The primary determinants of bank stock valuation are, as is well known, return on equity relative to the investors' required return, and the earnings growth rate. In the late '80s, however, the time-tested formula that relates these two variables to the ratio of a bank's market value to its book value did not seem to apply. Credit quality - i.e., loan-loss volatility - supplanted profitability and growth as the principal driver of bank stock prices.
Recent analysis done at our firm shows that this is no longer the case. Today, about two-thirds of the variation in market-to-book ratios at 30 large regional and superregional institutions can be explained by these banks' projected ROEs and growth rates. Comparatively little of thisvariation is traceable to differences in credit quality and credit risk.
Return on equity is a variable that already incorporates, to a large degree, the impact of many measures of credit quality. For example, the higher the ratio of nonperforming loans, the higher the loan-loss provision and the lower the risk-adjusted revenue - factors that work to depress both ROA and ROE. But the ROE measure includes more than the effects of credit quality over the cycle; it reflects everything that management does to increase shareholder wealth.
So while differences in credit quality should explain some of the variations in market-to-book ratios, differences in ROE expectations should explain more. The fact that they didn't in the late '80s reflected the market's considerable unease. Investors were fearful that the deteriorating credit situation was symptomatic of a systemic fault - an inability of bankers to make acceptable risk-return tradeoffs - which would eventually undermine projected ROEs.
In brief, in the late '80s, the market distrusted nearly all bank earnings estimates; by the mid-'90s, a substantial measure of trust had been restored.
Evidence of this renewed faith can be seen in how the market currently values banks with varying degrees of loan-loss volatility. As might be expected, volatility, as measured by the standard deviation of loan losses, tends to be inversely correlated with stock prices. In other words, for most banks, the market-to-book ratio falls as the standard deviation of loan losses rises.
But not for all banks. Somewhat perversely, the top quintile of stock market performers have higher average loss volatilities than those in the second through fourth quintiles.
The average loss standard deviation of top-quintile banks from 1991 to late 1994 came to 46 basis points, appreciably higher than for some banks with lower market-to-book ratios - e.g., Wachovia and Comerica. Such institutions have both low average losses and limited loss volatility, characteristics that once attracted investors and may do so again in the future.
At the present time, the market believes that those banks with the best projected ROEs and growth rates are strong enough to shrug off the effects of somewhat elevated levels of loss volatility. In other words, the investor reasons that while future credit problems might adversely influence earnings, they won't convert a manifestly superior earnings performance into a merely average one.
In the late '80s, that same investor would not have offered so confident a judgment about any bank that had problems with a significant measure of credit risk, however strong its management.
It is clear, however, that although the market is more relaxed about credit risk than it was a few years ago, it is by no means indifferent to the type of credit risk. For example, the market obviously prizes loan growth. Banks with strong acquisition-adjusted loan growth achieve high stock prices; those with low growth are stuck in the bottom quintile of stock performers.
But banks whose loan growth is primarily in the consumer area fare much better in valuation terms than those whose growth is concentrated in the C&I area. Top-quintile banks grew their consumer loans by 6.3% a year from 1991 to late 1994, but their C&I loans by only 1.1%. Bottom-quintile banks managed only a 0.1% rise in consumer loans, compared with a 3.4% increase in commercial lending.
One plausible reason for the market's aversion to C&I loans is that they have greater loss volatilities than consumer ones, and the investor remembers with a shudder the escalating levels of unexpected commercial chargeoffs of a few years ago.
Today's market assigns different values to the assortment of factors that influence the expected ROEs of banks. It is partial to banks that generate a lot of fees since every 10 basis points of fee income can raise corporate ROE by 30 to 50 basis points. Thus, top-quintile banks sport a ratio of noninterest income to assets of 2.4%, compared with 1.8% for the bottom-quintile dwellers.
By the same token, the market is skeptical of the importance of an outstanding bank efficiency ratio. That's because it is aware that the fee businesses of which it is so fond are often high-cost businesses, and banks with a lot of such activities may well outearn those that are singlemindedly wedded to cost control - the pennywise but pound foolish.
As might be expected, the market rewards those with a strong net interest margin; the most highly valued banks have a 4.5% margin, compared with 3.6% for the poorest 20% of stock performers. High fees and a good margin sum to strong revenue magnitude, an obvious favorite with investors.
Since good margins generally require cheap funding, the market is down on bank wholesale funders. Its dislike of bought money may also stem from the understanding that when earnings problems surface, liquidity difficulties are not far behind. Thus, those banks stuck in the bottom stock-price quintile fund 42% of their assets with wholesale money, while the comparable percentage for those in the top quintile of stock performers comes to only 27%.
In summary, the banks that are currently enjoying the best market valuations push consumer loans, chase fees (trust, deposit, and cash management), fund with core money, and avoid outsize C&I involvements.
Though risk- and cost-conscious, they are not risk- and cost-fixated. They take risks, provided they can get paid for taking them. And they aren't afraid of spending for business development - an attitude that may cause them to invest heavily in the infrastructure needed to perfect customer-knowledge-based marketing.
This new approach to marketing could easily propel skillful banks to the kind of ROE and earnings-growth improvements that would solidify their status as stock market favorites for many years to come. Mr. Zizka is a managing vice president of First Manhattan Consulting Group, New York. Mr. Rose, formerly senior columnist for this newspaper, is also associated with the firm.