How Risky Is M&T Bank?

M&T Bank (MTB -0.56%) reported lower-than-expected fourth-quarter 2016 earnings on Jan. 19. This less-than-stellar result caps a large increase in price that followed the entire banking industry over the bullish November-December period. I believe that M&T Bank has become overvalued, which could lead to poor performance over the next few years.

M&T Bank's stock price shot up recently

The chart below contrasts M&T Bank's performance, from Nov. 1, 2016 to today, to the entire bank sector -- in the form of the PowerShares KBW Bank ETF (NYSEMKT: KBWB) -- and to other regional banks -- represented by the SPDR KBW Regional Banking ETF (KRE -0.35%):

MTB data by YCharts.

While M&T has done well, it clearly matches other regional banks' performance over the same time period. I believe this is because some investors are buying up banks without considering how expensive they might be.

The reasons for this are complicated -- higher interest rates, lower taxes, and looser regulations could all benefit banks' bottom lines. But MTB has risen much more than can be justified by potential returns.

Current earnings vs. future earnings

Earnings per share (EPS) at the end of 2016 rose about 8% from last year, reversing a negative trend:

MTB EPS Diluted (Annual) data by YCharts.

Unfortunately, they were also slightly lower than analysts had expected. Investors mostly shrugged this news off, and the stock rose after the earnings announcement. That indicates investors are focused mostly on future earnings.

Looking at analyst predictions for future earnings paints a much rosier picture. Analysts are predicting an average five-year growth rate of 7.07% in net operating EPS. Astute investors will notice that this growth rate is for "net operating EPS," not regular GAAP (generally accepted accounting principles) EPS.

Analysts like to predict net operating EPS because it shows the performance of a company's vital profit-making segments, while ignoring taxes and one-time costs. It is easier to predict, and ideally increases in net operating EPS will translate into regular GAAP EPS.

When I see something that says "current earnings are not very important," I become concerned. Try telling your mortgage holder and landlord that and see what they say: I don't think they'll agree.

Two valuation methods for M&T Bank

One easy way to compare banks is the ratio of price to tangible book value (P/TBV), which measures market capitalization divided by tangible assets minus liabilities. It ignores intangible assets, like goodwill, and shows the price an investor pays per dollar of remaining assets. A lower value is generally better, since it indicates an investor can purchase the company's assets at a lower price.

MTB Price to Tangible Book Value data by YCharts.

You can see that since Nov. 1, M&T moved up in valuation along with other mid-cap regional banks. Its line is light blue and its current P/TBV ratio is between 2.3 and 2.4; this is closer to the high end of the group, indicating that investors are willing to pay more for M&T's tangible assets.

A stock with a high P/TBV can be a good investment if its income will grow quickly, so it's important to look at the earnings growth for MTB too. The analyst predictions from earlier might support a high P/TBV, but might not be enough. Let's run a quick discounted cash flow (DCF) simulation to see if M&T is overvalued or undervalued at current prices:

Data source:  ____________.

Here I've given M&T Bank a generous discount rate of 8% and assumed it lasts 20 years beyond the analysts' five-year prediction. It is extremely hard to predict growth rates out that far, but I have again given M&T a generous assumption of 4%.

Investor takeaway

Even with generous assumptions, M&T's predicted value is still way below its price -- by 31%. To be a good investment at current prices, M&T would have to earn substantially more in the next five years than analysts are currently predicting. The fact that the bank performed slightly below expectations for fourth-quarter 2016 doesn't help.

For now, I consider this wishful thinking. I don't recommend selling M&T stock short, but if this huge growth doesn't appear, its price may stagnate over the next few years. If you own shares now, consider selling it to lock in your gains. Switching it for a mid-cap regional bank with a lower P/TBV ratio wouldn't be a bad idea.