US Earnings Season: Will banks' results justify their valuation?

US banks will start reporting their Q4 2016 results on Friday. Investors will be on the lookout as to how good their earnings are compared to how much their stocks have gone up by in the last two months.
By Markets Chimp

1/11/17 11:49 PM


By end of this week, a slew of earnings reports by some of the largest US banks will come out. Specifically, Bank of America, JPMorgan Chase and Wells Fargo will kick off the earnings season for financials on Friday. Meanwhile, Morgan Stanley, Goldman Sachs and Citigroup will follow with their earnings reports next week. Investors will be looking forward to this earnings season in specific because of two points:
(1) Financials stocks have been amongst the top performers following the Trump victory in the US presidential elections.
(2) Valuation levels as indicated by price-to-book value ratios have been increasing as well.

The question is now, will banks deliver enough earnings to justify the now-higher-than-two-months-ago valuation levels? For one, interest rates have recently been hiked, so banks should start seeing their net interest margins (NIMs) expand. However, with USD rates raised only mid-December, Q4 2016 results will not be reflecting the full impact of the rate hike just yet. This is why other investors may care less about the strength of earnings growth spit out by banks in Q4 2016, as they have been bidding the shares higher in expectations of more than just a set of quarterly results. They have been betting that banks will benefit off higher interest rates, stronger economic growth, and healthier trading activity.

Again, for investors to get a sense of where banks valuation should be, they can simply compare each bank's return-on-equity (ROE) ratio versus its cost of equity (COE). In other words, the higher the ROE versus COE, the higher investors should be willing to pay for a bank's stock above its book value. Some US banks continue to trade below book value, which quite understandable given their current ROE which fall well below COE. Example is Bank of America. Meanwhile, other US banks trade at a premium to book value, thanks to their ROE which exceed COE. Examples are JP Morgan Chase and Wells Fargo.

So, we think investors will rather study banks' earnings releases (both numbers and management discussions) to look for any sign of change, be it positive or negative.


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