Calculating Intrinsic Value for Bank Stocks

Intrinsic Value of Bank Stocks

Financial institutions, including banks, are highly regulated, extremely leveraged, and susceptible to interest rate fluctuations. Due to this unique exposure, calculating intrinsic value for bank stocks requires modification of the most popular valuation models. There are about five widely accepted intrinsic valuation models used with determining the core price for stock of most companies. Novice or lazy investors rely heavily on these so-called textbook models to calculate intrinsic value as the baseline for buying stock. Sophisticated investors will modify popular models to create a customized formula for each respective industry. It requires some rational thinking and reasonable assumptions to design and implement a model for any industry. This article goes into detail about designing and executing an intrinsic valuation model for banks.

To cover the thought process of creating this banking model, it is first explained how banks are in their own corner of the business world. Certain business attributes of banking are unusual and therefore demand modification to the intrinsic calculation model. Secondly, compliance regulation further complicates calculating value. In some situations, the government penalizes banks by restricting their ability to conduct business which then impacts earnings. Since most valuation models are oriented around earnings, compliance in banking demands changes to the intrinsic formula. A third dynamic with banks is the leverage issue. Most stock price valuation models assume the respective company is at least mildly leveraged. Banks are not not mildly leveraged in comparison to other industries; they are extremely leveraged. Therefore, the respective intrinsic value formulas must take this into consideration. Finally, banks and other financial institutions are susceptible to interest rate changes. If they have too much money loaned for extended periods of time (long-term notes) at low interest rates and the market rates for loans increase, earnings tied to interest will lag until these lower interest rate loans mature. Thus, the formula for intrinsic value must adapt to this interest spread between what is earned and what is paid out for use of money.

The last section of this article ties all of this together and explains how the model is fully modified and then applied against a popular bank stock. But first, it is important for the investor to understand the unique business environment with which banks exist.

Intrinsic Value – Banking Business Model

The historical model for banking is as a depository institution that would loan out money from the deposits of patrons. The use of actuarial science is how a bank primarily earns its income. There are literally tens of thousands of patrons each depositing varying amounts of money. In turn, the bank makes loans to well qualified individuals and earns interest on behalf of the patrons. The bank then in-turn pays patrons a portion of the total interest earned from loans. The difference between what is earned and paid out is used to pay for operations of the bank; any balance left over is profit. In order for this to work, economy of scale is essential; deposits from patrons must be in excess of tens of millions of dollars. A simple example illustrates how this works.

Main Street Bank has 30,000 patrons among six branches. Each patron carries $3,000 on average on deposit with Main Street Bank. Therefore, Main Street Bank has $90 Million in deposits. Main Street issues 9,000 loans, each with a face value of $10,000. Main Street loans out $90 Million. Each loan has a simple interest rate of 7% per year. Therefore, each year, Main Street bank earns $6,300,000 in interest. Main Street agreed to pay interest to its patrons of 2% per year. Main Street pays out $1.8 Million of interest. The difference is $4.5 Million of net interest. Net interest is the primary source of revenue generated by banks and the common term used to define revenue for a bank.

Main Street’s operating costs are $600,000 per location including payroll, facilities, technology and all other operating expenses. Total costs to run the bank equals $3.6 Million. The bank generates a $900,000 annual profit.

This is the primary business model for banks. However, over the last 100 years, this model has developed into a much more multi-dimensional model. Today, banks have several streams of revenue. Here are several examples of other sources of revenue (referred to as non-interest income in banking terminology):

  • Banks issue credit cards on behalf of large lenders and earn fees when customers use the cards;
  • Banks provide fiduciary services, i.e. they act as trustees for estates and large trusts, thereby earning professional service fees;
  • Service charges are made on accounts for stop payments, overdrafts, processing, minimum balances etc.;
  • Commercial loan fees, fees for letters of credit and loan origination fees;
  • Foreign exchange charges to convert money; AND
  • Brokerage fees.

This is a simple bank. The really big banks are involved in several revenue venues. A typical big bank refers to these revenue venues as ‘Segments’. All of them have the traditional bank format as above and they commonly called this ‘Traditional Banking’. In general, the traditional segment is the powerhouse of the entire organization. Other segments include:

  • Wholesale Banking – large corporations, commercial real estate, and government banking (think of local and regional governments/boards/authorities);
  • Wealth and Investment Banking – asset management and wealth management for high net worth individuals;
  • Consumer Banking – loans for autos, RV’s, boats and big consumer ticket items;
  • Credit Card Services including fees, revolving charges and processing (think of credit card discounts paid by retailers to conduct transactions).

It is important to note the two obvious risk factors involved with banking. First is the interest spread or net interest income for the loans made and the amounts paid out to borrow the money. If this spread decreases, the end result is much less net interest income to the bank. The bank must be flexible enough to absorb or adjust to any change in this interest income. Typically these changes occur quickly in the market and the bank’s ability to adapt takes a lot more time. This is further evaluated in the net interest section below.

Secondly, banks make a lot of loans. If a borrower defaults on their loan, not only is the bank out of earning interest, it also must take a loss associated with the open balance of principal on that note. Thus, loan management, what banks refer to as risk management is extremely important to eliminate or significantly reduce loan losses. All banks have a single line item on their income statement identifying provision for loan losses. For the big banks, this line item is in the hundreds of millions of dollars per year. Wells Fargo’s provision for loan losses in 2019 was $2.7 Billion, yes, you read that correctly, $2,700,000,000 was written off the books. Wells Fargo’s total revenue in 2019 was $85 Billion. This means Wells Fargo’s lost 3.1% of every dollar it earned because of bad loans. This is not unusual; JP Morgan Chase set aside $5.6 Billion for loan losses against $115.6 of revenue. This is 4.8% of every dollar earned.

Finally, before explaining the broad intrinsic value determinants, the balance sheet for a bank must be explained. In general, they do not display the traditional current, fixed and other assets format. A bank’s format is basically presented as follows:

  Cash                                                                      5% of all assets
  Earning Assets                                                    88% of all assets
  Other Assets Including Fixed                               7% of all assets
Liabilities and Equity
   Non-Interest Bearing Deposits                          17% 
   Interest Bearing Deposits                                  51%
   Borrowings                                                        21%
   Equity                                                                11%                          

Thus, the earning assets portfolio is the primary asset to be concerned with when calculating intrinsic value. Remember, intrinsic value includes both elements of income and assets. Since loan assets are shorter term than traditional fixed assets, they are more susceptible to changes in value tied to money in the market. In effect, inflation and the market’s accepted interest rate drives the value of these loans. Given this, intrinsic value for a loan pool is rarely significantly greater than the face value of the respective loans. This is almost the exact opposite of real estate based operations; there, the intrinsic value is lifted higher due to the fair market value of the underlying real estate.

With this in mind, it can be easily deduced that intrinsic value will rarely exceed 125% of book value. Why? The underlying assets’ fair market value will rarely exceed the respective face value of the loans. Thus, a value investor’s first step with determining intrinsic value for a bank is to focus on book value. Then, immediately set a maximum value point of 125% of book value. This is the absolute BEST CASE for intrinsic value for a bank stock. Rarely will the loans have much greater value than the face amounts of these loans. The most common cause for this unusual greater value situation is when loans have high interest rates and the market interest rate is much lower. 

On the opposite aspect of this is the quality of those loans. Since the loans are reported at face value LESS a provision for bad loans, it is possible that in a dramatic or extended economic downturn with the economy or with certain types of loans such as auto, consumer or mortgage, the economic impact can impair the face value of this loan portfolio. Thus, a low point or adjustment should be considered to include a ‘what if’ the default rate is much higher than the current set aside. How much can this affect the intrinsic value related to book value? 

The answer is simple, to set an impairment adjustment tied to quality of loans, simply assume that whatever the existing loan portfolio is, reduce it another 5% and adjust the book value accordingly. Thus, in the example above, instead of the loans being 88% of total assets, it is reduced to 84% ((.88 X (1-.05) = .836)) of all assets. This must be adjusted to the equity element in the bottom half of the balance sheet. This means that instead of the equity position at 11%, it is now 7% as the liabilities cannot change. This is then reflected with an adjustment to book value as a percentage of this equation. Since 7% equity position equals 64% of the original equity, then the bottom or floor value for intrinsic value must approximate two-thirds of book value. 

Now the range for intrinsic value is set. In general, intrinsic value will approximate somewhere between 66% and 125% of book value. 

Before finishing, there is one last important point about bank stock book values. Banks actually report two book values. They place a lot of importance on this with their reports. The first is the traditional book value as defined in textbooks. The second one is much more conservative. It is called ‘Tangible Book Value’ and it reflects the existing traditional book value adjusted lower related to intangible assets. Many banks grow by not opening new branches but by merging with other small bank organizations. This method of expansion is common as it brings into play a business principle known as economy of scale. The larger the bank, the better its chances of borrowing money at lower interest rates and demanding better terms with loans issued. This merging often requires the recording of goodwill as an asset in the other assets section of the balance sheet. In addition, there are other intangible assets including ‘rights to certain contracts’ and derivatives.

For the purpose of determining intrinsic value, always use traditional book value as the beginning basis in the formula. It is not uncommon for the difference between traditional book value and tangible book value to have a 25% lower differential of traditional book value. However, use the traditional book value to determine floor and ceiling for intrinsic value. 

Therefore, rule number one with calculating intrinsic value of a bank stock. Intrinsic value of bank stocks will NEVER exceed 125% of traditional book value and will most likely (assuming a good operation) end up around the traditional book value as reported with the financial statements.

For example, Wells Fargo recently released their 4th quarter 2020 financial supplement. On page 23 of their supplement, they indicate book value at $40 per share and tangible book value at $33 per share. Thus, 66% of traditional book value is the floor value for intrinsic calculation. The ceiling is 125% of traditional. This means that the extreme floor and ceiling for intrinsic value for Wells Fargo are $25 for the floor and $50 for the ceiling. This sets the price barriers. Always think that intrinsic value will end up around the traditional book value as reported with the bank’s financial results.

Here is a summary of the first two rules of intrinsic value calculation for bank stocks:

  1. Best possible (CEILING) outcome is 125% of traditional book value of a bank’s stock; AND
  2. Worse case (FLOOR) is about 66% of traditional book value of a bank’s stock.

For now, this section is designed to explain how to determine the general ceiling and floor intrinsic value points for bank stocks. From here forward, the tangible book value is used to determine the true intrinsic value; the limits let us know where this final result will end up.

The first adjustment for a bank stock’s intrinsic value calculation relates to compliance. Compliance refers to the regulations and reporting requirements the government imposes on banks.

Intrinsic Value – Compliance

Banks are one of the most regulated industries in the United States. There are at least four levels of regulation for big banks. Value investors are only interested in the larger banks. Smaller banks have at least three levels of regulation.

The upper level of regulation starts with the Federal Reserve. All national banks, i.e. they serve more than one state, must become a member of the Federal Reserve. In addition to the traditional membership requirements of the Federal Reserve, the Graham-Leach-Bliley Act of 1999 grants the Federal Reserve more authority over large financial institutions which most banks fall under. From the Federal Reserve’s website: The Federal Reserve is responsible for supervising–monitoring, inspecting, and examining–certain financial institutions to ensure that they comply with rules and regulations, and that they operate in a safe and sound manner. Supervision of financial institutions is tailored based on the size and complexity of the institution”.

In addition, at the Federal Reserve level, members must comply with proper controls and data management including safeguards for technology.

A second federal level of compliance is the Office of the Comptroller of the Currency of the United States. This is referred to as the OCC. The OCC is a department within the U.S. Treasury and it is responsible to charter, regulate and supervise all national banks. In effect, they act as the money system’s sheriff related to banks.

A third federal level compliance requirement is the Federal Deposit Insurance Corporation (FDIC). The FDIC acts like an insurance agency and backs up the amounts held in deposit with banks for U.S. citizens to a certain dollar amount. To comply, it charges each bank a fee, like an insurance premium. In return, the FDIC “examines and supervises financial institutions for safety, soundness, and consumer protection; makes large and complex financial institutions resolvable; and manages receiverships”.

The fourth level is at the state level. Each state is different in how they manage banks within their purview.

Whenever reviewing or analyzing bank stock, it is important for the value investor to review current status of the bank with the respective governmental regulator. As an example, back in early 2018, the Federal Reserve hit Wells Fargo Bank with an order capping their total assets to $1.95 Trillion. This means that Wells Fargo can not grow its assets. It can try to improve the quality of its assets; but the face value of its assets cannot exceed this $1.95 Trillion mark until the bank has complied with the directives set by the Federal Reserve. Thus, for this particular stock, the intrinsic value formula must be modified to reflect this dampening penalty. A typical bank like Wells Fargo will increase their assets portfolio about four to seven percent per year. Thus, Wells Fargo could be adding $100 Billion in loans per year if not for this cap. $100 Billion in loans at .75% net interest rate adds around $750 Million per year in additional revenue with only marginal managerial costs. This greatly impacts the intrinsic value formula, it affects the outcome $2 to $5 per share depending on how long the cap is in effect. Since Wells Fargo has about 4.1 Billion shares outstanding; a $750 Million bottom line hit for the first year and then double that for the second year adds up quickly.

The key to adjusting the intrinsic value formula tied to compliance is if the respective potential investment is under some kind of restriction or is under review for a penalty tied to improper behavior with consumers. Some simple research will provide the answers and minor infractions will adjust the intrinsic value lower by about a $1 per share. Strong and lengthy restrictions like the one Wells Fargo must endure will reach the $5 per share level.

Compliance is just a minor adjustment. The next intrinsic value adjustment will range from $1 to upwards of $4 per share positive or negative depending on proper portfolio arrangement.

Intrinsic Value – Leverage

Banks use debt leverage to significantly increase the net interest earned. Recall from above, the primary source of revenue for a bank is net interest. Net interest is defined as gross interest charged on loans less interest paid out to use that money. Look at the following table of five large banks for 2020, their gross interest earned, net interest, other income and the ratio of net interest to total revenue.

Bank                             Gross Interest Earned      Net Interest Earned     Other Revenue     Ratio of Net Interest to Total Revenue
Wells Fargo                              $47.8 B                               $39.8 B                      $32.5 B                                      55%
Bank of America                      $51.6 B                               $43.4 B                      $42.2 B                                      51%
JP Morgan Chase                     $64.5 B                               $54.6 B                      $65.0 B                                      46%
Comerica Bank                          $2.8 B                                 $2.3 B                        $1.0 B                                      70%
Bank of New York     Not Provided in 4th Qrt Report          $3.0 B                      $12.8 B                                      19%

Other services provided by banks including brokerage types of services have higher cost ratios than traditional loan portfolios. Many banks can borrow money for extremely low interest costs and in many cases no interest cost at all. Many banks do not pay interest on patron deposit accounts with their financial institution. Thus, money held with these non-interest bearing accounts can be loaned out and earn the bank relatively good returns. A good example is Comerica Bank. Its total loan portfolio as of December 31, 2020 is $51.6 Billion; non-interest bearing deposits total $33 Billion. Thus, Comerica Bank has no interest expense associated with 63% of its loan portfolio.

The key to a superior portfolio is to leverage the portfolio with inexpensive sources of capital. For banks, there is a hierarchy of sources. Non-interest bearing accounts are the best; however, it takes a lot of marketing to acquire new accounts and often the patron deposit amounts average lower values. Other sources of cheap capital in order from low to high include:

  • Interest bearing checking;
  • Market rate accounts;
  • CD’s and other time deposit accounts;
  • Short-term borrowings;
  • Long-term debt.

The stronger the values toward the less expensive sources of capital, the more net interest earned from the portfolio. This is how leverage works for a bank.

For example, in 2019, Wells Fargo’s loaned out $1.754 Trillion and sourced this money as follows:

  • Non-Interest bearing accounts – $439 Billion (25%)
  • Customer Deposits including CD’s and interest bearing accounts – $942 Billion (54%)
  • Short-Term Borrowings – $115 Billion (6%)
  • Long-Term Debt – $258 Billion (15%)

The more weighted the sources are towards non-interest and traditional customer deposits, the greater the leverage of the portfolio. With Wells Fargo, 79% of the source of funds for loans is from the traditional patron deposits at the bank. Let’s look at how some other banks leverage their respective portfolios (data is sourced from their respective 2019 annual report):

Bank                                    Non-Interest Sources      Traditional Deposits        Borrowings         Leverage
Wells Fargo                                     25%                                54%                               21%                      79%
Bank of America                            20%                                 48%                               32%                      68%
Comerica Bank                               55%                                 44%                                 1%                      99%
Bank of New York Mellon             17%                                 61%                               22%                      78%                                          

The greater the leverage, the higher the intrinsic value for the particular stock. Some simple math illustrates the value utilizing inexpensive sources of funds to finance the earning assets portfolio. In accordance with two of the largest banks in the United States, they pay approximately .7% interest with traditional sources of capital. The average loan pays back to the bank about 3.8%. The net interest earned is 3.1% on average. Thus, if a bank can increase its traditional source of capital by $100 Billion, it can increase its net interest earned about $3 Billion. Assuming a cost of approximately two-thirds to manage the additional loans, the net increase to the bottom line is $1 Billion. A typical large bank will have about 5 Billion shares outstanding. Thus, an increase of $100 Billion sourced from traditional depository accounts can add about 20 cents of value per share per year. A reasonable multiplier of this is ten; thus $100 Billion of additional traditional sourcing of capital adds about $2 of intrinsic value to a bank’s stock. To develop a pattern of growth, look at least the last five years of traditional sources of capital to determine the average growth of deposits and in turn calculate the additional amount to add or subtract to the tangible book value to determine intrinsic value. 

Remember, this isn’t perfect and accurate math; intrinsic value is an approximation. It does not have to be accurate to the penny. The key is to determine an approximate value plus or minus a few dollars. To illustrate, let’s look at Comerica Bank’s sources of capital over the last five years (2015 – 2019).

Year     Non-Interest Bearing    Traditional Accounts    Total Patron Deposits          Change
2014            $25 Billion                         $29.8 Billion               $54.8 Billion
2015           $28.1 B                                $33.2 B                       $61.3 Billion                   $6.5 Billion
2016           $29.8 B                                $33.0 B                       $62.8 Billion                    $1.5 Billion
2017           $31.0 B                                $31.5 B                       $62.5 Billion                   ($.3) Billion
2018           $29.2 B                                $32.6 B                       $61.8 Billion                   ($.7) Billion
2019           $26.6 B                                $36.2 B                       $62.8 Billion                   $1.0 Billion
Average                                                                                                                              $1.6 Billion

Comerica’s average yearly increase with customer deposits is $1.6 Billion. Its net interest margin is 3.5%. Thus, the growth of interest is approximately $56,000,000 per year. The net contribution towards bottom line profit is about one-third of this amount; thus, the average increase of value per year is $18.5 Million. Using a multiplier of ten to determine aggregated contribution towards intrinsic value, the total equals $185 Million. Comerica has 150 Million shares outstanding. Therefore, this ability to leverage the portfolio adds about $1.23 per share.

Don’t expect this part of the formula to add more than $4 per share. In order to increase intrinsic value this much, the average increase with traditional patron deposits would have to exceed $5 Billion per year on average. Larger banks are adding $20 to $30 Billion per year in additional patron deposits. However, since their total outstanding shares are in the billions, the average increase to intrinsic value is still in the $1 to $4 range. The key is to look for positive growth in this part of the sources of funds for loans. Negative change reverses the results. 

This is just one of the contributing attributes towards the final intrinsic value formula. The next attribute relates to the loan portfolio itself. Here, the more risk the bank takes by shifting the portfolio towards more riskier loans (consumer and revolving charges) the greater the net interest earned. However, there is a counter offset to this. Thus, value investors pay close attention to the portfolio’s makeup.

Intrinsic Value – Net Interest Income

With the exception of super large financial institution like JP Morgan Chase, a bank’s primary source of revenue is net interest. Unlike traditional financial income statement presentations, banks net the gross interest earned against the associated interest expense to get net interest income. In the prior section, more than 50% of the bank’s revenue is tied to net interest; there are a couple of exceptions to this rule because these banks focus on alternative sources of revenue and deliberately shy away from the traditional loan portfolio as their primary source of income.

Net interest is directly correlated to the loan portfolio’s makeup. Many banks prefer to reduce risk by having portfolios that are weighted towards better credit worthy financial instruments. For example, banks will buy government bonds, authority bonds and high quality industry bonds. These bonds pay less interest per dollar of basis; but they have strong credit backing which reduces and in many cases eliminates any reserve for bad loans.

Some banks will have a vast array of loans from government securities all the way to some of the higher risk consumer loans. With these types of loan portfolios, the bank earns more interest per dollar lent and of course their respective cost of interest is similar to other banks; especially if their leverage (traditional patron deposits) is high.

With this knowledge, it is important for the value investor to understand net interest income and the best term used in this industry is net interest margin.

The better banks issue both quarterly and annual reports with a particular report included. This report is called the ‘Average Balances and Interest Rates’. The report breaks out the earning assets portfolio into the respective groups and identifies the average interest rate earned from that group of loans. Here is a snippet of Bank of America’s report from 2019:

Intrinsic Value


Total earning assets are $2,040 Billion ($2 Trillion) with the strongest earning segment of consumer loans earning on average 5.17%. This is driven by credit card interest earned at 10.76%. Notice before consumer loans are deposits with other banks, government securities and traditional debt securities (bonds with large corporations). Notice how government securities have very low interest rates on average.

In the bottom part of earning assets are commercial loans. Here, interest rates are much better than government or traditional bonds; but there is a different risk factor for this portion of the earning assets portfolio.

At the very bottom are the non-earning assets such as cash at the branches, and other assets such as fixed and intangible assets. Look at the total loan portfolio as a percentage of all assets; for Bank of America it is 84%. Thus, Bank of America’s loan portfolio as a percentage of total assets is slightly lower than other banks (see above Business Model section).


Notice the final yield rate for all loans – 3.52%. Bank of America’s interest expense is 1.49% with a net interest income of 2.04%.


As a value investor, you must monitor this net interest income yield and ensure that the five year average is NOT decreasing. Stagnant or increasing average yields are a good sign.

Actual net interest income in dollars is a function of interest yield and the volume of earning assets. If both are improving, this is a very positive sign and it improves the intrinsic value formula (50 cents to a $1 per share). The key is to identify the average over time for the respective bank. If only one of the elements is improving, then adjust the intrinsic value amount only slightly higher. If both elements of net interest income are stagnant or indicating negative trends, intrinsic value is adjusted lower.

To illustrate, look at Bank of America’s trend for a five year period from 2014 to 2019 (six years is required to get a five year average change).

Bank of America
Average Earning Assets Portfolio and Interest Rates
Year          Earning Assets Balance     Change      Net Yield        Change       Total Earnings Delta
2014                $1,809 Billion                                      2.08%                               (Table 6 2019 Report)
2015                $1,825 Billion             $16 Billion       1.95%            (.13%)            ($1.8 Billion)
2016                $1,867 Billion             $37 Billion       2.01%              .06%              $2.5 Billion
2017                $1,922 Billion             $55 Billion       2.13%              .12%              $3.8 Billion
2018                $1,980 Billion             $58 Billion       2.08%             (.05%)            $2.9 Billion
2019                $2,040 Billion             $60 Billion       2.04%             (.04%)              $.7 Billion
Average                                            $45.2 Billion                             (.008%)         $1.62 Billion

Just as with the leverage formula from above, take one-third of the average improvement as the net bottom line improvement. In this case, the average per year improvement related to net interest increase is $540 Million per year. With a multiplier of 10, this equates to $5.4 Billion of value overall. Bank of America has 8.8 Billion shares outstanding. This means that the net interest income changes the intrinsic value about 60 cents per share. Why so little? The key is that there should be growth every year with net interest income. In order to add any real value to the intrinsic value formula, the increase must be extraordinary. Change must exceed five or more percent per year; year over year for at least three years to move the needle related to the intrinsic value formula for a bank.

With growing banks, it is common to see extraordinary growth in earning assets from one year to the next which then significantly improves the net interest income delta from one year to the next. Thus, it is possible to see upwards of three dollars improvement to intrinsic value from this one attribute of a bank’s financial information. However, expect one to two dollars per year if the total net interest income delta is improving. The key is to discover any negative delta as this is an eyebrow raiser with the intrinsic value formula.

There is no consistency between the financial statements among banks. Some banks report the net interest income NET OF PROVISION FOR CREDIT LOSSES; whereas others place this adjustment after all income is combined (net interest and non-interest income). Thus, it is important to be consistent with your formula. Either way is acceptable, as long as it is adapted across the board when comparing bank stocks.

The take-away from this part of the intrinsic value formula is this: growth in a bank’s bottom line is driven by net interest income increases. In effect, the annual change is driven by an increase in earning assets and an improvement in net yield (gross yield less interest expense). In order to generate improvements of at least $1 per share for intrinsic value, the delta with earnings from net interest income from one year to the next must exceed five percent. Normal increases are in the three to five percent range. Thus, intrinsic value cannot increase unless there is more than five percent improvement year over year. 

Calculating Intrinsic Value for Bank Stocks

Calculating intrinsic value for bank stocks is an eight step formula. The first step involves setting the barriers of intrinsic value. The second step determines what level of growth the particular bank is experiencing. This second step helps to set the numerical multiplier for several other steps. With step three, the value investor investigates the compliance factor with the formula. In step four, the leverage ratio is evaluated and this adjustment is applied to the basis. Step five modifies the basis for the net interest factor. In step six, two other consolidated elements of the income statement are analyzed and a value factor is inputted into the formula. The seventh step addresses other comprehensive income and its impact with intrinsic value. Finally, it is all put together in step eight, the final intrinsic value.

At the end of this section, the author explains how to adjust this intrinsic value on an annual basis. Once the core model is built for the respective bank, the annual adjustments take very little marginal time and then, the value investor will have their intrinsic value for a bank stock.

Step One – Set the Barriers

One of the most popular intrinsic value formulas is the discounted earnings formula. It mirrors a formula promulgated by Benjamin Graham, the father of value investing. The discounted earnings formula is a standard formula used with many spreadsheet software. In layman’s terms, it is simply the current present value of a stream of future earnings discounted by a reasonable rate. It is similar to the discounted cash flows formula, however, the earnings formula adds a terminal value at the end. If the stream of discounted earnings extends beyond 25 time periods, it is almost purely similar to discounted cash flows. In a typical discounted earnings formula, there is some growth associated with earnings from year to year. Since growth is very difficult to predict, many value investors ignore this and modify the formula to mirror discounted cash flows. Many investors use five to seven percent discount rates. The formula is:

Present Value of Discounted Earnings = Earnings Yr 1  + Earnings Yr 2 = Earnings Yr 3 +  … pattern repeats to 25
.                                                                   (1 + Rate)¹         (1 + Rate)²          (1 + Rate)³

As an example, the average earnings per share for Wells Fargo over the last five years 2016 – 2020 equals $3.40. This EPS is weighted down by the poor performance in 2020 which is direct result of the pandemic and the compliance requirement imposed by the Federal Reserve. Given this, Wells Fargo’s present value of discounted future earnings at a 6% discount rate equals $43.46. Each additional year of earnings beyond 25 years only adds about 50 cents per year.

The problem with this formula is that it has more credibility if the following conditions are met:

  1. Earnings are stable over an extended period of time (at least the last seven years);
  2. The respective company is well managed;
  3. The particular earnings are sourced from a respected and necessary industry in the economy;
  4. In general, the company is growing faster (even slightly is acceptable) than the economy even during recessions;
  5. The industry and the economic sector is stable and maintains its position within the Gross Domestic Product formula.

Overall, the banking industry and the financial sector comply with the above conditions. However, Wells Fargo has not had a good history of being well managed and in 2020, its earnings fell dramatically due to the imposed cap on total assets. After all, the Federal Reserve specifically pointed out issues not only with the Chief Executive Officer but also with several members of the Board of Directors back in 2018. Thus, the current replacement team has not had enough time to demonstrate a well managed company. The $43 valuation using the discounted earnings tool is likely high at this point in time (February 2021).

Wells Fargo currently reports at the end of the 4th quarter 2020 the following:

Book Value Per Share                       $39.76
Tangible Book Value/Share              $33.04

Thus, to set the ceiling value for intrinsic value, it cannot exceed 125% of traditional book value. This equals $49.70. The floor, is 66% of traditional book value; for Wells Fargo this equals $26.50. Thus, the intrinsic value will end up between $49.70 and $26.50 when this valuation method is completed.

Notice how the discounted earnings formula indicates $43 per share; this is towards the higher value of the floor and ceiling values set as barriers.

Since the ceiling is much higher than the discounted earnings method and the discounted earnings method is not 100% reliable because Wells Fargo fails two of the six conditions required to consider the discounted earnings method, this means the adjusted ceiling is now set to $43. Therefore, the floor remains at $26.50 and the ceiling is now $43. For the purposes of the following steps, the starting point is tangible book value at $33.04.

Step Two – Determine Level of Growth 

Continuing with Wells Fargo, can Wells Fargo grow? The answer is a definite NO. Due to the compliance restriction place on the company, assets are capped at $1.925 Trillion. The only thing Wells Fargo can do is to transition as much borrowed funds into traditional deposits thus upping its leverage. This in turn will increase the net interest earned margin which is the only available method tied to earning assets to increase net income. This is covered more in-depth with step five of this calculation. For now, Wells Fargo cannot grow and thus, this negatively impacts the intrinsic value for this stock. 

Since the cap placed on Wells Fargo by the Federal Reserve is now three years old (placed on Wells Fargo in February 2018) and the Federal Reserve is expecting results for its requested changes; it is safe to assume these changes will be completed and the restraint lifted within the next two years. Once this is done, assuming Wells Fargo has shifted its funding sources towards customer deposits and away from borrowed money; it should be able to expand its earning assets quickly by simply borrowing money. This instantaneous expansion will result in immediate and strong growth with its earning assets, specifically loans. Given this, a reasonable value investor would not immediately assign a negative value; three years ago, it would have been definitely a negative value. Instead, for now, a value investor would take a neutral position and not modify tangible book value higher nor lower due to the level of growth. If anything, there might be a slight indication of a more than 1:1 factor and begin to look at a 1.1 or even a 1.2 factor application for the respective value adjustments in Steps Four and Five.

Those banks with strong growth rates or showing signs of favor would get growth factor multipliers of 1.2 to 1.5 when used in Steps Four and Five below. Banks in disfavor or having difficulty keeping up with the industry, the multiplier factor would drop to .9 or in really severe cases .8. In Steps Four and Five it is explained how this multiplier is used.

Step Three – Compliance Adjustment

Go to all four compliance organizations to research any compliance issues associated with the particular bank for this intrinsic value calculation. It is not uncommon to have one or two of the organizations issuing some form of failure to timely file reports or issue late filing penalties. What a value investor is really seeking is any direct order to change the banks upper management team or officers. This is a huge red flag. In addition, in rare situations, the particular company may be under observation or have an order to change a policy or internal control to improve overall operations. These types of directives are punitive in nature and will affect net income significantly. 

A good example is Wells Fargo’s Federal Reserve order to stop growth until they create a better monitoring of bank programs to prevent misleading the public. This particular order has already caused Wells’ Fargo to have no growth during 2018, 2019 and 2020. It is estimated that this directive will take at least another year to fulfill. Once done though, the bank should grow quickly and at a robust rate for a couple of years. For now, this compliance order is considered a severe case and a value investor should adjust the tangible book value downward. Since the bank was able to generate a small amount of net earnings per share in 2020 (40 cents/share), the compliance adjustment is not as severe as it was with 2018’s formula. Here are the guidelines to follow for intrinsic value related to open compliance requirements:

                                                                                                                      Ranges of Tangible Book Value
Penalty Source                                                           <$25/Share         >$25 to <$40/Share     >$40 to <$60/Share        >$60/Share
Federal Reserve
   Severe Directive                                                       ($1/Share)                  ($2/Share)                      ($3/Share)             ($4/Share)
   Any Notice/Warning                                                     –                             ($1/Share)                       ($2/Share)            ($3/Share)
Office of Comptroller of the Currency 
   Bank Operational Issue                                                 –                                  –                                      –                       ($1/Share)
   Criminal Activity                                                      ($1/Share)                 ($2/Share)                       ($3/Share)             ($4/Share)
   Unauthorized Activity                                                   –                                 –                                         –                     ($1/Share) 
Federal Deposit Insurance Corporation                      –                             ($1/Share)                       ($2/Share)             ($3/Share)

Since Wells Fargo’s directive is severe and their tangible book value falls within the $25 to $40 range, there should be at least a $2 per share downward adjustment.   

Thus, through Step Three, Wells Fargo’s intrinsic value formula stands as follows:

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                         $33.04 
Step Three – Compliance Adjustment                               (2.00)     

Step Four – Leverage Adjustment

From above, leverage refers to how much of the earning assets are capitalized by traditional deposit accounts with the bank. If this leverage is increasing, it is an excellent sign of financial management. As leverage increases, net interest income increases due to reduced interest expenses. This is Wells Fargo’s five year history of leverage.

Year        Earning Assets    Sourced from Traditional Patron Accounts    Borrowings    Total Leverage   Traditional Deposits Leverage
2015         $1,572 Billion                       $1,194 Billion                                    $289 Billion           94.3%                               76.0%
2016         $1,711 Billion                       $1,251 Billion                                    $371 Billion           94.8%                               73.1%
2017         $1,777 Billion                       $1,304 Billion                                    $337 Billion           94.1%                               73.4%
2018         $1,738 Billion                       $1,276 Billion                                    $343 Billion           93.7%                               73.4%
2019         $1,754 Billion                       $1,286 Billion                                    $374 Billion           94.6%                               73.3%
2020         $1,772 Billion                       $1,380 Billion                                    $323 Billion           95.9%                               77.9%

The breakout of the traditional patron accounts is as follows:

Year       Interest Bearing      Non-Interest Bearing
2015           $855 Billion                $339 Billion
2016           $891 Billion                $360 Billion
2017           $939 Billion                $365 Billion
2018           $918 Billion                $358 Billion  
2019           $942 Billion                $344 Billion
2020           $926 Billion                $454 Billion    

Notice the distinct shift towards traditional patron accounts in 2020? Why? Again, one tool available to banks to improve the quality of their net interest earned is to shift the sourcing of funds to finance earning assets towards traditional patron accounts. Traditional patron accounts have an overall lower effective interest rate thus improving the net interest margin. Furthermore, look at Wells Fargo’s traditional patron account breakout in 2020. They even improved the quality of the ratio of non-interest bearing to the overall source. This is a significant improvement in the quality of the interest earned for the bank. Remember, the Federal Reserve’s penalty restriction doesn’t allow Wells Fargo to expand their pool of total assets. Thus, the bank has resorted to improving the quality of the sourcing of funds which in turn lowers the overall effective interest rate for the net interest income aspect of operations.

This means that when the cap is lifted (expected in late 2021 or early 2022), Wells Fargo can quickly increase their size of earning assets by using borrowed funds to increase the size of the pool of earning assets. If Wells Fargo decides to leverage with more borrowed sources and revert to the historical 73.4% traditional leverage, it can increase the earning assets pool a whopping $100 Billion instantly. This $100 Billion of additional earning assets will generate another $2 Billion of net interest margin. This will add around $800 Million to the bottom line of the bank. Earnings per share will increase 20 cents. This may not seem like a lot, but what is really important here is that the bank can also increase their pool of interest bearing deposits too. The bank should be able to add another $200 Billion of earning assets in a short period of time (about two years) and really increase the aggregated net interest generated. Once the overall interest rate improves to pre-Covid rates; overall bottom line net interest income will close in on the 2015 2.9% range. At 2.7%, bottom line profits will improve from the current year (2020) $3.3 Billion to more than $22 Billion. This means earnings per share will shift from a current 41 cents per share to $5.30 per share. The average earnings per share from the prior five years will improve to almost $4 per share and thus the discounted earnings formula result will improve to $45 to $46 per share from the current $43 per share.

This leverage opportunity adds $2 per share for intrinsic value. In effect, the quality of Wells Fargo’s current position allows them to leverage up once the cap is removed from the bank. Furthermore, the level of growth factor from Step Two above is about a 1.2 multiplier given the situation. Thus, leverage for Wells Fargo adds about $2.40 per share. The updated formula now stands as follows:

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                                    $33.04 
Step Three – Compliance Adjustment                                          (2.00)
Step Four – Leverage Capacity                                                      2.40

Step Five – Net Interest

Look at Wells Fargo’s net interest revenue, net marginal interest rate and net profits from the last six years.

Year       Net Interest Revenue   Net Marginal Interest Rate     Net Profit
2015           $46.4 Billion                         2.95%                             $22.9 Billion
2016           $49.0 Billion                         2.86%                             $21.9 Billion
2017           $50.9 Billion                         2.87%                             $22.2 Billion
2018           $50.7 Billion                         2.91%                             $22.4 Billion
2019           $47.8 Billion                         2.73%                             $19.5 Billion
2020           $39.8 Billion                         2.27% *(See Note)           $3.3 Billion

*Interest rates as a whole in the entire market went down driven by multiple government programs and the devastating effect of the COVID pandemic.

Notice the best year was back in 2018 when net interest revenue was $50.7 Billion and the net interest margin was 2.91%? In 2020, the net interest margin drops .6% from 2018’s much higher rate. The additional .6% interest would have earned another $10.6 Billion on the $1,772 Billion of earning assets had the loan rate averaged 2018’s rates. This would have added $2.50 per share as there are no marginal costs involved to service the loans.

A common question concerning intrinsic value calculations is: ‘Does the formula use the current actual or the projected future earnings to determine intrinsic value?’. The answer is neither. The correct method is to use the average of the last few years, the longer the look back, the more reliable the result. Using the last six years of net interest, the average is $47.4 Billion per year. This means, 2019 is the most likely outcome for earnings per share as an average. In that year, Wells Fargo earned $4.05 per share on 4.4 Billion shares. Today, Wells Fargo has 4.1 Billion shares outstanding which means the actual earnings per share would be $4.30. 

For the purpose of this section, notice that the actual difference between 2019’s net profit and 2020’s net profit is $16 Billion. This means each share would earn an additional $4 per share on average boosting the current tangible book value. If one were to extrapolate out for three years, this is $12 more than the current tangible book value. Thus, adding $4 per share is a reasonable estimate of value associated with net interest income for Wells Fargo. Using the multiplier from Step Two above, it is reasonable to multiply the $4 by a factor of 1.2 given Wells Fargo’s potential growth. Thus, it is reasonable to add $4.80 to the intrinsic value formula for net interest income.

Yes, a value investor could be aggressive and add $12 to the tangible book value; but, remember what intrinsic value is about. Intrinsic value is about determining a fair and reasonable value one would expect to receive in a worst case scenario. If an investor gets too aggressive and the worst case materializes, the value investor would lose money. It is better to be conservative and buy the stock at a lower price than to buy at a price that isn’t going to provide pure protection from all the associated risks of investing.

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                                    $33.04 
Step Three – Compliance Adjustment                                          (2.00)
Step Four – Leverage Capacity                                                      2.40

Step Five – Net Interest                                                                  4.80

Step Six – Consolidated Elements

There are two other important contributing factors towards the bottom line of a bank’s financial income statement. The first is other non-interest income sources. From above, banks provide more than just traditional loans; banks also earn revenue from issuing credit cards, servicing those bank deposits, providing fiduciary services and providing letters of credit to commercial customers. In addition, banks also have expenses.

Non-interest income varies among banks. Wells Fargo is a traditional bank and its primary source of revenue is net interest. Whereas, Bank of New York and JP Morgan rely more on non-interest sources of income to contribute value to the bottom line. Thus, when comparing banks and calculating intrinsic value, if the bank is more reliant on non-interest sources of revenue, adjust the formula more towards a service based operation than a traditional bank operation. Service based operations generally have a more liberal intrinsic value adjustment than capital based operations (traditional banking is capital intensive). 

Wells Fargo has not experienced any real increase in its non-interest bearing income over the last five years. Thus, there is no basis to either increase nor decrease the intrinsic value formula tied to this particular consolidated element of the income statement.

A term used with key performance indicators with banking is the efficiency ratio. The efficiency ratio is the dollar costs per dollar of net revenue to service the bank. These costs include employee compensation, technology, occupancy, professional outside services, promotion and compliance. 

What is interesting with the efficiency ratio is that it can be easily misinterpreted. If aggregated revenue decreases as a function of lower interest rates as illustrated with 2020’s net interest, the efficiency ratio will increase if there are no other changes. Thus, do not look at the ratio as a percentage, look at expenses in aggregated dollars. Here are Wells Fargo’s expenses for the last five years:

Year            Expenses
2016          $52.4 Billion
2017          $58.5 Billion
2018          $56.1 Billion
2019          $58.2 Billion
2020          $57.6 Billion

Notice that from 2018 to 2019, expenses increased $2.1 Billion driven by the increase for compensation for employees. This is a red flag for many. Prior to 2016, Wells Fargo only had one year where total non-interest expenses exceeded $50 Billion. It is only during the last five years that expenses have accelerated and it is driven by employee compensation. The bank definitely needs to get this under control. A good sign is of course the half billion dollars decrease in non-interest expenses during 2020. However, it is unlikely that the bank will get non-interest expenses below $57 Billion in the near future or anytime in the future. 

In order to affect the intrinsic value formula, the average would need to change $4 Billion in order to change the intrinsic value formula by one dollar per share (4.1 Billion shares outstanding). The average of non-interest expenses over the last five years is $56.6 Billion, the current year is $57.6 Billion. Thus, the current amount is $1 Billion over the average. This would only warrant decreasing the intrinsic value by 25 cents per share.

For the purpose of this section, the intrinsic value formula is modified as below:

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                                    $33.04 
Step Three – Compliance Adjustment                                          (2.00)
Step Four – Leverage Capacity                                                      2.40

Step Five – Net Interest                                                                  4.80
Step Six – Consolidated Elements                                                  (.25)

Step Seven – Other Comprehensive Income

The final adjustment is difficult for non-accountants to understand. Other comprehensive income is not included on the income statement. It is specifically excluded under Generally Accepted Accounting Principles because it reflects unrealized gains on securities and changes in derivatives the bank purchases to control loan risks. Think of it as the value that is unrealized with your investment portfolio. It is only recognized on the income statement once the respective securities mature, are sold or dissolve. In the interim, they are aggregated as a single value in the equity section of the balance sheet.

Each year the bank is responsible to determine how much change exists in this portfolio of various investments and temporarily add this value to the equity section of the balance sheet. In 2019, lifetime to date comprehensive income that is not included in the income statement sits at a negative $1.3 Billion and is included in total equity. At the end of 2020, this account’s balance is a positive $200 Million. This particular line item can fluctuate wildly because the stock market is unpredictable. Thus, comprehensive income is important to consider but one should be mindful that its underlying value is fleeting and thus a very conservative valuation is necessary to protect against sudden or long-term large market decline in overall value. 

When reviewing financial statements, consider this element only if there is a significant change in value affecting tangible book value by more than $2 per share in any form (positive or negative). If less than $2 of per share impact, then only include this value change by a factor of 25% of the total dollar impact on the shares. BUT only if the value is $2/share or more of an impact in the equity section of the balance sheet.

The change from 2019 to 2020 was $1.5 Billion positive but since this is significantly less than $2 per share (4.1 Billion shares); there is no need to modify the intrinsic value. It is built in with the tangible book value.

Here is the formula updated to include other comprehensive income:

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                                    $33.04 
Step Three – Compliance Adjustment                                          (2.00)
Step Four – Leverage Capacity                                                      2.40

Step Five – Net Interest                                                                  4.80
Step Six – Consolidated Elements                                                  (.25)
Step Seven – Other Comprehensive Income                                    –

Step Eight – Calculate Intrinsic Value

At the beginning of this article, the bank business model was explained. Banks have two sources of revenue and a set of expenses. The primary source for the traditional banking model is net interest and it is effectively the difference between total interest earned and the interest paid out. This value is impacted by both leverage and the interest rate for earnings. 

With Wells Fargo, its overall ability to earn money is negatively impacted by a penalty imposed by the Federal Reserve. Once lifted, this will add several dollars of value to the stock because the bank can improve its leverage and expand the size of the pool of earning assets. 

The intrinsic value formula takes all these factors into consideration. The current intrinsic value is $38 per share calculated as follows:

Floor Value (66% of Traditional Book Value)               $26.50 (Minimum)
Ceiling Value (125% of Traditional Book Value)          $49.70
Adjusted Ceiling to Discounted Earnings                      $43.00 (Maximum)
Starting Point – Tangible Book Value                                    $33.04 
Step Three – Compliance Adjustment                                          (2.00)
Step Four – Leverage Capacity                                                      2.40

Step Five – Net Interest                                                                  4.80
Step Six – Consolidated Elements                                                  (.25)
Step Seven – Other Comprehensive Income                                    –     
Step Eight – Final Value                                                            $37.99

Does this seem reasonable? The answer is YES. First the value is within the floor/ceiling range. Secondly, it is less than the traditional earnings per share discounted valuation outcome. That particular formula is only effective if the stock is high quality with consistent earnings AND is well managed. Wells Fargo does not have a current history of good management nor consistent earnings. The discounted earnings tool is merely a validation tool for intrinsic value.

Overall, Wells Fargo’s intrinsic value is approximately $38 per share. Its current tangible book value is $33 per share and its traditional book value is $40 per share. In 2020, each share earned 41 cents with an historical earnings of $4 to $5 per share. This prior year poor results are a reflection of multiple factors impacting the ability to earn better net income. Even though Wells Fargo was leveraged well, the market interest rates charged by banks affected the final net interest earned. Furthermore, Wells Fargo is not allowed to grow, it has improved its portfolio of investments; but until that cap restriction is removed, the ability of the bank to earn more than $5 per share is hampered. 

As Wells Fargo nears the release of the cap restriction, Wells Fargo’s intrinsic value will most likely jump to $42 to $44 per share in late 2021. For now, owning Wells Fargo for less than $38 per share is a very secure investment. It is likely that the stock’s market price will soar to $45 to $48 per share over the next year, especially as the bank gets closer to having the restriction removed. At the writing of this article, the current market price for Wells Fargo is $33 per share (02/07/2021). This current market price provides a 13% margin of safety, i.e. it is selling at 87% of intrinsic value. 

In summation, the intrinsic value for a bank tends towards tangible book value. For banks that are growing, the intrinsic value will improve towards the traditional book value per share. For high quality banks with an excellent history of earnings and good management (no compliance issues), intrinsic value will exceed traditional book value. However, DO NOT BUY BANK STOCK FOR MORE THAN 125% OF TRADITIONAL BOOK VALUE; there is no marginal gain to be earned for buying bank stock at such a high price. Anytime the stock can be purchased for two-thirds of traditional book value; it is a super buy. Remember, value investing only considers high quality, highly stable large companies (top 2,000 ranking). Act on Knowledge.

Value Investing Episode 1 – Introduction and Membership Program