Understanding your bank's value is critical to evaluating managerial performance. It also provides information to estimate pricing targets for capital raises, acquisitions and share repurchases.
The last five years have been challenging for banks to reconcile their valuations with market prices. Industry tangible book value multiples have fallen from pre-crisis highs of 2.5 or more to below one during the crisis. They have rebounded somewhat to 1.5 for profitable banks with clean loan portfolios. The multiples reflect a consensus view regarding expected operating performance. The consensus, however, is not always right. Furthermore, prices do not always equal value. Prices are a fact reflecting what investors are willing to pay. Value is an opinion of what investors expect to receive. Prices can diverge from value for a significant time. Management's objective is to improve the match between its share price and intrinsic value to ensure a reasonable reflection of its operating performance. This requires a realistic value of your bank's expected operating performance, and what investors are signaling to you through your stock price.
Balance sheets measure money spent, not value. Thus, they need to be converted from historical cost to market values. This is complicated by the opaque nature of bank balance sheets. The wide disconnect between real and actual loan values during the crisis illustrates this issue. This continued concern underlies the discount to tangible book value at many institutions. Another reason for a depressed multiple is a lack of a going concern or franchise value as evidenced by a spread between a bank's cost and its return on equity. Absent franchise value, an institution will be valued on a less favorable asset basis.
Franchise value represents the future earnings power of the bank minus any reinvestment in regulatory capital required to maintain a target capital ratio. This adjusted earnings power, or owners' earnings, represents potential dividends available to shareholders. Capitalizing these at the bank's cost of equity, which banking analysts estimate to be in the 10% to 12% range, yields a workable estimate of the bank's equity value. There is no inherent or one true intrinsic value. Rather, it depends on what strategy is being pursued. Consequently, successfully switching to a higher valued strategy can improve your share price. Recent examples of a switch include banks downsizing commercial real estate for retail banking.
Stock prices below management's value estimates can be viewed as an investor mistake based on incomplete understanding of the bank's true value. If true, this expectation value gap will eventually close once the higher operating performance is realized. Alternatively, it may express a legitimate concern over the bank's future prospects. Thus, investors may have issues with the strategy and management's ability to execute on it in the lower growth post-crisis banking environment. If true, ignoring these depressed market prices can frustrate investors and delay needed adjustments.
Banks compete in two markets. The first is the product market for customers. The second is the financial market for capital. Also, in the financial market, banks trade at two prices. The first is the passive going concern public trading price. The second is the higher control price in the private merger market. The bank may be worth more to an alternative owner utilizing a higher value strategy. This strategic value gap will persist, and undoubtedly attract unwanted suitors.
Management should evaluate its stock price against its internal forecast to gauge potential value gaps. It can reverse engineer the implied earnings power inherent in the stock price. This can then be compared to management's performance estimates. Large differences reflect either an investor relations communication problem or questions concerning the validity of management's plan. Next, the plan's validity can be evaluated by converting it into a share price. This price can be converted into tangible book value multiples. Multiples exceeding the current market 1.5 level by a substantial margin suggest an optimistic plan.
Bank values and prices have been negatively impacted by the hostile post-crisis industry environment. This change may be uncomfortable for some to accept as it conflicts with their higher valuation beliefs. Nonetheless, market prices provide useful feedback on strategy and performance. Interrupting this feedback can assist managers updating their business models. The problem may not be that investors do not understand your bank. Rather, management many not understand its investors, and what they are trying to express.
Joseph V. Rizzi is senior investment strategist for CapGen Financial, a private equity firm focused on financial institutions.