Finding Value In The Stress Test

Financial companies are often black boxes with incalculable risks. Mark-to-model accounting and high-failure modification programs cast dispersions on the valuations of bank assets. Fortunately, the Federal Reserve released stress test results which help clarify which banks are well capitalized. Under the extreme scenarios posited in the stress test there is a wide range of tier 1 capital ratios:

Ticker	Company	Stress Scenario Tier 1 Capital Ratio	P/E	P/S	P/B	P/FCF
STT	State Street Corp.	15.1%	11.6	7.3	1.1	7.7
BK	The Bank of New York Mellon	13.3%	11.5	7.8	0.8	28.7
AXP	American Express Company	12.4%	13.3	2.0	3.4	7.5
FITB	Fifth Third Bancorp	7.7%	12.3	3.1	1.0	7.2
USB	U.S. Bancorp	7.7%	12.6	4.7	1.7	6.7
BBT	BB&T Corporation	7.3%	16.6	3.1	1.2	5.4
COF	Capital One Financial Corp.	7.2%	7.3	1.6	0.8	3.3
PNC	PNC Financial Services Group	6.6%	10.9	3.2	1.0	6.1
WFC	Wells Fargo & Company	6.6%	11.8	3.6	1.3	17.1
JPM	JPMorgan Chase & Co.	6.3%	9.7	2.7	0.9	1.8
KEY	KeyCorp	6.3%	9.1	2.7	0.8	5.0
C	Citigroup, Inc.	5.9%	10.2	1.5	0.6	2.4
GS	The Goldman Sachs Group	5.8%	28.2	1.7	0.9	3.5
BAC	Bank of America Corporation	5.7%	0.0	1.4	0.4	1.5
RF	Regions Financial Corp.	5.7%	0.0	1.7	0.4	1.7
STI	SunTrust Banks, Inc.	5.5%	24.3	2.0	0.6	2.8
MET	MetLife, Inc.	5.4%	6.3	0.6	0.7	5.3
MS	Morgan Stanley	5.4%	15.6	1.0	0.6	7.4

We can use these projected capital ratios under extreme scenarios as a crude measure of bank risk. We can then plot how risky a bank is against how cheaply it trades relative to the book value of its equity:

Higher risk banks end up with lower capital ratios, and are to the left of this plot. Banks trading at the deepest discounts have lower price-to-book ratios and are plotted lower in this plot. A regression was performed to identify banks which fall well below and to the right of the trend line, indicating that they are promising candidates for risk-adjusted outperformance. This plot identifies two banks which stick out in a good way: State Street and The Bank of New York Mellon.

At $43.87 per share, State Street is a a great value, even as it tops the list in terms of robustness to doomsday stresses. At this price level, the stock has a 1.6% dividend yield. STT shareholders have seen a 8.8% change in share price over the past year, and shares trade at a price-to-book ratio of 1.1, a price-to-earnings multiple of 11.6, and a price-to-sales multiple of 7.3 (trailing twelve months). Over the past decade shareholders savored a 11.4% average annual return on equity.

The Bank of New York Mellon Corporation is almost as robust, and is a deeper value at $23.28 per share. At present, shares of this large cap stock trade at a price-to-book ratio of 0.8, a price-to-earnings multiple of 11.5, and a price-to-sales multiple of 7.8 (trailing twelve months). At this price level, the stock has a 2.2% dividend yield.

BK shareholders have been rewarded for sticking it out. Over the past decade shareholders savored a 12.6% average annual return on equity. For 10 out of the past 10 fiscal years, a share of BK paid a total of $7.46 in dividends. Of these dividend payments, a total of $3.61 were paid in the last five years. More recently, they savored a 17.7% change in share price over the past year.

Alternatively, U.S. Bancorp and Wells Fargo stick out above the trendline, indicating that they are overvalued relative to other banks when compared to the riskiness of capital structures. Their reputations for safe portfolios apparently have preceded them, making them overvalued based on risk from their stress test results. Investors should consider The Bank of New York Mellon and State Street before they consider adding U.S. Bancorp and Wells Fargo. They should prioritize research and investment according to financial metrics before reputation.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.