Bankers are frustrated by lackluster earnings and low stock prices despite improving balance sheets. Many long for the return of pre-crisis earnings growth and pricing multiples. Some will be tempted to pursue increased earnings through misguided expansion strategies rather than returning excess capital to investors.
Moody’s recently warned of banks diversifying into new higher risk activities to offset weak core operations. This threatens to depress pricing and trigger a race for the bottom in potentially dangerous segments like specialty lending. Additionally, although currently muted, ill-advised dilutive acquisitions are sure to follow once market conditions improve.
Banks must guard against such actions based on the mistaken belief that investors value earnings increases. Generally accepted accounting principles earnings are an incomplete profitability measure as they ignore the cost of equity capital needed to generate earnings.
Markets do not passively respond to reported earnings with a constant valuation multiple. Rather, the multiples change to reflect the quality of earnings generated given the level of capital employed. Investors focus on residual income, earnings less the cost of equity employed, not earnings alone. Consequently, banks should distinguish between value-added residual income growth and earnings expansion that destroys value. Capital may look free to managers, but not to investors who provide it. Value is created only when returns on equity exceed the cost of equity. Expansion, with its subpar returns, may make the kingdom bigger, but its citizen investors will be poorer as it traps capital in a hostile environment.
The pressure to expand is among the greatest threats to effective strategy. Asset expansion consumes capital as equity is required to maintain target levels. Earnings growth ignores capital efficiency as balance sheets measure money spent and not value. Capital efficiency, not earnings alone, creates value. A simple example illustrates this fact.
Assume you double an investment in a certificate of deposit at the same cost of capital. Earnings doubled, but clearly no one should receive a bonus on that increase as residual income, after the capital charge for the increased investment, is unchanged. This demonstrates that earnings, not necessarily value, can always be manufactured by simply employing more capital in investment with positive earnings.
What really matters is the spread on new investment less the equity costs on the capital required to generate the return. Current bank equity costs are approximately 10% based on published sources such as Morningstar. Consequently, banks with single digit ROE, even if their earnings per share are growing, are destroying shareholder value. These banks should and do trade at discounts to tangible book value.
Some believe current ROE will improve over time to pre-crisis levels. Unfortunately, the favorable pre-crisis industry conditions of economic growth, favorable rates and modest regulation are unlikely to return in the foreseeable future. Leveraged growth banking has been replaced with the new slow growth regulated utility banking reality. Thus, the likelihood of investing in positive spread growth opportunities is low.
Improving returns by making existing operations more efficient will have a larger value impact than asset expansion in this mature environment. Betting on growth in the consolidating banking industry while maintaining a high cost structure for a larger volume of business than is realistically achievable is folly.
Despite these facts, growth strategies remain popular as they fit the conventional wisdom that bigger is better. Also, it reflects how management performance is rewarded and evaluated. Unlike investment proposals, which reflect a capital cost, most performance and incentive systems are largely earnings based. Thus, they can be gamed to favor management at shareholder expense through unwarranted expansion. The focus needs to be on residual income not earnings when evaluating strategies, assessing performance and awarding incentives to ensure management and shareholder interests are aligned. Current low bank multiples partly reflect investor concerns that managers will misallocate capital by engaging in value-destructive expansion. Banks should temper their ambition to fit reduced industry opportunities instead of trying to create opportunities to match their ambition.
Size matters, but not necessarily in the way many think. Getting bigger can be a means to improving intrinsic value. It is not, however, an end in itself. The paradox of expansion is that increased earnings can be hazardous to shareholders wealth. The preferred near-term bank strategy is to manage for return by curtailing asset expansion and returning excess capital to investors subject to regulatory constraints. The key is delivering value to shareholders, not building an empire. The kingdom may be smaller, but its citizens will be richer.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.