The phrase "shareholder value" has surely become one of the great fuzzy pieties of banking, indeed a talisman seeming to protect its wearers against suspicion of complacency.
Sadly, this reassuring article of faith, embraced today by every up-to-date manager and consultant, has a deep flaw. For unless shareholder value can somehow be transmuted into stock price, like base metal into gold, the alchemy is powerless.
What action-steps can managements take to turn value into price? First, executive management should commit to internalizing a definition of shareholder value consistent with a theory of investment value. Is the standard to be short-term performance, long-term, or a mix?
Standard Must Be Set
More important, is the standard to be based entirely on nominal accountancy or on an analytically reconfigured view of earnings and capital? To put it another way, until management buys into a "shareholder value scoreboard" that defines and captures the investor-significant elements of its performance, shareholder value will remain an unquantified slogan.
Next, the scoreboard becomes the basis for articulating and documenting a corporate story that, if cogent and well presented, can gain market recognition. Historical precedents exist, furthermore, to justify this claim.
Phase one: build a shareholder value scoreboard. We have gradually evolved a practical theory of bank stock investment value that recognizes but goes far beyond the sales-driven theory underlying most of the activity in the bank stock market. Having been a buy-side (later a sell-side) analyst for over 10 years, I know how the system works.
Sales-driven bank analysts distort both the concept and measurement of investment value. Why? Consider the. pressure cooker in which this all takes place. For starters, there is at least a 50-to-1 ratio of buy-siders to sell-siders.
The former consist of analysts and portfolio managers who tend to be overstretched generalists. The sell-siders are typically well-informed industry specialists who compete for brokerage commissions with timely information and persuasive stock "ideas."
This symbiosis means that the valuation concepts and methods which "wrap" the sales ideas are necessarily limited to a rather low common denominator of complexity, so that the ideas can be easily understood by everybody during the very brief conversations that caseload pressure dictates.
These standards must serve two additional goals as well. First, stock ideas must cater more to the short-run price performance goals of active portfolio managers and less to the goals of longer-term investors, whose style generates far fewer commissions.
To illustrate, earnings and stock price projections are carried out no more than two years, and are used to estimate near-term P/E ratios, therefore stock price potential.
Second, the standards must permit, however superficially, P/E ratio comparison across stocks in totally different industries. It is easy to see how the "inner quality" of stock ideas can get lost in this maelstrom.
Listen to the Contrarians
My observations about this often value-blind factory are not intended to disparage the work of individual analysts who understand the determinants of investment value. Such independent-minded analysts, however, are rarely the publicized oracles who work for major investment banking firms, and whose compensation is partly based on promoting corporate finance.
Incidentally, managements who want an objective window into the bank stock market are better advised to seek out the nervy contrarians who typically find berths at smaller firms.
The factory cannot be dismissed or bypassed, nor can its workings be readily altered, since this is, after all, how the world works.
The practical challenge to a management is, first, how to define and document those elements of performance that most determine investment value, and second, how to communicate these elements to analysts and investors working within the existing system. Forget about changing the system, and think twice about quarreling with an analyst.
We construct a shareholder value scoreboard in three steps. First, we reconfigure the nominal financials according to an investment value standard of meaning, very different in its methods and goals than a GAAP-based standard.
This has the effect of adjusting net income to its "sustainable" level, and capital to its "economically real" level. The purpose of these adjustments, of course, is to lay a base for the projection of "earning power" into the future.
Whereas accountancy deals almost entirely with past events, investors are in the business of gauging the future. It is this profound difference in perspective that best explains the impatience of analysts with accountancy.
One of our reconfigurations, to illustrate, includes the estimation of "franchise value," based on the likely continuing profitability of customer relationships, allowing for the uncertain inroads of attrition and competitive events.
Another sub-step is estimating the realizable value of the loan portfolio, including as many market tests as possible.
Earnings Projections
Second, working from "base year" data, we project the next three to five years of earnings, earnings per share, dividends, etc., with client input, of course, often in a group setting. Finally, we compute the net present value of investor cash flows to be expected from dividends across the period, plus the assumed realization of the estimated stock price at the end of the projection period.
The discussion of applicable discount rates always generates provocative insights regarding professional investor goals, expectations, and alternative opportunities. The end product of this exercise is a number (better, a range of numbers) that we call "fair value."
We have recently introduced an academically unconventional treatment of terminal stock price. We argue that it is more correct to stimulate the experience of investors in a widely held, marketable stock by "spreading" the estimated terminal value across the period, than by postponing the realization. Our reasons are threefold.
First, investors enjoy the psychological fact of appreciating stock values (which they can measure daily), and they can also sell or pledge their holdings at any time.
'Total Return' Concept
Second, spreading the gain is consonant with the widely accepted concept of"total return," according to which an investor's annual return is the sum of dividend yield plus the historic (or projected) rate of capital appreciation.
Third, we think it misrepresents the fluidity of a body of shareholders to assume that all will cash out at the end of a three- to five-year period.
At this point in the design of a shareholder value scoreboard, a management now has two numbers to compare: yesterday's closing stock price (representing, by definition, the market's consensus of value) and a range of fair value, resulting from our discounted projections.
Two additional numbers are also worth computing: net asset value, representing the current market value of all assets and liabilities, including intangibles; and the estimated sell-out value that the institution might realistically command today.
Variations on a Theme
It does not take much imagination to see how this summary framework forms the bottom line of the scoreboard. After all, each of the four numbers expresses a different perspective on the same theme, namely, the definition of shareholder value.
In our experience, managements can get quite absorbed interpreting and juggling the juxtaposition of values, especially since each has been subject to insider input along the way. There is budget flexibility as well. A low-cost version of the scoreboard exercise, based on guesswork and untested assertions, may take a day to construct.
A higher-cost version may bring with it, for example, some documentation of intangibles, or a detailed asset value review, as well as a summary written report.
Phase two: communicate the elements of bank stock value. We envision a "drive train" of corporate actions bearing upon the creation of shareholder value.
First come the strategic initiatives themselves, which is where most managements and consultants stop, believing they have finished the task of value creation.
Second, as pointed out above, there should be a disciplined exercise in appraising shareholder value from the perspective of investors.
Finally, to finish the job of value creation, the corporate story must be developed and told as strongly and credibly as possible, if market attention is to be attracted.
To put it another way, numbers don't sell bank stock, because bank stock (to use a broker expression) is "story paper," largely dependent on market perception of the people, plans and policies behind the numbers.
Reputation vs. 'Real Story'
Our advisory work on the communication of shareholder value rests on five principles.
First, every company already has a market-defined story - its "street rep" in roughly 25 words (sometimes less) - which invariably oversimplifies and often distorts the real story.
Second, every company also has a real story, but - hold on to your seats - this real story is more or less latent, that is, incompletely developed and articulated, even in the minds of management.
The real story, moreover, often requires going beyond GAAP with supplementary information that is not yet customary disclosure. And the story must be articulated in ways that serve investor information needs and research styles.
Third, if managements don't actively tell a cogent, documented, and interesting story, the market version will prevail. Merely reporting and explaining GAAP financials - which many banks erroneously think is the chief study of analysts - doesn't make a story.
Fourth, the modalities of story projection need to be as compelling and varied as possible. This is true for a curiously overlooked reason. The marketplace of analysts and investors (institutional and individual) is blitzed into stupefaction by the ever-rising blizzard of reports and presentations.
Since these communications - the snowflakes of the storm - almost always follow standards and objectively tiresome formats, the stupefaction is multiplied.
It's as though the universe of communications unthinkingly believes that their paper-harassed readership has an insatiable appetite for biz buzz and technobabble. It is hard even for a good story to become memorable, if conventionally presented.
We have experimented with ways to create saliency for a good story. These include such relatively refreshing events as one-table luncheons for no more than eight carefully matched analysts plus several senior managers, conducted with the appearance of unrehearsed spontaneity; colloquial interviews between a management figure (usually the CEO, but not always) and one or two recognized analysts; mailings of reprints of trade-press articles on topical subjects, written by (more likely, ghosted for) division-level managers.
Also to be considered are reprints of articles about the company in business journals, and interestingly informative annual and quarterly reports, aimed primarily at the skeptical analyst.
Provocative Nuggets
Regardless of the particular medium, the best way to make a good story effective is to drop provocative nuggets in among the generalities. For example, don't stop with "relationship building," which is becoming just another unquantified slogan. Instead, talk about customer longevity, attrition rates, account profitability, and cross-selling effectiveness.
Finally, while it is true that the most influential analysts will always need personal stroking, interesting published materials should be mailed directly to a wide universe of buy-siders as well. The reason is that the "conveyor belt" theory isn't working well anymore.
This holds that if a management has good relations with influential sell-siders, these will inform the buy-side via reports, telephone and visits.
The flaw in the conveyor belt theory is not only that story quality is lost in this process, but also that buy-siders have come to distrust much of the sell-side, on grounds of competence and conflict. Thus a bank needs to reach the buy-side directly with its story.
Such a program cannot be expected to work overnight, which makes it hard to quantify a cost-benefit equation. Patience is required. Long-standing experience as a policy adviser to now-major banks, however, has taught us that these methods will gradually generate market interest in what once were obscure names.
Reverence for Accounting
Another hurdle is internal apathy, even opposition. To begin, there is the lay reverence - on the part of many managements and directors - for the procedures and end-product of public accounting, as though these represent financial truth more rigorously than do revisionist approximations by analysts.
Also, the internal preparers of bank's financial reports are controllers reporting to CFOs, one or both of whom can be expected to have Big Six backgrounds. There also tends to be a high regard for the opinions and valuation methods of sell-side analysts, whose favorable nod is so assiduously courted.
In our experience, breaking the hold of conventional GAAP-based disclosure at particular banks happens only after the front office discovers that their value-building strategies are ignored or distorted, not only by auditors but by analysts as well.
In the present environment, when so many emerging strategies are off balance sheet, shareholder value creation must embrace more than the strategies themselves.
Mr. Cates directs the Cares Bank Rating Service as a consultant to Thomson BankWatch.
