Make your bank easy for Wall St. to understand.

For most of the past 18 months, the prices of bank stocks have been lower than normal valuation techniques would predict.

The reason: questions about the true value of banks assets.

In the past few months, the market has adjusted to those questions, so bank stocks will now follow more normal parameters of valuation.

However, prices will never attain the price-earnings multiples of industrial company stocks until investors are convinced that banks are in a good business. Specifically, this means each bank must:

* Define the markets into which it sells its products (and they should be growing markets).

* Define the products sold and show that sales are growing faster on a units basis than the market being served.

* Indicate the profitability of the specified product lines.

If investors do not get such information, they will continue to see banks as undefined packages of assets. As a result, bank stocks will not attain high multiples. The prices will reflect investors' feeling that they cannot reliably predict banks' rates of return.

'Plowback Return'

Innumerable studies have shown that a company's expected rate of return, as reflected by return on equity, is the best indicator of future earnings growth and determines the stock price multiple. Most significant of all is "plowback return" - cash plowed back into the business (after all necessary charges, including dividends, depreciation, and repayment of debt) divided by equity

A company that convinces investors it will obtain a higher cash plowback return than the Standard & Poor's 500 will be rewarded with an above-average multiple. Because expected real returns for that company exceed the market average, investors expect earnings growth to compensate for the lack of current earnings yield.

Discounts Versus Premiums

As far back as studies go, industrial stocks have followed this valuation technique. Clearly, in the past 18 months banks have not. If they had, Bankers Trust Co.'s stock would now be selling at a substantial multiple premium to the market, instead of a major discount.

Why can't investors generate reasonable growth projections of bank earnings? There are two reasons:

* Uncertain about the real value of banking company assets, investors do not know what level of loss to amortize against future earnings.

* ignorant of what a bank actually sells, they cannot project sales growth.

The View from 1990

We completed a study in mid-1990 of 200 bank holding companies to determine how the market was valuing their stocks.

The results clearly indicated that banks that were able to report high-quality assets would sell at higher multiples than other banks.

* Banks with more cash and cashlike holdings relative to total assets tended to be more highly valued than banks with large loan portfolios - no matter what the types of loans the portfolios comprised.

* Banks with above-average levels of high-risk loans relative to assets tended to receive below-average valuations.

* From a market-valuation standpoint, the most undesirable loans tended to be those to lesser-developed countries. Next worse were real estate loans, excluding mortgages on homes for one to four families. Worst were commercial and industrial loans to highly leveraged companies.

It is clear that having a number of loans in categories thought likely to cause default made it difficult to assess future earnings. Conversely, the presence of substantial cash holdings led to expectations of low levels of amortizable losses, which penalize earnings.

Sources of Income

The 1990 study also showed that investors wanted a credible base on which to develop earnings projections.

Companies that reported a high level of fee income from definable sources - for examples, data processing or trust activities - were more highly valued than companies with a large portion of net interest income.

Stock market valuation was lowest for companies thought to derive their earnings from non-recurring sources - for examples, bond and foreign exchange trading.

Basically, the market awarded "best buy" status to banks such as State Street Boston Corp., relatively low in loans and relatively high in earnings from definable sources. Such companies let investors make reasonably low-risk projections of earnings and compare those projections with other returns offered in the marketplace.

Fundamental Changes

Recently we completed a similar study. Surprisingly, the results were significantly different. They suggest that bank stocks from this point forward will be evaluated much as industrial companies and other financial investments are.

For example, in the 1991 study it was found that investors were indifferent to the composition of a bank's assets. No meaningful penalty was ascribed to a stock solely on the basis of the composition of the bank's loan portfolio or the level of cash on the balance sheet.

Rather, the market is focusing on a more narrow set of balance-sheet numbers - the coverage of questionable loans.

Calculating Coverage

Apparently the harsh government audits of the past 18 months have convinced investors that banks now report all their questionable loans as non-performing in some fashion. Therefore, one does not have to look beyond the annual report to see where the problems lie.

Investors now want to know if the problems are adequately covered.

This determination is made by comparing balance-sheet risk to equity. An example of this calculation would be:

* Determine the net difference between reserves (including foreclosed real estate) and all nonperforming loans.

* Add to this the net difference between the market and book value of securities.

* Add goodwill from all sources.

* Add this sum - positive or negative - to equity

* Divide by assets.

If a high ratio of real assets is derived from this calculation, the company's balance sheet is viewed to be satisfactory. The multiple on the stock is likely to be higher than if the ratio of real equity so derived were low.

A Premium on Efficiency

The income statement is now also being looked at differently - like industrial companies, essentially without regard to the source of revenues.

Because there has been no change in the ability to determine what drives company revenues, there is no clear link between the source of revenue and the price-earnings multiple on bank stock.

However, investors can develop realistic numbers concerning costs relative to revenues. It is apparent that those companies with low operating ratios are valued more highly in the marketplace.

To Bolster Prices

So here is some advice for bank managements seeking higher prices for their stocks:

* Rethink the approach being used to define the company to investors.

By failing to analyze productline profitability, banks discourage investors from analyzing them as industrial companies are analyzed. This makes it difficult for the outsider to project relative real returns - and easy for the outsider to consign the stock to a low valuation.

* Concentrate on balance-sheet values. If the markets begin to suspect that a balance sheet is questionable, there is absolutely nothing a management can do to maintain the value of the company's stock.

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