Workout Period Is Best Measure of a Deal's Value
There is at present no standard financial tool for comprehensively evaluating bank acquisitions. The usual measures of acquisition pricing - including price to book value, price to tangible book value, price to assets, and price to earnings - suffer from two defects.
First, they are, with the exception of price to earnings, forms of balance sheet accounting; price to earnings is a ratio based on accounting income. Too often, these measures prove to be poor proxies for real economic value.
Second, none of these measures can account for any of the factors that eventually make an acquisition succeed or fail.
The success of an acquisition depends on many factors. The list below is not all inclusive - good management communications, for example, which may be the single most important factor, is not listed because it is not quantifiable. The following are among the more important quantifiable factors that affect the success of a merger.
* Any merger achieves some efficiencies. The most dramatic ones are achieved when in-market mergers such as Chemical-Manufacturers Hanover (expected efficiencies of $650 million after three years) and BankAmerica-Security Pacific (expected efficiencies of $1 billion after three years) permit branch closings and reduce operating and marketing costs.
The management of NCNB and C&S/Sovran, in contrast, projects operational savings of just $350 million because only a fraction of the respective markets overlap.
* Any merger has associated costs, including separation packages, software development, and name change.
* Income potential and acquisition premiums are dependent on economic growth. Acquisitions in Illinois and Ohio, for example, are more expensive because the Midwest economy is relatively strong and getting stronger.
The inadequacy of the currently accepted measurements can be shown by comparing the three recent megamergers. If price to book, for example, were to make sense as a comparison, then at least one of the deals wouldn't make sense: The ratio ranges from 69.5% for Chemical-Hanover to 143.4% for NCNB-C&S Sovran. [Tabular Data Omitted]
There is, however, a little-known alternative measurement of acquisition price that can account for these factors in a cash flow analysis. That measurement is the workout period.
The workout period is used to assess the effectiveness of an acquisition. It refers to an estimate of how long it will take a buyer to achieve its targeted rate of return on an acquisition. Typically, the targeted rate of return ranges from 12% to 15%.
The estimated workout period results from calculating the income required over time to meet the targeted return on capital and contrasting it with the projected income of the acquisitions, adjusted in the early years for the estimated efficiencies as well as associated merger costs.
Why have a measure based on units of time? The reason is that time is the only reliable standard in a financial world in which all other measures are changing. A deal may be struck today based on the expectation of high future income to meet a high return-on-income standard. If the cost of capital should decline during the next few years, the ROI standard will have proved to be too high.
However, a decline in the cost of capital would probably signal a shift in economic preferences from a consumption to savings. Such a shift would put downward pressure on future income streams. These two factors would tend to counterbalance, leaving the workout period as a reliable measure of the financial quality of a merger or acquisition.
How Long Will It Take?
The length of the workout period is determined by the amount of time it takes projected cumulative earnings attributable to an acquisition to reach cumulative earnings computed on the basis of the selected ROI objective.
Anything less than 10 years is a very good deal, 11 to 20 is good to acceptable, and 21 to 30 is questionable but may be justified by strategic considerations such as market penetration. Workout periods of more than 30 years are generally considered unacceptable.
The workout periods of the three deals in the table are about the same, because all three deals make good economics sense and the workout period is designed to measure the economies of a deal. The calculations assumed a targeted ROI of 14% and middle-of-the-road economic forecasts (deposit and asset growth of 5% a year and long-term income growth of 5% to 10% a year).
The calculation of workout periods can be complex. Consider, for example, the acquisition announced in July of Davenport Bank and Trust Co., a $1.8 billion-asset company based in Davenport, Iowa, by Norwest Corp., a $37 billion-asset Minneapolis-based super-regional.
Nominally, Norwest is paying about $295 million for the acquisition. However, since Davenport has an equity-to-assets ratio of 12.4% and an exceptionally clean balance sheet, Norwest is acquiring at least $75 million in excess capital that can be used to support future expansion.
Capital Helps Offset Deal Price
This capital inures to the benefit of the buyer and can be regarded as an economic offset to the acquisition price.
The resulting projected income ($22.0 million in 1992, rising to $41.8 million in 2001), in addition to Davenport's expected earnings after the removal of $75 million in equity from its balance sheet, takes into account merger costs, savings, and the revenue enhancements attributable to Norwest's investment in Davenport.
The projected income results in a median workout period of 10 years. According to the model, this is the time it will take Norwest to fully earn a 14% return on its acquisition investment. And 10 years, by the workout period standards developed over the past five years, means that Davenport is a very good deal for Norwest.
Precisely because the analysis models the cash flow decision-making that should go into planning a sound acquisition, the workout period provides the best available measure of acquisition pricing.
Mr. McRae is a contributing editor of Bank Mergers and Acquisitions, a newsletter published by SNL Securitoes. The data base and oublishing firm, based in Charlottesville, Va., specializes in the banking and thrift industries.