns can vary greatly. In 2022, the predicted rise of interest rates will improve earnings for the banks.

The relationship between P/B and ROE (Return on Equity) should also be considered when evaluating a bank. Usually, P/B will be proportional to ROE because investors are willing to pay a higher price to buy shares of a company that gives them more profit. Companies with high growth rates tend to have correspondingly high P/B ratios. For example: A bank with a high P/B ratio and low ROE implies that the total assets of the business are no longer growing well. This means that this bank is being overvalued. Conversely, investors can view a bank with a low P/B ratio and high ROE as a potential investment opportunity. The relationship between P/B and ROE is also expressed through the formula: P/B = (ROE – g) / (r – g). (Where: g is the growth rate, r is the cost of equity).

Let's compare valuation multiples for current banks in our portfolio and 2 other banks on the market - one good and one bad. Our Morgan Stanley (MS) trades at 13.07x fwd P/E, 1.79x P/B, ROE of 14.70%. Our Wells Fargo (WFC) trades at 15.4x fwd P/E, 1.40x P/B, ROE of 10.40%. An arguably bad bank out there is Citigroup (C), which trades at 8.54x fwd P/E, 0.74x P/B, ROE of 11.80%. On the other end of the spectrum, a considerably good bank out there is JP Morgan (JPM), which trades at 13.14x fwd P/E, 1.86x P/B, and ROE of 19.20%. 

You can look at the low multiples of Citigroup (C), be intrigued and be all over it as a value investment. However, you have to understand it trades at low multiples for reasons. At the end of the day, valuation multiples are what the market places on the stock based on how well the market perceives the company is doing. Frankly, Citi as a business hasn't been doing well when compared to other banks; take the latest quarterly results for example: Citi reported $1.46 EPS in Q4 2021 compared to $1.92 EPS in Q4 2020 (24% decrease). CEO Jane Fraser stated on the release: "We had a decent end to 2021 [...]" and we would direct your attention to the word "decent." Compared to Wells Fargo, they reported $1.38 EPS in Q4 2021, compared to $0.66 EPS in Q4 2020 (109% increase). CEO Charlie Scharf commented "The changes we've made to the company [...] make us feel good about how we are positioned entering 2022." No wonder Wells Fargo traded up 3.7% after the results, adding to an incredible ~ 100% gain from a year ago, compared to Citi which traded down 1.2% and only has a ~ 8% gain from a year ago.

Bottom Line: we remain comfortable owning our two financial names, Morgan Stanley and Wells Fargo. We didn't discuss Morgan Stanley too much today because we believe it is more of a multiple-expansion story, given the company's continued transition from a trading-based revenue stream to a subscription-based revenue stream from asset and wealth management. Wells Fargo fits more to the topic of today's post, and from what we told you, we see Wells trade in the middle of the range of valuation multiples (compared to a bad Citi and a good JPMorgan). We feel comfortable owning Wells in the middle of the range here, but it's also important to remind you that Wells is a re-structuring story led by "Chief Architect" CEO Charlie Scharf.