Why Do Wells Fargo's Shares Trade for a Premium to JPMorgan Chase's?

Although JPMorgan Chase and Wells Fargo are equals when it comes to prudent and profitable banking, you'd never know it by looking at their respective stock valuations.

Wells Fargo's shares trade for a 74% premium to book value compared to a 17% premium for JPMorgan Chase.

At first glance, this doesn't make sense. Both banks are run by the industry's best executives. Both not only survived the financial crisis, but thrived as a result of it, thanks to bargain-basement acquisitions of competitors made at the nadir of the downturn. And both are within the elite group of too-big-to-fail lenders that sit atop the U.S. bank industry.

What, then, explains the disparity in their valuations? In my opinion, it boils down to two things.

The first is that JPMorgan Chase's business model is riskier than Wells Fargo's. This is primarily a result of the former's large trading operations, which accounted for 12% of its net revenue in the latest quarter compared to only 0.62% at Wells Fargo.

Income from trading is notoriously volatile, as even small changes in global financial markets can wreak havoc on a bank's positions. In 2012, for instance, JPMorgan Chase suffered a roughly $6 billion loss thanks to a single trader's wrong way bet on the value of derivatives tied to the health of American corporations.

You can see the tell-tale signs of this by comparing JPMorgan's earnings volatility since the crisis to Wells Fargo's. Since the beginning of 2009, JPMorgan's quarterly net income has moved by a median of 31% compared to the year-ago period -- this figure doesn't distinguish between upward and downward changes. Meanwhile, the median year-over-year change in Wells Fargo's quarterly net income has been 17%.

The same story comes through when you look at the volatility of the two banks' stocks. Wells Fargo's stock has a beta of 0.8, meaning that its shares are 20% less volatile than the broader market. JPMorgan Chase's stock sports a beta of 1.25, meaning that it's 25% more volatile than the broader market.

The second reason is that JPMorgan Chase will soon face tighter capital requirements than Wells Fargo. Under new rules covering systematically important financial institutions -- generally speaking, banks with more than $50 billion in total assets -- JPMorgan will have to reserve an additional 2.5 percentage points more capital to absorb future loan losses than Wells Fargo.

This may seem inconsequential, but it's important for banks given the fact that they earn money by leveraging their capital bases. If one bank is limited to using less leverage than another bank, than the latter has an advantage over the former.

You can see this in the chart above, which contains the so-called SIFI buffers faced by the nation's biggest banks. Due to its size, complexity, and leading role in global financial markets, JPMorgan Chase faces a buffer equal to 4.5% of its capital. But thanks to Wells Fargo's smaller, more domestic, and less complicated business model, its SIFI buffer is only 2%.

The net result is that JPMorgan Chase, while still a phenomenally run operation, is at an inherent disadvantage to its smaller and simpler rival, Wells Fargo. It's this disadvantage that explains why their stocks trade for such different valuations.

The article Why Do Wells Fargo's Shares Trade for a Premium to JPMorgan Chase's? originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of 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.

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