How to value banks: book value and excess return

Gkratsian Dimitriou
Oct 17, 2026 · 5 min read

In short

A bank makes its money with borrowed money. For a bank, debt is therefore not a risk next to the business but the business itself – and cash flow models do not fit. Banks are valued by their equity: what matters is how much more they earn on it than their shareholders require.

Why banks are different

A machine maker borrows money to build factories. The debt finances the business. A bank, by contrast, takes in deposits and lends them on. Its "raw material" is borrowed money, its profit the difference between the interest it pays and the interest it receives.

That is why the usual tools do not work. Free cash flow can hardly be defined sensibly for a bank, and EV/EBITDA would count customers' deposits as debt. Instead you look at what belongs to the shareholders: the equity, also called book value.

The three numbers that matter

Book value is the bank's equity, i.e. assets minus liabilities, according to the balance sheet. Divided by the number of shares, it gives book value per share.

Return on equity (ROE) says how much profit the bank earns per year on that equity. 12% means: €100 of equity turns into €12 of profit.

Cost of equity is the return shareholders demand for the risk. It follows the same thought as the rate in discounting: the riskier, the higher.

The price-to-book ratio

The P/B ratio divides the share price by book value per share. A P/B of 1 means: on the stock market, the bank costs exactly what its equity is worth on the balance sheet. Whether 1 is a lot or a little depends on how well the bank uses that capital. A fair P/B can be calculated:

Fair P/B = \frac{ROE - g}{k_{e} - g}

ROE: return on equity, for example 12% = 0.12
k_e: cost of equity, for example 10% = 0.10
g: long-term growth, for example 4% = 0.04

The formula says something very simple: if a bank earns exactly its cost of equity, it is worth exactly its book value. If it earns more, it is worth more. If it earns less, it is worth less – even if it makes a profit.

The worked example

The made-up Example Bank has a book value of €50 per share. Shareholders require 10%, growth is 4%. This is how fair value depends on return on equity:

Example Bank · fair value by return on equitybook value €50, k_e 10%, g 4%

ROE	Fair P/B	Fair value
8%	0.67	€33.33
10%	1.00	€50.00
12%	1.33	€66.67
14%	1.67	€83.33

Made-up company. Values rounded.

At 8% return on equity, the bank does make a profit, but less than its shareholders require. It is then worth only two thirds of its book value. That is exactly why some banks trade below book value for years – and that is not automatically a bargain.

The excess return

A second look at the same idea: what a bank earns beyond its cost of equity is called the excess return.

Excess return = (ROE - k_{e}) \cdot Book value

For Example Bank with a 12% ROE, that is (12% − 10%) × €50 = €1 per share a year. Fair value is then book value plus all future excess returns, discounted to today.

One realistic assumption matters here: a lead rarely lasts forever. Competitors catch up, interest rates change. That is why the excess return is often allowed to shrink slowly to zero over the years. What remains in the end is book value.

Three common mistakes

A single good yearA bank's return on equity swings with interest rates, loan losses and one-off items. Use an average over several years, not the best year.

High returns from thin equityA bank with very little equity quickly shows a high return on equity – but also carries more risk. A look at equity relative to total assets belongs in the picture.

Trusting book value blindlyBook value also contains goodwill from acquisitions and loans that may not be repaid. Cautious investors therefore often use tangible book value without goodwill.

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Frequently asked questions

What is a good P/B for a bank?

It depends on return on equity. A bank that earns more than its cost of equity over time may cost more than book value. One that earns less is not necessarily cheap even below book value.

Can I use the P/E ratio for banks?

Yes, as a quick comparison. But it says nothing about how much equity the bank uses for that profit. P/B together with return on equity gives the more precise picture.

What is tangible book value?

Book value without goodwill and similar intangible items created by acquisitions. It shows more cautiously how much tangible equity there is if things go wrong.

Does this also apply to insurers?

Largely yes. Insurers also work with other people's money – their customers' premiums. For them too, book value and return on equity are the key figures.

Not investment advice. All content is for informational and educational purposes only. Example Bank is made up.