The primary determinants of bank stock valuation are, as is well known, return on equity relative to the investors' required return, and the earnings growth rate. In the late '80s, however, the time-tested formula that relates these two variables to the ratio of a bank's market value to its book value did not seem to apply. Credit quality - i.e., loan-loss volatility - supplanted profitability and growth as the principal driver of bank stock prices.
Recent analysis done at our firm shows that this is no longer the case. Today, about two-thirds of the variation in market-to-book ratios at 30 large regional and superregional institutions can be explained by these banks' projected ROEs and growth rates. Comparatively little of thisvariation is traceable to differences in credit quality and credit risk.