Multiple envy

Wells Fargo and US Bancorp raise Citi bar higher

Wells Fargo and US Bancorp are raising the bar even higher for slowly recovering rivals like Citigroup. Many banks struggling to put the effects of the financial crisis behind them target a return on equity of 10 per cent, aiming to placate long-suffering shareholders. That would be enough to cover the cost of capital, but maybe not much else.

With three big US lenders reporting tepid results on Friday, it brings broad industry valuations into sharper focus. These days, there tends to be a simple and direct correlation between returns and multiples of book value. J P Morgan, for example, which generated an annualised 10 per cent in the second quarter, trades right at one times the value of its assets minus liabilities. Bank of America, which is due to unveil second-quarter earnings on Monday, trades at 60 per cent of book value, against a six per cent annualised return on equity analysts are expecting.

There are some small variances. Citigroup also is being valued at 60 per cent of book value, even though in the three months to June it cranked out an annualised equity return of seven per cent. Boss Mike Corbat is making progress, but the bank's propensity for stumbling into virtually every crisis since the 1980s may be keeping shareholders from giving Citi the benefit of the doubt.

Earning more than the cost of capital, however, can turbo-charge a valuation. US Bancorp, for example, cranked out a 13.8 per cent return on equity last quarter, sustaining its years-long run as the nation's best performer. It trades at 72 per cent above book value. Wells Fargo, meanwhile, is worth a third more than book after earning an 11.7 per cent return.

Shareholders even will be forgiving in such instances. Wells Fargo in May cut its targets and that may explain why its shares only have increased six per cent since February. J P Morgan's are up 20 per cent and Citi's 27 per cent. Expectations that Wells Fargo boss John Stumpf will keep returns up are buoying its valuation multiple, however.

Laggard lenders of course will be happy just to achieve the baseline multiple of book value that suggests a nod of approval from shareholders. By the time they do, though, the outperformers may already have powered substantially further ahead.