A blowout earnings report from Goldman Sachs Group Inc. on Wednesday may send investors jumping on the bandwagon of U.S. investment bank stocks. A look at historical valuation levels in the sector suggests this would be entirely justified.
The accompanying chart tracks a market-cap-weighted benchmark of the five major U.S. investment banks – JPMorgan Chase & Co., Citigroup Inc., Bank of America, Goldman Sachs and Morgan Stanley – compared to their valuation levels in terms of price to tangible book value.
Tangible book value is a conservative measure of a company's worth that approximates what shareholders would receive in the event of bankruptcy. From 2003 to 2006 the major banks traded at three times their tangible book values. Beginning in January, 2007, stock prices plunged until the stocks traded at an average of 0.51 – a mere half – their tangible book value.
The chart shows that the recovery in U.S. banking stocks got ahead of itself between early 2009 and mid 2011. The rising red line indicates that the sector was becoming more expensive despite the fact that the stock prices were barely moving. The book value – the denominator in the price-to-tangible-book-value ratio – was eroding because of asset writedowns, notably of mortgages.
The situation appears to be changing and Goldman's spectacular results – fourth-quarter profit more than doubled from a year ago – add to the momentum. While investors' lingering distrust with financial institutions' balance sheets suggests that U.S. banking stocks will not return to previous lofty valuation levels any time soon, Goldman's strong earnings boost optimism around a sector that has already climbed 70 per cent since July, 2012. Investment banking stocks currently trade around one times tangible book value; a climb to two times – still well below pre-crisis peaks – would see these stocks double.
Scott Barlow