Bank on It

Bank on It

Valuing Financial Service Companies

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Through The Decades, banks and insurance companies have been touted as good investments for risk averse investors who value dividends. Invest in Citigroup (CITI) and American Insurance Group (AIG), they were told, and your investment will be safe. Not only did these firms pay large and stable dividends, but they were regulated. The banking crisis of 2008 revealed that even regulated firms can be guilty of reckless risk taking. While some of these firms may be good investments, buyers have to do their homework, assessing the sustainability of dividends and the underlying risk.

Financial service businesses fall into four groups depending on how they make their money.

A bank makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it, and from other services it offers to depositors and its lenders. 

Insurance companies make their income in two ways. One is through the premiums they receive from those who buy insurance protection from them and the other is income from the investment portfolios that they maintain to service the claims. 

An investment bank provides advice and supporting products for other firms to raise capital from financial markets or to consummate transactions (acquisitions, divestitures). 

Investment firms provide investment advice or manage portfolios for clients. Their income comes from fees for investment advice and sales fees for investment portfolios. With the consolidation in the financial services sector, an increasing number of firms operate in more than one of these businesses.

Financial service firms are regulated all over the world, and these regulations take three forms. 

First, banks and insurance companies are required to meet regulatory capital ratios, computed based upon the book value of equity, to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. 

Second, financial service firms are often constrained in terms of where they can invest their funds. For instance, until a decade ago, the Glass-Steagall Act in the United States restricted commercial banks from investment banking activities as well as from taking active equity positions in nonfinancial service firms. 

Third, the entry of new firms into the business is often controlled by the regulatory authorities, as are mergers between existing firms.

The accounting rules used to measure earnings and record book value are also different for financial service firms than those for the rest of the market. The assets of financial service firms tend to be financial instruments such as bonds and securitized obligations. Since the market price is observable for many of these investments, accounting rules have tilted towards using market value for these assets—marked to market, so to speak.

Valuation Issues

There are two primary challenges in valuing banks, investment banks, or insurance companies. The first is that drawing a distinction between debt and equity is difficult for financial service firms. When measuring capital for nonfinancial service firms, we tend to include both debt and equity. With a financial service firm, debt has a different connotation. Debt to a bank is raw material, something to be molded into other products that can then be sold at a higher price and yield a profit. In fact, the definition of what comprises debt also is murkier with a financial service firm than it is with a nonfinancial service firm, since deposits made by customers into their checking accounts at a bank technically meet the criteria for debt. Consequently, capital at financial service firms has to be narrowly defined as including only equity capital, a definition reinforced by the regulatory authorities, who evaluate the equity capital ratios of banks and insurance firms.

Defining cash flow for a bank is also difficult, even if it is defined as cash flows to equity. Measuring net capital expenditures and working capital can be problematic. Unlike manufacturing firms that invest in plant, equipment, and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are treated as operating expenses in accounting statements. If we define working capital as the difference between current assets and current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth.

The same issues rear their head in relative valuation. Multiples based upon enterprise value are very difficult, if not impossible, to compute for financial service firms. Controlling for differences in growth and risk is also more difficult, largely because accounting statements are opaque.

Valuation Solutions

If you cannot clearly delineate how much a financial service firm owes and what its cash flows are, how can you ever get an estimate of value? We deploy the same techniques in both intrinsic and relative valuation to overcome these problems: We value equity (rather than the firm) and use dividends, the only observable cash flow.

Intrinsic Valuation

If you accept the propositions that capital at a bank should be narrowly defined to include only equity, and that cash flows to equity are difficult (if not impossible) to compute because net capital expenditures and working capital cannot be defined, you are left with only one option: the dividend discount model. While we spend the bulk of this section talking about using dividends, we also present two other alternatives. One is to adapt the free cash flow to equity measure to define reinvestment as the increased regulatory capital required to sustain growth. The other is to keep the focus on what financial service firms generate as a return on equity, relative to the cost of equity, and to value these excess returns.

Dividend Discount Models

In the basic dividend discount model, the value of a stock is the present value of the expected dividends on that stock. For a stable growth dividend-paying firm, the value of a stock can be written as follows:

(value of equity = expected dividends next year / cost of equity - expected growth rate)

In the more general case, where dividends are growing at a rate that is not expected to be sustainable or constant forever during a period, we can still value the stock in two pieces: the present value (PV) of dividends during the high growth phase, and the present value of the price at the end of the period, assuming perpetual growth. The dividend discount model is intuitive and has deep roots in equity valuation, and there are three sets of inputs in the dividend discount model that determine the value of equity. 

The first is the cost of equity that we use to discount cash flows, with the possibility that the cost may vary across time, at least for some firms. 

The second is the proportion of earnings that we assume will be paid out in dividends; this is the dividend payout ratio, and higher payout ratios will translate into more dividends for any given level of earnings. 

The third is the expected growth rate in dividends over time, which will be a function of the earnings growth rate and the accompanying payout ratio. In addition to estimating each set of inputs well, we also need to ensure that the inputs are consistent with each other.

There are three estimation notes that we need to keep in mind, when making estimates of the cost of equity for a financial service firm.

Use sector betas: The large numbers of publicly traded firms in this domain should make estimating sector betas much easier.

Adjust for regulatory and business risk: To reflect regulatory differences, define the sector narrowly; thus, look at the average beta across banks with similar business models. Financial service firms that expand into riskier businesses—securitization, trading, and investment banking—should have different (and higher) betas for these segments, and the beta for the company should reflect this higher risk.

Consider the relationship between risk and growth: Expect high growth banks to have higher betas (and costs of equity) than mature banks. In valuing such banks, start with higher costs of equity, but as you reduce growth, also reduce betas and costs of equity.

Consider a valuation of Wells Fargo (WFC), one of the largest commercial banks in the United States, in October 2008. To estimate the cost of equity for the bank, we used a beta of 1.20, reflecting the average beta across large money-center commercial banks at the time, a risk-free rate of 3.6 percent, and an equity risk premium of 5 percent.

Cost of equity = 3.6% + 1.2(5%) = 9.6%

There is one final point that bears emphasizing here. The average beta across banks reflects the regulatory constraints that they operated under during that period. Since this valuation was done 4 weeks into the worst banking crisis of the last 50 years, there is a real chance that regulatory changes in the future can change the riskiness (and the betas) for banks.

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Value Driver #1: Equity Risk

While financial service firms may all be regulated, they are not equally risky. How does your firm’s risk profile compare to that of the average firm in the sector?

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There is an inherent tradeoff between dividends and growth. When a company pays a larger segment of its earnings as dividends, it is reinvesting less and should thus grow more slowly. With financial service firms, this link is reinforced by the fact that the activities of these firms are subject to regulatory capital constraints; banks and insurance companies have to maintain equity (in book value terms) at specified percentages of their activities. When a company is paying out more in dividends, it is retaining less in earnings; the book value of equity increases by the retained earnings. In recent years, in keeping with a trend that is visible in other sectors as well, financial service firms have increased stock buybacks as a way of returning cash to stockholders. In this context, focusing purely on dividends paid can provide a misleading picture of the cash returned to stockholders. An obvious solution is to add the stock buybacks each year to the dividends paid and to compute the composite payout ratio. If we do so, however, we should look at the number over several years, since stock buybacks vary widely across time—a buyback of billions in one year may be followed by three years of relatively meager buybacks, for instance.

To ensure that assumptions about dividends, earnings, and growth are internally consistent, we have to bring in a measure of how well the retained equity is reinvested; the return on equity is the variable that ties together payout ratios and expected growth.

Expected growth in earnings = Return on equity * (1 − Dividend payout ratio)

The linkage between return on equity, growth, and dividends is therefore critical in determining value in a financial service firm. At the risk of hyperbole, the key number in valuing a bank is not dividends, earnings, or expected growth, but what we believe it will earn as return on equity in the long term. That number, in conjunction with payout ratios, will help in determining growth. Returning to the October 2008 valuation of Wells Fargo, the bank had reported an average return on equity of 17.56 percent in the trailing 12 months. We assumed that regulatory capital ratios would rise, as a result of the crisis, by about 30 percent, thus reducing the return on equity to 13.51 percent:

Wells Fargo paid 54.63 percent of its earnings as dividends in the trailing 12 months. Assuming that payout ratio remains unchanged, the estimated growth rate in earnings for Wells Fargo, for the next five years, is 6.13 percent:

Expected growth rate = 13.51%(1 − .5463) = 6.13%

Table 9.1 reports Wells Fargo forecasted earnings and dividends per share for the next five years.

Table 9.1 Expected Earnings and Dividends for Wells Fargo in October 2009

This linkage between growth, payout, and ROE is also useful when we get to stable growth, since the payout ratio that we use in stable growth, to estimate the terminal value, should be:

payout ratio in stable growth = expected growth rate / stable period roe

The risk of the firm should also adjust to reflect the stable growth assumption. In particular, if betas are used to estimate the cost of equity, they should converge towards one in stable growth. With Wells Fargo, we assume that the expected growth rate in perpetuity after year 5 is 3 percent, that the beta drops to one in stable growth (resulting in a cost of equity of 8.60 percent), and that the return on equity in stable growth is also 8.60 percent.

payout ratio in stable growth = 1 -  (3.00% / 8.60%) = 65.12%

terminal price = eps in year 6 x stable payout ratio / cost of equity - expected growth rate

terminal price = 2.91(1.03)(.6512) / (.086 - .03) = $34.83

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Value Driver #2: Quality of Growth

Growth can add, destroy or do nothing for value. What return on equity do you see your firm generating, as it pursues growth?

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Discounting the expected dividends for the next 5 years (from Table 9.1), and the terminal price back at the current cost of equity of 9.60 percent, yields a value per share of $27.74, slightly less than the prevailing price at the time.

Cash Flow to Equity Models

Earlier in the chapter, we looked at the difficulty in estimating cash flows when net capital expenditures and noncash working capital cannot be easily identified. It is possible, however, to estimate cash flows to equity for financial service firms, if you define reinvestment differently. With financial service firms, the reinvestment generally is in regulatory capital; this is the capital as defined by the regulatory authorities, which, in turn, determines the limits on future growth. To estimate the reinvestment in regulatory capital, we need to define two parameters. The first is the target book equity capital ratio that the bank aspires to reach; this will be heavily influenced by regulatory requirements but will also reflect choices made by the bank’s management. Conservative banks may choose to maintain higher capital ratios than required by regulatory authorities, whereas aggressive banks may push towards the regulatory constraints.

To illustrate, assume that you are valuing a bank that has $100 million in loans outstanding and a book value of equity of $6 million. Assume that this bank expects to make $5 million in net income next year and would like to grow its loan base by 10 percent over the year, while also increasing its regulatory capital ratio to 7 percent We can compute the cash flow to equity thus:

Net income = $5.00 million

Reinvestment = $1.70 million (7% of $110 million − $6 million)

Cash flow to equity = $3.30 million

This cash flow to equity can be considered a potential dividend and replace dividends in the dividend discount model. Generalizing from this example, banks that have regulatory capital shortfalls should be worth less than banks that have built up safety buffers, since the former will need to reinvest more to get capital ratios back to target levels.

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Value Driver #3: Regulatory Buffers

Shortfalls (safety buffers) in regulatory capital can affect future dividends. How does yourfirm’s capital ratio measure up against regulatory (and it’s own) requirements?

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Excess Return Models

The third approach to valuing financial service firms is to use an excess return model, where excess returns are defined as the difference between ROE and the cost of equity. In such a model, the value of equity in a firm can be written as the sum of the book value of equity the value added by expected excess returns to equity investors from these and future investments.

Value of equity = Equity capital invested currently + Present value of expected excess returns to equity investors

The most interesting aspect of this model is its focus on excess returns. A firm that invests its equity and earns just the fair-market rate of return on these investments should see the market value of its equity converge on the equity capital currently invested in it. A firm that earns a below-market return on its equity investments will see its equity market value dip below the equity capital currently invested. The two key inputs into the excess return model are the return on equity and the cost of equity.

Excess equity return = (Return on equity − Cost of equity) (Equity capital invested)

Framing the value of financial service firms in terms of excess returns also provides insight into the risk/return tradeoff that they face. Faced with low returns on equity in traditional banking, many banks have expanded into trading, investment banking, real estate, and private equity. The benefits of moving into new businesses that offer higher returns on equity can be partly or completely offset by the higher risk in these businesses. To analyze a bank you need to look at both sides of the ledger: the return on equity the bank generates on its activities and the risk it is exposed to as a consequence. The excess returns approach also provides a framework for measuring the effects of regulatory changes on value. Increases in regulatory capital requirements will reduce return on equity and by extension, excess returns and values at banks.

We can frame the Wells Fargo valuation in excess returns terms. The book value of equity at Wells Fargo in October 2008 was $47.63 billion. The present value of excess returns, assuming that it can maintain its current return on equity of 13.51 percent and cost of equity of 9.60 percent forever, is approximately $58.22 billion. Adding this to the book value yields a value for equity of $105.85 billion and a value per share of $28.38 per share, very close to the estimate we obtained in the dividend discount model.

Relative Valuation

In keeping with our emphasis on equity valuation for financial service firms, the multiples that we will work with to analyze financial service firms are equity multiples—PE ratios and price-to-book ratios.

The PE ratio for a bank or insurance company is measured the same as it is for any other firm, by dividing the current price by earnings per share. As with other firms, the PE ratio should be higher for financial service firms with higher expected growth rates in earnings, higher payout ratios, and lower costs of equity. An issue that is specific to financial service firms is the use of provisions for expected expenses. For instance, banks routinely set aside provisions for bad loans. These provisions reduce the reported income and affect the reported price/earnings ratio. Consequently, banks that are more conservative about categorizing bad loans will report lower earnings, whereas banks that are less conservative will report higher earnings. Another consideration in the use of earnings multiples is the diversification of financial service firms into multiple businesses. The multiple that an investor is willing to pay for a dollar in earnings from commercial lending should be very different from the multiple that the same investor is willing to pay for a dollar in earnings from trading. When a firm is in many businesses with different risk, growth, and return characteristics, it is very difficult to find truly comparable firms and to compare the multiples of earnings paid across firms.

The price-to-book-value ratio for a financial service firm is the ratio of the price per share to the book value of equity per share. Other things remaining equal, higher growth rates in earnings, higher payout ratios, lower costs of equity, and higher returns on equity should all result in higher price to book ratios, with return on equity being the dominant variable. If anything, the strength of the relationship between price to book ratios and returns on equity should be stronger for financial service firms than for other firms, because the book value of equity is much more likely to track the market value of existing assets. While emphasizing the relationship between price to book ratios and returns on equity, don’t ignore the other fundamentals. For instance, banks vary in terms of risk, and we would expect for any given return on equity that riskier banks should have lower price to book value ratios. Similarly, banks with much greater potential for growth should have much higher price-to-book ratios, for any given level of the other fundamentals.

Assume that you were looking at Tompkins Financial (TMP), a small bank trading at 2.75 times book value in early 2009. That was well above the median value of 1.13 for price-to-book ratios for small banks at the time. However, Tompkins Financial also has a much higher return on equity (27.98%) and lower risk (standard deviation = 27.89%) than the median small bank, both of which should allow the firm to trade at a higher multiple. Using a technique adopted in prior chapters, the price-to-book ratio is regressed against ROE, growth, and standard deviation.

PBV = 1.527 + 8.63 (ROE) − 2.63 (Standard deviation) R2 = 31%

Plugging in the ROE (27.98%) and standard deviation (27.89%) for Tompkins into this regression:

PBV for Tompkins = 1.527 + 8.63(.2798) − 2.63(.2789) = 1.95

After adjusting for its higher ROE and lower risk, Tompkins still looks overvalued.

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Value Plays

Investing in financial service companies has historically been viewed as a conservative strategy for investors who wanted high dividends and preferred price stability. Investing in these firms today requires a more nuanced strategy that goes beyond looking at the dividend yield and current earnings, and looks at potential risk in these firms by examining the following.

Capitalization buffer: Most financial service firms are governed by regulatory requirements on capital. Look for firms that not only meet but also beat regulatory capital requirements.

Operating risk: Risk can vary widely across financial service firms within a sector (banks, insurance companies). Seek out firms that are operating in average risk or below average risk businesses, while generating healthy earnings.

Transparency: Transparency in reporting allows investors to make better assessments of value, and the failure to be transparent may be a deliberate attempt to hide risk. Search for firms that provide details about their operations and the risks that they may be exposed to.

Significant restrictions on new entrants into the business: High returns on equity are a key factor determining value. Look for firms that operate in profitable businesses with significant barriers to new entrants.

In summary, invest in financial service firms that not only deliver high dividends, but also generate high returns on equity from relatively safe investments. Avoid financial service firms that overreach—investing in riskier, higher growth businesses—without setting aside sufficient regulatory capital buffers.

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Aswath Damodaran, The Little Book of Valuation