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With Bank of America's (NYSE: BAC) stock rising steadily since the presidential election, investors would be smart to start thinking about whether or not it's overvalued. But to do so, of course, you need a sense for how bank stocks are valued for investment purposes. Here's a primer.
Valuing bank stocks
There are a couple ways bank stocks can be readily valued. Just like any other stock, you can compare how much a bank earns per share relative to its share price. This is done through the price to earnings, or P/E, ratio.
In Bank of America's case, it has earned $1.37 a share over the past four quarters. Meanwhile, its shares cost around $21.50 each. This means its P/E ratio is 15.63.
There are two ways to interpret this. First, it means that you're paying $15.63 for each dollar's worth of Bank of America's earnings. Or second, you can invert it (divide 1.0 by 15.63) and turn it into an earnings yield -- in this case, 6.4%.
Now you can compare these numbers to other investment alternatives. The average stock on the S&P 500 trades at a P/E ratio of 24.35, which is obviously higher than Bank of America's stock. This may go without saying, but because this method lends itself so easily to comparisons, it's a great approach to use.
When it comes to bank stocks, though, there's another approach that industry analysts and commentators tend to prefer. This is the price to tangible book value ratio, which is calculated by dividing a bank's share price by its tangible book value per share (you can get the latter from the "consolidated financial highlights" page in Bank of America's quarterly financial supplement, which you can find here).
In Bank of America's case, its tangible book value per share is $17.14. Meanwhile, its share price is $21.50. Thus, its price to tangible book value ratio is 1.20, meaning it trades for a 20% premium to its tangible book value.
As someone who writes about and invests in bank stocks myself, this is the metric I prefer to use. I say that because bank earnings, and Bank of America's in particular, tend to fluctuate from quarter to quarter, and year to year. This throws off the P/E ratio, making it hard for the average investor to know whether or not Bank of America's stock is actually cheap or expensive at a particular point in time.
The only thing that fluctuates regularly in the price to tangible book value ratio, by contrast, is the share price. This makes it easier to isolate whether or not the share price seems to be under- or overvaluing a stock.
So, how can you tell? As a general rule, banks will trade from anywhere between half of book value (a 50% discount to tangible book value) and two times tangible book value (a 100% premium to tangible book value).
For a good bank that's reasonably well run, a threshold that essentially all of the large banks currently satisfy, your goal should be to buy bank stocks either below or as close to 1.0 times tangible book value as you can. Once they cross 1.5 times tangible book value, the upside is pretty limited. And as they approach 2.0 times tangible book value, it's fair to assume that the downside will outweigh the upside.
With respect to Bank of America, then, with a price to tangible book value ratio of 1.20, there's no reason to think it's egregiously overpriced. At the same time, though, it's also clear that the bank's shares are no longer a screaming bargain. This is why bank analysts over the past few weeks have begun downgrading its stock from buy to hold.
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John Maxfield owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. 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.