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When you're looking for a bank stock to add to your portfolio, one of the first things you should consider is profitability. Aside from valuation, in fact, nothing is more important.
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To gauge profitability, you look at a bank's return on equity. This measures how much a bank earns relative to the amount of shareholder equity used to generate the earnings.
Here's how it's calculated:
A higher return on equity is better than a lower one. And at a bare minimum, you want to see a bank earn at least 10% on its equity. If you factor in the opportunity cost of not investing your money elsewhere, a bank that earns less than this is effectively destroying shareholder value.
With all of this in mind, here are the top 10 bank stocks ranked by profitability:
*The entire list included the 23 bank stocks on the KBW Bank Index -- First Niagara Financial Group was excluded in light of its recent merger with KeyCorp. Data source: YCharts.com.
The top four are worth paying particular attention to -- that is, U.S. Bancorp (NYSE: USB), Wells Fargo (NYSE: WFC), Commerce Bancshares (NASDAQ: CBSH), and Northern Trust (NASDAQ: NTRS).
Not only are these banks the most profitable, but their shares are also the most expensive. For instance, U.S. Bancorp tops the list with its 14.4% return on equity and comes in near the top with a valuation of 1.79 times book value.
The same is true for Commerce Bancshares and Northern Trust, both of which reported double-digit returns on equity over the past year and trade for at or near twice their respective book values. Even Wells Fargo, which has a lower valuation than the other three, is still priced above most of its peers when you expand the list to include a larger sample of banks.
It may go without saying, but the relationship between these two metrics isn't a coincidence. Banks that earn more money are given higher valuations. And as an offset for banks with lower profitability, their shares trade at lower valuations.
In this instance, then, if you were on the hunt for a top bank stock to hold for the long run, you'd be excused for concluding that Wells Fargo is a bargain -- at least compared to other highly profitable banks. While it's just as profitable as U.S. Bancorp, Commerce Bancshares, and Northern Trust, its valuation is considerably lower.
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John Maxfield owns shares of U.S. Bancorp and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool recommends Cullen/Frost Bankers. 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.