A lot of people are picking up shares of Bank of America (BAC) based on its lowly advertised P/B of 0.6. They are doing so either because this valuation is lower than BAC's peers (industry average of 1.0) or because they feel the price is fair right now but they speculate that once the economy turns around, the earning power of BAC will lift shares substantially.
This reasoning and investment however comes with an opportunity cost that I felt was worth writing about. That cost being the opportunity forgone by not buying Wells Fargo (WFC) shares instead. Below I have outlined why Wells Fargo shares offer a lot more value than those of Bank of America, even when BAC's shares can be purchased with a lower P/B.
First off, I have based this analysis on values that can be drawn between the balance sheet and income statements. I have done so because book value has a lot of people purchasing shares and I wanted to compare the earning power of that value. I am not even getting into the much larger dividend rate that Wells Fargo offers (right now and without FED approval) or the large share buybacks that Wells Fargo has already been purchasing (before the recent FED approval). And, I won't even go into how many more dangerous derivatives BAC has listed as assets, how many pending lawsuits BAC has, how Buffett loves him some WFC, or how both companies have close to the same amount of money set aside in reserves (same in amount, not in proportion to liabilities). Mentioning all of those details would just be wrong and a little biased. With that out of the way, let's begin:
*all calculations are from 2012 year-end amounts (BAC and WFC) and in millions of dollars. Please also keep in mind, small percentages of billions of dollars is a lot of money and that I have only put BAC above WFC in the calculations below because the rest of my article has WFC on top.
1. Banks make money by lending out deposited money for a higher interest than the amount paid on the deposits (at least they should). So, the interest revenue from loans divided by the net loans will give us the average percentage of interest earned on the loans.
BAC: 38,880/903,054 = 4.3%
WFC: 38,348/829,773 = 4.6% (winner)
2. Now, for banks, loans are an asset. Since the calculation above gives us the income percent made on the loans, let's calculate the percentage made on the other assets. To do this, we need to subtract the interest made on the loans from the net revenue and then divide by the assets less the loans and intangibles.
BAC: 44,454/1,224,410 = 3.63%
WFC: 47,738/547,593 = 8.72% (winner)
3. Deposits for banks represent the cheapest form of leverage or liability that a bank can obtain. If it weren't for deposits, banks would either have to take higher interest loans or fund the loans that make them money with capital raised by the shareholders. To see how cheap deposits are as liabilities, we can find the interest percent paid on the deposits by dividing the interest expense on deposits by the total deposits:
BAC: 1,990/1,105,261 = 0.18%
WFC 1,727/1,002,835 = 0.17% (winner)
4. Wells Fargo and Bank of America have other expenses and so, removing the interest expense on deposits from the total interest expense and then dividing the figure by the liabilities less deposits will give us the interest percent paid on other liabilities. Before I calculate this, keep in mind that I have done so to illustrate how much cheaper deposits are compared to other bank liabilities and to demonstrate why WFC is better than BAC.
BAC: 14,754/867,757 = 1.7%
WFC 3,434/262,579 = 1.3% (winner)
5. Now, from calculations 3 and 4 above, we can easily see how much cheaper customer deposit financing is in comparison to other bank liabilities. With that said, we can also conclude that it would be in the better interest of a bank to have a larger percentage of its liabilities made up by deposits. This percentage we find by dividing deposit by total liabilities:
BAC: 1,105,261/1,973,018 = 56%
WFC: 1,002,835/1,265,414 = 79% (winner)
6. Now for the book value discussion. A quick calculation of market cap / shareholders equity would give you a 0.6 P/B for Bank of America and a P/B of 1.4 for Wells Fargo, which indicates a 133% higher valuation on the book of Wells Fargo. If however, we calculate the tangible book value, we would find that BAC has a P/B of 0.9 and WFC has a tangible P/B of 1.76. This calculation yields a smaller but still material 95.5% difference in valuations but, wouldn't you pay 2 times more for better assets and a better business? From calculations 1-5, we can conclude that buying WFC would give you (from calculations above):
1. 6.98% higher revenues from loans.
2. 140% higher revenues from other non-loan tangible assets.
3. 5.56% cheaper deposits
4. 23.53% cheaper non-deposit liabilities.
and 5.41% more deposits (cheapest leverage)
This, in addition to the items I said I wouldn't be talking about like positive cashflows from operating activities, dividends, pending lawsuits or Buffett's WFC heavy portfolio.
Those speculating on BAC's recovery need to remember that a better banking environment will benefit all banks. Based on the calculations above, it's clear to see that Wells Fargo can do much better with what's given to it as it produces more on its assets and pays less for its liabilities than BAC does. I would even say that WFC is valued lower because of BAC and other banks.
For more on that you can read my other article here.
Disclosure: I am long WFC.