Why Does Wells Fargo's Stock Seem So Cheap Compared to Other Highly Profitable Banks?

By Markets Fool.com

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Shares of Wells Fargo (NYSE: WFC) aren't cheap right now, but they're certainly cheaper than shares of other highly profitable banks. Why is this?

Bank stock valuations

For the record, I'm referring to valuation, not price. By looking at valuation -- specifically the price-to-book-value ratio -- you can compare bank stocks on an apples-to-apples basis.

Your typical large-cap bank stock trades at a 10% premium to book value, which translates into a price-to-book-value ratio of 1.1. Wells Fargo, by contrast, trades for 1.4 times book value.

In essence, this means that Wells Fargo shares are 27% more expensive than the average of its peer group.

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But let's narrow this down further...

This may sound expensive, but if you slice and dice the data a little more, Wells Fargo comes across, at least at first, as being cheap.

You can see this by comparing Wells Fargo's valuation to the three other banks that join it atop the industry in terms of profitability (i.e., return on equity):

Bank

Return on Equity (TTM)

Price to Book Value Ratio

US Bancorp

14.40%

1.79

Wells Fargo

13.02%

1.39

Commerce Bancshares

11.69%

2.01

Northern Trust

11.60%

1.82

Data source: YCharts.com.

The three other banks have price-to-book-value ratios of between roughly 1.8 and 2.0. Wells Fargo's is 1.4.At least compared to these banks, then, Wells Fargo's shares look cheap.

The more interesting question...

While it's worth noting that Wells Fargo may not be as expensive as it's usually reputed to be, this begs a more interesting question: Why?

If Wells Fargo is such a well-run bank (and it is), then why haven't its shares been awarded the same premium as its similarly profitable peers?

The answer, I believe, is that investors are discounting Wells Fargo's shares because it's a global systemically important bank, or G-SIB. This is what regulators call banks with more than $250 billion of assets on their balance sheets and a presence in the capital markets.

You know them as the too-big-to-fail banks.

One of the many downsides to being labeled a G-SIB is that a bank then faces higher capital requirements, which reduces leverage. This is a big deal because even highly diversified banks such as Wells Fargo earn half their revenue using leverage to generate net interest income.

More specifically, Wells Fargo has to hold 2% more of its capital in reserve than each of these three other banks, none of which are G-SIBs.

That may not seem like a lot, but it translates roughly speaking into somewhere around $30 billion worth of assets that Wells Fargo could otherwise be earning interest from. Depending on the yield, that could reasonably equate to as much as $1 billion worth of added net interest income a year.

That's a lot of money, and it's why, to answer the question posed in the headline, Wells Fargo's shares seem so cheap compared to other highly profitable banks.

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John Maxfield owns shares of US Bancorp and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.