Valuation of Canadian Banks

Book value is the key metric, adjusted for return on equity

Canada’s Big Five banks follow tight accounting rules (IFRS) and are closely supervised by the Office of the Superintendent of Financial Institutions (OSFI). Since the vast majority of a bank’s assets and liabilities are financial and not physical, tangible book value is about as good a valuation of a bank as any you might dream up, except that some banks systematically earn higher returns on equity than others so higher return on equity banks should and do command a premium valuation if that higher return is expected to persist.

If you buy a bank stock at book value, you should expect a return equal to its return on equity (ROE), regardless of whether that return is in the form of dividends or price appreciation. If you buy at a premium or discount to book value, your actual return will be less or more than the bank’s ROE. A useful and simple method to account for the differing rates of ROE is to multiply ROE by the ratio inverse of the bank’s price to book value (BV) to estimate the expected return you should enjoy. Of course, the implicit assumption in this analysis is that ROE is more or less constant.

Take Canada’s most profitable bank in terms of ROE for example. Royal Bank (RY) has a book value of $87.33 estimated for 2024 and an expected return on equity of 14.1%. With Royal trading at $133.20 a share, Royal’s price to BV is 133.20/87.33 = 1.5 times. The return implied by this premium is 1/1.5 x 14.1 = 9.4%.

If you do the same exercise for each of the Big Five banks, you find the implied return on their shares to be:

CM - 11.5%
TD - 11.4%
BNS - 11.3%
BMO - 10.7%

Royal Bank’s premium market price implies RY investors returns will underperform Royal’s peers.

Many would argue that the differing outcomes reflect differing expectations for growth, and they would be right. But over the longer term, all of these banks will exhibit growth more or less equal to the growth in the Canadian economy and short term differences in growth rates will not persist indefinitely.

The “best buy” in the bank stocks today is a toss-up between CM,TD and BNS.