Bank investors are increasingly turning their focus from book value to profits, which could pressure more banks to make acquisitions.

A shift to profit-based valuations is typical during upswings in the economic cycle, investors say. As concerns about capital and asset quality dissipate, people tend to place more weight on banks' earnings potential.

"When fear abounds, people rely on book value. When the economy is healthier, they rely more on earnings," says Joe Stieven of Stieven Capital Advisors. "This is the same back-and-forth I've seen for 32 years."

A shift to earnings is a good sign for the banking industry, suggesting that smaller banks are stronger and investors are more comfortable with their health. But such a focus could spur more moves to boost short-term profit.

De-emphasizing tangible book could lead to price "frothiness" and, eventually, a market correction, Mark Fitzgibbon, an analyst at Sandler O'Neill, wrote in a note to clients last week, adding that banks disregard tangible book value at their own peril.

"When valuations get frothy, sometimes banks will do things that are destructive to tangible book value," Fitzgibbon wrote. "Over the long haul, an acquisition that permanently dilutes tangible book value is going to be harmful to your stock price."

Fitzgibbon analyzed the relationship between stock price and tangible book value over the past decade. He found a very strong correlation, indicating that growth in tangible book value explains a large percentage of the banking industry's stock price appreciation over that time.

Banks have used several different strategies to lift shareholder value since the financial crisis. Banks with the highest tangible book value range from giants like Wells Fargo and PNC Financial Services to specialized lenders like Signature Bank and SVB Financial. Fitzgibbon's list also included Cass Information Systems, a payments processor with a commercial bank.

Signature and SVB, in particular, have expanded without making major acquisitions.

Other banks on Fitzgibbon's list are taking advantage of their valuations by making acquisitions.

Bank of the Ozarks, which topped the list with an 18.8% compound annual growth rate in tangible book value, is among the industry's most active consolidators.

Still, Bank of the Ozarks' strategy makes sense given pressure on banks with high multiples to keep increasing earnings, says Anton Schutz at Mendon Capital Advisors.

"Banks that have big multiples have to use them," Schutz says. "If you can't keep doing deals, you eventually have a sunset on your accretable yield."

Overall, Schutz seems less concerned about the shift toward earnings metrics, noting that investors are moving past the "crisis mentality" that led to a reliance on tangible book value.

Tangible book value is more popular in times of danger since it represents the theoretical value of a bank if liquidated. So the ratio of price to tangible book value gives a rough estimate of the risk of investing in a bank — the higher the ratio, the greater potential losses.

"There were no earnings a few years ago, so what else did you have to lean on?" Schutz adds.

For others, there is a belief that the shift should help reinvigorate M&A. It is up to acquirers to do their due diligence and avoid making the same types of deleterious deals that crippled many institutions during the financial crisis.

As the focus shifts to price-to-earnings ratios, M&A will likely become an even more important part of the strategy for top-performing banks, industry observers say.

The market is increasingly rewarding banks that generate strong earnings growth and penalizing those that can't, giving the top earners even stronger currency. Investors have, by and large, also been receptive to banks that have announced small, but strategically important, acquisitions.

"We're seeing separation between good and bad banks," Schutz says. "It's going to help M&A, as more banks have currency that is attractively priced. We'll see M&A continue to accelerate."

The big change in the current cycle, however, is that the biggest banks are avoiding deals. While many industry observers are optimistic about M&A, there is a limit on how much consolidation will take place, says Harvard Winters, a former investment banker who writes equity research on banks.

"It wouldn't surprise me if investors are becoming more optimistic with respect to earnings and asset growth," Winters says.

"That said, the largest institutions are so much bigger compared to last cycle," Winters adds. "So if you believe M&A has helped the per-share growth of the largest banks, be prepared for less growth over the next cycle."

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