There is no point in repeating the current uncertainties facing banks. In times of extreme uncertainty, it is especially important to get back to basics. And I see two basic tenets worth repeating at this point:
- Purchase good banks (such as Goldman Sachs, JPMorgan Chase, et al) at or near book value have proven to be very successful investments – both in backtesting and in our real world experiences. For obvious reasons. We only pay for the book and get everything else (like future earning power) for free.
- For a juggernaut as complicated as JPMorgan Chase (NYSE:JPM), it’s kind of pointless trying to get a good idea of all the moving parts (let alone where they would be next). In the end, using fewer but reliable data points is often more efficient than using a ton of less reliable data points.
In this context, you will see that based on these simple principles, why it would be obvious to buy JPM if its price drops to around $70 under current conditions where its TBV (tangible book value) is around $68. Although highly unlikely – it didn’t even happen at the bottom of the COVID panic sell. For an excellent bank like JPM, I’m willing to pay a premium of up to 10 times its dividends, leading to a target share price of $95.
In the rest of this article, you will see how I reach this magic number based solely on two data: the TBV and the dividend. The two least ambiguous pieces of information.
Buy good banks at their book value
As I just mentioned, buying good banks from TBV should be a no-brainer because you only pay for the book and get everything else for free. However, the problem is that in most cases good banks are not for sale at TBV, not even nearby. As seen below, in the case of JPM, historical data has shown that on average its price is 1.35 times its TBV.
Even at the bottom of the COVID panic selling, stock prices remain above the TBV as seen (thought by a thin margin of only 2%). The last time JPM was selling below TBV was in 2012 during the peak of the European banking crisis as seen. And you can see the return the stock produced if bought at that time (over 400% from price appreciation alone, ie excluding dividends).
So the bottom line is: buy JPM if its prices drop below TBV – which you probably already know. And besides, it’s a bit of useless advice because it almost never happens.
And the really useful question is: how much premium should you pay? Then you will see that I am willing to pay a premium of up to 10 times its dividends.
Buy excellent banks with a premium of 10 times the dividends
For stocks that generate income based on tangible assets (like banks or REITs), a very intuitive and effective valuation approach that we use ourselves is based on its asset and income. Details are provided in my previous articles, and a brief summary is provided here to facilitate this discussion:
If you think like a long-term business owner (instead of a stock trader), then investing in these stocks is nothing more than buying an asset (monetary capital in the case of banks or real estate in the case of REITs) to collect income (interest for banks and rents for REITs). The investment value therefore consists of two parts: the value of the property itself and the future rent.
Our valuation method approximates the first part by its book value and the second part by 10x of its dividends. In other words, the investment value (“IV”) of a REIT share must be:
IV = BV + 10 x dividend
This method offers the advantage of a valuation anchored in the most easily accessible data with the least uncertainty: BV and dividend. When it comes to investing, we always prefer the use of a few reliable data points rather than many less reliable data points.
With the above understanding, the following chart shows the results of this method applied to JPM since 2010. As can be seen, it captured the long-term market price very well. Specifically, the current IV, based on its last TBV and dividends, is around $108. And at its current price of $117, it’s close to IV but still about 8% higher.
And then we’ll look under the hood a little closer and see how I arrived at a target price of $95.
JPM: profitability and growth
JPM is arguably the best managed diversified bank in the United States, if not the world. So it’s definitely worth a premium. It operates in all major banking businesses, including retail and community banking, corporate and investment banking, commercial banking and asset management. Led by its capable CEO James Dimon and his management team, JPM has generated stable returns, as shown below, in different market conditions. Return on assets (“ROA”) has always been near or around 1% since 2015, and return on equity (“ROE”) has always been near 10% over the past decade. These measures of profitability compare favorably with those of other major banks and the industry average. Its current ROE of 11.7% is slightly above the industry median of 11.5%, and its current ROA of 1.02% is slightly below the industry median of 1.2%.
Valuation of bank stocks as a bond
Then, why use TBV? The short answer is that it really is the best we have for a bank’s current value. For a large bank holding trillions of dollars in assets and liabilities, I don’t think even the executives themselves know exactly what their bank is worth today – let alone what revenue it will generate in the future. As stated in my previous articles,
If you find this hard to accept, imagine a task on a much smaller scale – imagine yourself trying to figure out our current household net worth. Even for liquid assets such as stocks, their value fluctuates from day to day and dramatically for a few days. Less liquid assets such as our house involve a much larger margin of error. The margin of error gets even worse when dealing with even less liquid assets such as collectibles, intellectual property, and commercial contracts (if you also run a small business on the side). The above uncertainties are multiplied by LOT for large banks.
And in the end, TBV is as good as it gets. Even here, there are still uncertainties. To get a very rough idea of the magnitude of the uncertainties, the following chart shows the difference between the TBV and the Pound Valve (including all intangibles). As you can see, the difference between these two can be over 40% and it has been around 25% in recent years for JPM. Currently, the difference is about 26%. And also note that spreads are larger in uncertain and turbulent market conditions – spreads changed drastically from 40%+ to around 30% from 2011 to 2013 and stabilized thereafter as market conditions eased. are stabilized. This is a key consideration in my target price estimation, which will be developed later. And finally, when we evaluate the growth rate, TBV and BV can also lead to slightly different answers. In the case of JPM, TBV has increased by 6.1% CAGR over the past decade and BV by 5.35%, and I trust the TBV data more.
Second, why use dividends rather than profits? The short answer is that the dividend is more reliable and indicative of a bank’s performance than earnings. The following table gives some overviews. As can be seen, for JPM over the past 10 years, the dividend has steadily increased (at an impressive CAGR of 12.7%). For years it has stagnated because capital constraint regulations (instituted after the 2008 financial crisis) won’t let them.
On the other hand, as we can see, income fluctuates from one year to the next. In addition, earnings are subject to many factors beyond anyone’s control: fluctuating interest rates, the overall economy, or simply bad luck. Earnings are also more open and subject to accounting manipulation and interpretation.
For these reasons, TBV and dividends are the easiest and most reliable way for me to rate a good bank. In a way, this method values a bank stock much like a 10-year bond, if you think of the TBV as the face value of the bond and the dividend as the coupon payment. And I hope it’s intuitive enough for you.
Risks and Final Thoughts
So why am I setting a target price at $95, not $108? And remember that $108 is the current IV based on his TBV plus 10x his dividends. The reason is to provide a safety margin to deal with risks. The company faces many risks, such as interest rates, the trajectory of loan loss provisions and the possibility of a recession. All of these risks have already been adequately discussed in other trial articles by other authors. So here I would focus only on the risks associated with the valuation method itself.
Readers should be aware that book value (either BV or TBV) is a moving target itself. When JPM announced its last BV of $86.3 per share and its TBV of $68.7, the number was already delayed due to filing time. And the numbers keep changing with market conditions. So, as investors, we need to estimate its current TBV and, more importantly, its future TBV if the market continues to fall. And my estimate of a $95 price target is based on A) its TBV value when the market is down another 5% from the current value, and B) the fact that historically the price of bank stocks moves more dramatically than book value. change as I explained in a previous article. These factors, when combined, led me to the target price of $95, about 12% below the current IV and about 19% below its current $117. At this price level, I’ll buy his asset (which has grown in mid-digits over the past decade) at face value and get the income for free (which has grown in double-digits in the past, measured by its dividends).