These days, the financial sector seems cheap … very cheap. Despite the U.S. economy’s continued growth, investors appear to be anticipating the end of the 10-year bull market and a subsequent downturn, which would drag financial stocks along with it. Yet the pessimism around banks has attracted at least one famous investor: Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) Chairman and CEO Warren Buffett.

Why is the market worried?

Recent interest rate hikes, along with downward projections for U.S. economic growth, have caused the yield curve to flatten.

The yield curve is the spread between short-term interest rates and longer-term interest rates.

When it narrows, lending becomes less profitable, since banks typically borrow short-term via deposits and lend longer-term.

That means banks don’t lend — and a recession could be looming.

As you can see, the yield curve for the 10-year minus 2-year treasuries is still positive, though it has flattened quite a bit over the past year.

10-2 YEAR TREASURY YIELD SPREAD DATA BY YCHARTS.

But just because the yield curve is flattening doesn’t necessarily mean it will go negative, or that we’ll have a recession. That seems to be Buffett’s position, as the Oracle of Omaha loaded up on bank stocks in Berkshire’s portfolio last year, including a new stake in JPMorgan Chase (NYSE:JPM).In a recent interview with CNBC, Buffett gave his reasoning behind the purchase, along with his thoughts on the company’s intrinsic value.

A checking account that pays 17%?
When asked about the JPMorgan purchase, Buffett said:

You can find a bank like JPMorgan that earns maybe 15%, maybe 17%, even, on net tangible equity. A business that earns 15% or 16% or 17% on net tangible equity, that’s incredible in a world of 3% bonds. I mean, just imagine that you had a deposit account with JPMorgan that they made a mistake and they gave you 15% on it. And they couldn’t redeem it. What would you sell that account for? You wouldn’t sell it for 100 cents on the dollar. You wouldn’t sell it for 200 cents on the dollar. You wouldn’t even sell it for 300 cents on the dollar. You have an FDIC-guaranteed instrument that would now be at 300 cents on the dollar. If it was 15% on equity, you’d be earning 5% on it, which is way better than treasuries.

What is Buffett saying here exactly? First, he’s discussing JPMorgan’s incredible return on tangible equity, which is net income divided by this tangible equity figure. Tangible equity is the bank’s common equity minus preferred stock, goodwill from acquisitions, and other intangible assets. Essentially, its the bank’s loans and cash minus its liabilities.

Last year, the company earned an incredible 17% on tangible common equity. That’s a testament to CEO Jamie Dimon’s leadership, as well as JPMorgan’s competitive advantage as the country’s largest bank.

One way to value large, mature banks with steady-state growth is by this formula:

(Return on equity-growth rate) / (cost of equity-growth rate) = price-to-book value

Buffett appears to be making the simple calculation in his head using no growth but rounding down JPMorgan’s normalized ROE to 15% and using a low cost of capital of just 5% — a bit above the 10-year U.S. treasury’s yield of 2.63%:

(15%-0%) / (5%-0%) = 3 times book value

Replacing JPMorgan’s exact numbers with just a 2% growth rate and, let’s say, a more conservative 7% cost of equity, would yield the same figure:

(17%-2%) / (7%-2%) = 3

JPMorgan’s current tangible book value is $56.33, so according to this formula, JPMorgan’s intrinsic value would be a whopping $169 per share, more than 60% higher than today’s price of $105.

But wait, there’s more
While most would take a nice 60% return, it’s possible this figure could actually be conservative. That’s because JPMorgan isn’t done growing just yet. Last year, JPMorgan grew revenue over 8%, and it recently unveiled a new growth initiative to open 90 branches in underpenetrated markets in 2019.

Growing above steady-state GDP growth could yield an even higher value in Buffett’s eyes:

If, on top of that, your deposit allows you to let your interest compound to some extent, now, that instrument becomes even worth way more. Because if you have an instrument that could compound at 15% for 10 years and use the added capital, that’s worth way more than three times tangible equity at current interest rates, way more.

Risks to the rosy outlook
Of course, there is nothing automatic about Buffett’s take or the valuation above. Buffett’s rough cost of equity of 5% appears to assume JPMorgan is nearly as safe as a 3% treasury note, which is backed by the U.S. government. While the government insures FDIC deposits, it doesn’t insure stockholders of banks — though the banks are much, much safer now than they were before the financial crisis.

In addition, banks received a huge boost from the government due to last year’s Tax Cuts and Jobs Act, which dropped the federal corporate tax from 35% to 21%, boosting the earnings of all banks. Should the Democrats sweep the White House and Congress in 2020, it’s possible that could be clawed back somewhat.

Nevertheless, JPMorgan is just about as well-managed a bank as they come. While it’s not exactly going out on a limb, I’d lean toward Buffett’s take on this one: JPMorgan is a buy.

— Billy Duberstein

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Source: The Motley Fool