Warren Buffett's Favorite Banks Are Quite Undervalued

Includes: USB, WFC
by: Gregory Vousvounis

A couple of days ago Mr. Buffett did an interview with Becky Quick on CNBC where among other things, he was asked about valuing banks. He elaborated that the key to valuing banks is earnings instead of book value and that the best way to measure their performance is calculating their return on assets.

He also mentioned two banks as an example of high return on assets. Those banks were Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) of which Berkshire Hathaway (BRK.A/BRK.B) owns 8.2% and 3.2% respectively.

Both of these banks are currently trading at significant discount to their fair value and I believe that they are worth a look from long-term investors. But before we talk about valuation, let's see why they are so exceptional.

Both Wells Fargo and U.S. Bancorp have performed well during the last decade. Wells Fargo had an average ROA of 1.3% and a ROE of 15%. On the other hand, U.S. Bancorp's average ROA was 1.6% and its ROE 18%. These are exceptional numbers given that the US had a major financial crisis during 2008 & 2009.

Their resilience during the crisis is another thing to like about them. As you can see below, both companies managed to stay profitable and have already surpassed their pre-crisis EPS levels.

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Moving on to valuation, I'll follow Mr. Buffett's advice and I'll focus on earnings, ignoring book value calculations. During the last decade, Well Fargo has grown its EPS by an average 8% and U.S. Bancorp by an average 5%. Before the financial crisis, their average EPS growth was 10% and 8% respectively.

I am referring to pre-crisis growth rates to give us a better understanding about how those two banks will perform in a more "normal" economic environment.

Expectations for 2013 earnings are $3.6/share for Wells Fargo and $3.07/share for U.S. Bancorp. Given that we are in a recovering economy and that we'll probably continue to grow for many years to come, I will assume that Wells Fargo will grow by an average 9% over the next decade and U.S. Bancorp by an average 8%.

Using discounted cash flow calculation, Wells Fargo's fair value is found to be around $50/share and U.S. Bancorp's around $40/share. As a result, Wells Fargo and U.S. Bancorp need to rise by 40% and 20% respectively before reaching their respective fair values.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.