8 February 2016 US Equity Insights Bank stocks represent shareholders equity or residual real assets that are used to intermediate nominal assets and liabilities Bank stocks represent real entities with earnings that should rise with inflation. A bank, like any other business, should be valued based upon all of its future cash flows. Just like any business, a bank's earnings and dividends should grow with inflation over the long-term even if none of its earnings are retained for reinvestment. Thus, just like any business, a fair PE on a bank's steady-state EPS is 1 /real cost of equity and a fair PB on a bank's steady-state book value is its sustainable nominal ROE / real cost of equity. Although a bank's earnings should grow with inflation over the long-term, it is important to acknowledge that a bank's earnings are subject to the risk of unexpected inflationary/deflationary shocks. Abrupt changes in inflation expectations and/or inflation risk premiums and real interest rates, relative to the rates of return embedded in the income producing assets that a bank holds, or embedded in the rates of return of liabilities that a bank issues, can damage a bank's earnings power for the period of time it takes for any duration mismatch between its assets and liabilities to elapse. This issue along with leverage affects the path to normal EPS and real cost of capital (risk), but not the terminal value calculation. The perpetual growth rate of a bank's earnings should include inflation, i.e., its terminal value capitalization rate should be a real rate. The risk of change in the cost of capital relative to returns earned on assets is a risk that all businesses bear. Although this is generally a more significant risk for banks as relatively small interest rate changes (typical volatility) can significantly impact near- term EPS as amplified by leverage. However, banks are generally capable of adapting to secular interest rate shifts quicker than non-fina