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Buffet’s Key to Bank Valuations

In a recent CNBC interview, Warren Buffet cited the direct impact that a bank’s return on assets (ROA) should have on the book value multiple (P/BV) at which it trades.  Basically, the higher the ROA, the higher the multiple.  Here’s the direct quote:

“…well, a bank that earns one — 1.3 or 1.4% on assets is going to end up selling above tangible book value.  If it’s earning 0.6% or 0.5% on assets it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks.”

Buffet was referring to the valuation gap that exists between some of the large U.S. banks but let’s see if this logic holds true for the Canadian banks as well.

Company

Return on Assets

Price to Tangible Book Value

Royal Bank (TSX:RY)

0.9%

2.9

Bank of Nova Scotia (TSX:BNS)

1.0%

2.6

TD (TSX:TD)

0.9%

2.5

CIBC (TSX:CM)

0.8%

2.4

Bank of Montreal (TSX:BMO)

0.8%

1.9

Source:  Capital IQ

Foolish Takeaway

The distinct relationship that Buffet is referring to is not nearly as well illustrated by the Canadian banks because of the narrow ROA range that exists.  Based on these figures however, the valuations ascribed to Royal on the high side and BMO on the low appear slightly out-of-whack with the rest of the group.

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Fool contributor Iain Butler does not own shares in any of the companies mentioned at this time.  The Motley Fool has no positions in the stocks mentioned above.

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