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Third-Quarter Bank Earnings: 7 Things Investors Need to Know

The largest U.S. banks have now reported their third-quarter earnings, and the results were generally positive. Investment banks Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) reported strong asset growth and merger-and-acquisition activity, and of the five largest consumer banks -- JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), and U.S. Bancorp (NYSE: USB) -- four reported strong performance.

With that in mind, here are seven takeaways from bank earnings that investors who are interested in the financial sector should know.

Image source: Getty Images.

1. Revenue is growing across the board (in most cases)

Loans and deposits are growing across the banking industry, investment assets have grown because of strong market performance, and rising interest rates have resulted in higher margins for banks. The combination has resulted in higher revenue for banks.

With the exception of Wells Fargo, which we'll discuss in more depth later on, the big U.S. banks saw strong revenue growth during the third quarter.

Bank

Q3 2017 Revenue Growth (Year Over Year)

Morgan Stanley

3%

Goldman Sachs

2%

Bank of America

1%

JPMorgan Chase

3%

Citigroup

2%

U.S. Bank

4%

Wells Fargo

(2%)

Data source: company earnings reports.

2. Profits are growing even faster

One major focus within the banking industry is efficiency. Banks are investing heavily in their mobile and online platforms and as a whole are reducing their physical footprints. Just to name one example, Bank of America has closed more than 100 branches in the past year and has seen a big increase in its mobile user base.

Thanks to improving efficiency, while bank revenue is rising, expenses haven't increased proportionally, which translates into profit growth that's far more impressive than the revenue growth indicated in the chart in the previous section. Continuing with the Bank of America example, its 1% revenue growth isn't too exciting, but 17% growth in earnings per share (EPS) is.

Bank

Q3 2017 EPS Growth (Year Over Year)

Morgan Stanley

15%

Goldman Sachs

3%

Bank of America

17%

JPMorgan Chase

11%

Citigroup

11%

U.S. Bank

5%

Wells Fargo

(18%)

Data source: company earnings reports.

3. Wells Fargo's quarter left a lot to be desired

As I mentioned, the banking industry had a generally strong quarter, with the exception of Wells Fargo. The fallout from the bank's infamous fake-accounts scandal has resulted in significant legal expenses and a general reduction in business. For example, Wells Fargo was the only big U.S. bank whose loan portfolio shrank over the past year. In addition, the bank's net interest margin was flat year over year, despite rising interest rates, and its r returns on equity and assets (ROE and ROA) of 9.1% and 0.94%, respectively, failed to meet the industry's 10% and 1% benchmarks.

While there's no way to know for sure how long and how much Wells Fargo's business will be feeling the effects of the scandal, it's certainly apparent in the bank's recent results.

4. Valuations are higher, but there's a lot of variation

Instead of valuing banks with the commonly used price-to-earnings ratio, or P/E, a better metric to use is the price-to-tangible book value (P/TB or P/TBV) ratio. This is a measure of how expensive a bank's stock price is, relative to the value of its tangible assets.

Over the past year or so, bank stock prices have risen considerably, and their valuations have soared as a result. However, there is significant variation in the big banks' valuations, as well as in how much they've improved.

Bank

Q3 2017 P/TB

Year-Over-Year Change

U.S. Bank

2.94

17.5%

JPMorgan Chase

1.85

39.1%

Wells Fargo

1.77

19.4%

Bank of America

1.58

63.2%

Morgan Stanley

1.49

43.7%

Goldman Sachs

1.35

35.6%

Citigroup

1.08

39.7%

Data source: company financials. Year-over-year change from YCharts.

5. Bank of America could be the most improved bank

In the P/TB chart, you can see that while bank stock valuations have risen across the board, no company's valuation has grown as much as Bank of America's. And there's good reason for this.

Specifically, in the years following the financial crisis, Bank of America was one of the least profitable and most inefficient of the big banks, and for this reason, the stock traded for a discount to tangible book value for much of that time -- even thoughout most of 2016. Its ROA and ROE were simply awful compared with what bank investors typically look for.

BAC Return on Equity (TTM) data by YCharts

Recently, Bank of America has done an excellent job of improving its asset quality and the efficiency of its operation, and the company is now on the verge of achieving profitability that meets the 10% ROE and 1% ROA benchmarks that investors generally like to see.

6. Banks seem to think their stocks are attractive

Share buybacks have been a major focus of the big banks this quarter, after their capital plans were approved earlier this year. Now, there are several potential reasons companies could choose to buy back stock. For example, Bank of America CEO Brian Moynihan recently said one reason the bank is prioritizing buybacks is that it's easier to reduce a buyback than a dividend.

However, the major reason companies focus on buybacks is that they feel their stock is attractively priced. During the third quarter, Goldman Sachs spent more than $2 billion on buybacks and reduced its share count to less than 400 million for the first time. JPMorgan Chase spent $4.5 billion on buybacks during the quarter, while Wells Fargo spent $2 billion, and Bank of America has spent nearly $8 billion on its stock so far in 2017.

7. Tax reform could be a major catalyst for banks

At this point, there's no way to know for sure if a tax reform or tax-cut package will be passed, nor do we know what the exact corporate rate would be.

Having said that, it's fair to say that tax reform could be a big catalyst for bank profits, whether the corporate rate turns out to be 20% as the GOP tax plan suggests, or even if it's as high as 25% like some experts think it will be. Banks are highly taxed -- here are the big U.S. banks' effective tax rates for the third quarter.

Bank

Q3 2017 Effective Tax Rate

Morgan Stanley

28.1%

Goldman Sachs

22.6%

Bank of America

32.6%

JPMorgan Chase

29.6%

Citigroup

31.1%

U.S. Bank

27.3%

Wells Fargo

31.2%

Data source: company earnings reports.

A solid quarter, and the higher stock prices look justified

Bank stocks have performed tremendously well over the past year or so, but there's a good reason for the upward movement. Revenue is up, profits are rising, and there are potential catalysts such as tax reform that could cause the banks' bottom lines to improve even further.

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Matthew Frankel owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.