Bank valuations look unkind, but not irrational

British pound coins falling
Adam Gault | Getty Images
British pound coins falling

Banks are either imploding, or they're a screaming buy. Those are two ways to interpret the 22 percent slump in the share prices of European lenders since the start of January. But play around with a few bank valuation metrics, and a third possibility emerges – that markets are being unkind, but not irrational.

For investors, a bank must at least earn back its cost of equity, which is around 10 percent. On average, European banks will make a return on equity of 7 percent in 2016, Citi forecasts, creating a 3 percent destruction of value. Extend that out for five years, discount it back at the cost of equity, and the sector would have erased more than a tenth of its book value.