The rally in the share price of Laurentian Bank of Canada LB-T suggests that investors expect the up-for-sale lender to fetch an attractive premium when a bidder emerges – and it reinforces the notion that Canadian bank stocks are cheap.
Laurentian’s share price jumped 26.6 per cent on Wednesday, a day after The Globe and Mail reported that the Montreal-based bank had hired financial and legal advisers to explore a sale and may have received an offer from a rival already.
Investors have generally been taking a cautious approach to Canadian lenders. Rising interest rates are weighing on loan growth and feeding uncertainty over economic activity, regulators are tightening the banks’ capital requirements, a period of high inflation has raised compensation expenses and profits are struggling as the banks set aside more money to handle bad loans.
The S&P/TSX Composite Commercial Banks index – a basket that includes the Big Six banks along with Laurentian, Canadian Western Bank and EQB Inc. – has retreated more than 20 per cent from a recent high in early 2022. So far in 2023, the index is down 2.5 per cent, and as of Tuesday, is lagging the broader S&P/TSX Composite Index by five percentage points.
With the dismal performance in stock market, bank stocks are trading at valuation metrics that are well below historical averages.
After the banks concluded their second quarter financial reporting in May, Gabriel Dechaine, an analyst at National Bank of Financial, observed that the Big Six stocks traded at just 9.2-times estimated earnings, or 13 per cent below the 10-year average. Stock prices haven’t changed much since then.
Weekly valuation readings from RBC Dominion Securities point to a similar discount. The average price-to-book ratio – a valuation that compares the market value of a bank with its value if it were liquidated – was just 1.32 at the end of last week. That’s considerably lower than the 15-year average of 1.78.
Lastly, dividend yields are curiously high. The average yield is now about 5 per cent for the Big Six banks. Prior to 2020, the average yield rarely broke above the 3.5-per-cent threshold.
Smaller Canadian banks look even cheaper than their bigger rivals. Laurentian, the ninth largest Canadian lender and in the midst of a turnaround plan after reporting disappointing financial results for several years, stands out with an especially low valuation.
At the end of last week, the stock traded at just 0.56-times book value, according to RBC Dominion Securities. Laurentian’s price-to-earnings ratio, based on 2024 estimated earnings, was just 6.3. And its dividend yield was a lofty 5.7 per cent.
The low valuation is working in the stock’s favour now: The share price surged on Wednesday to $42.46, up $8.93, in anticipation of a bidder paying a hefty premium for the bank. Mr. Dechaine expects that the stock can rise further, to $51, based on his view that the valuation will expand to 0.8-times book value as bidders circle.
Low valuations might help other smaller bank stocks, too, if consolidation in the sector gains momentum.
“We believe that Canadian Western Bank could benefit from the Laurentian news in the near-term as investors may start to build in some level of takeout premium, which could be helped by the bank’s heavily discounted relative valuation multiples,” Mike Rizvanovic, an analyst at Keefe, Bruyette & Woods, said in a note.
The stock rose 3.9 per cent on Wednesday.
The case for bigger banks is less clear, given that they are not up for sale. But low valuations clearly help: They reflect a challenging economic backdrop, so a shift toward better conditions – declining inflation, for example, or less uncertainty about credit conditions – could push investors back to bank stocks.
There is plenty of room for gains if valuations return to historical norms. Laurentian may be an exceptional case here, as a takeover target. But it’s also an example of what can happen when investors pounce on cheap stocks.