bank valuations

7/28/2019 Bank Valuations

1/20

Bank valuations

Bank Financial Statement Analysis


2/20

2 FFAS 2009

Explain the differencesbetween book, economic, market

and intrinsic value.

Explain the main features and

assumptions of the perpetuitydividend discount model.

Give three common measuresused to compare bankvaluations.

Explain how to value a bank asan annuity.

Give examples of factors leading to

bank stocks trading at a premium ordiscount to intrinsic value.

Explain how to use two stageDDM models in valuing banks.

Session Objectives


3/20

3 FFAS 2009

What is value ?

Book value

- What accounting standards say- Reported and NTA

Economic value

- Market value of assets lessmarket value of liabilities

Market value- Stock prices, what investors say

Intrinsic value- What analysts estimateshould be fair value

Market value = intrinsic value Market value intrinsic value

- Growth and profitabilityexpectations

- Cost of equity

- Premiums and discounts

- Over- & under-valuedstocks

FFAS 2009

Efficient markets

If nobody else carried out investment analysis then active management(stock picking) would produce returns in excess of market

But if enough active investors perform investment analysis then marketswill be efficient and investment analysis will not produce returns in excess of

market


4/20

4 FFAS 2009

Common bank valuation measures

Measures used to illustrate relative valuations PER

(Stock) Price-EPS ratio (prospective/historic)

Used to compare bank stocks with one another and other stocks and overtime Crude relative measure as many stocks not valued on PER basis Gives no absolute price target or what a fair PER should be Historic PER bands

PBR Price-to-reported book and price-to-adjusted book Book adjusted for goodwill (NTA)

Crude relative measure to compare bank valuations (e.g. acquisition price) Gives no absolute price target or what a fair PBR should be

Dividend yield Used when arguing bank stocks are cheap Comparison of yield on bonds issued by bank versus stock dividend yield

Dividend discount model Valuation approach Used extensively by analysts to value banks Gives absolute price target based on profitability, growth prospects and cost

of capital Fair PER and PBR ratios are then derived values


5/20

5 FFAS 2009

Equity discounted cashflow valuations

Uncertain future dividends

Long-dated risk-free rate

Equity risk premium

Required return discount rate

N

nn

n

CfPVRR

1 1

Equity intrinsic value = Cfn given by dividends

Stock specific factor - beta

Special dividends, share buybacks

Rise, fall or be missed

Capital raising, convertible instruments

Required Return (RR) = Cost of equity = Risk free rate

+ Stock beta Equity risk premium = COE


6/20

6 FFAS 2009

Perpetuity dividend discount model

Standard equity valuation approach

Based on CAPM, PV approach Future dividends discounted at COE

Perpetuity growth model simplification dividends paid out at end of yearearned

Earnings growth at rate of g for ever

As n

Giving

where Book1 = Book0 x (1 + g)

PBRProspective =

With g = 0 PBRProspective = Annuity form

FFAS 2009

Equity grows at same rate as earnings gearing unchanged

and ROE given by

0

1

BookincomeNetROE

...

COE1

g1D...

COE1

g1D

COE1

g1DP

n

n

0

2

2

00

...

COE1

D...

COE1

D

COE1

DP

n

n

2

21

gCOE

gROEBookP 1valueFair

gCOE

gROE

COE

ROE


7/207 FFAS 2009

What value for equity to use?

Accountingpolicies &practices

Reportedbook

Legal solvencystatus

Capitalallowable asTier I

Basel/Regulatoryrequirements

Ability to paydividends

Need to raiseequity

Impact onintrinsic value

Ability to meetrequirements

FFAS 2009

Regulatoryfocus andmanagement

target

Other Tier 1 capital (minorities and preference shares) complicate matters


8/208 FFAS 2009

Wells Fargo Bank valuation at the start of 2008

Equity Earnings/ income statement

3% long-run growth

dividend payout ratio

88% =(1 3%/24.9%)

COE = 11%

ROE ($8,299/$33,347) 24.9%

ROE - g 21.9%

COE - g 8.0%

FFAS 2009

ROE/COE 2.26x

Value assuming no growth (2.26 x $9.86) = $22.31

2007A 2008F

Net profit $8,057m $8,299m

Dividends $7,086m $7,299m

EPS $2.38 $2.45

2007A

Reported equity $47,628m- Preferred stock ($450m)

- Goodwill ($13,106m)

- Accumulated comprehensive income ($725m)

Tier 1 equity $33,347m

2007A 2008F

Shares outstanding 3,383m 3,383m

Book value $9.86 $10.16

Prospective 2008F EPS ($) $2.45Fair PER prospective 11.35x

Fair-value Price-BookProspective -Ratio 2.74x

Prospective 2008F book ($) $10.16

Intrinsic value per share ($) = $27.8

Price in March 2008 $28


9/209 FFAS 2009

Strengths of DDM framework

Communicability & basis

Absolute valuation targets

Comparability

Sensitivity double edged sword

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

3% 4% 5% 6% 7%

PBR

8% 9% 10% 11% 12%

PBR

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

13% 14% 15% 16% 17%

PBR

0.0x

0.5x

1.0x

1.5x2.0x

2.5x

3.0x

3.5x

ROE 15%, COE 10% ROE 15%, growth 5% Growth 5%, COE 10%

Growth COE ROE

Flexibility

Speed

Effort

FFAS 2009


10/2010 FFAS 2009

Assumptions Cost of equity

Cost of equity = Risk free rate + Stock beta Equity risk premium

Beta - information providers(e.g. Bloomberg)

Stability time & periodicity

Business composition &acquisitions/ divestments

Changing market composition

FFAS 2009

Risk-free rate

Current 15-year yields? 20 years?

Expectations of future yields?

US$ swap rates in developingmarkets? 5-7 years.

Currency breakdown of earnings?

CAPM does not always produce plausible values for cost of equity e.g.Wells Fargo Bank had beta of about 0.4, 20-year Treasury bond yields about

5%, equity risk premium of ~ 4% implies cost of equity of about 7%

What is the equity risk premium?

m

im,ii r


11/2011 FFAS 2009

Assumptions - Return-on-equity (ROE)

Definitions and meanings of earnings and equity

Accounting policies & practices (e.g. gains of AFS investments)

Smoothing objectives (e.g. bad debt provisioning)

Mark-to-market vs. historic cost confusion

Earnings

Equity

Disposal gains vs. trading profits

Bad debt charge through the cycle

Goodwill charge should be excluded if included

Excess provisions

FFAS 2009

Treatment of goodwill

ROAE

Key performance measure but different than ROE used in

DDM modeling

ROE = Net income for first year of steady growth equity at

start of year


12/2012 FFAS 2009

Assumptions - growth, time and gearing

Growth

Long-term capped by nominal GDP

ROE greater than COE

Time

Short-term forecasts

Barriers to entry

Gearing remains constant

Gearing

Equity grows in line with earnings - requires

gPOR 1

ROE

Interpretation of actual payout ratio

FFAS 2009

Stock buy backs


13/2013 FFAS 2009

Multi-stage models

Short/medium-term forecasts

E.g. period of stronger growth, rebuilding

capital base

ROE to COE fade (more advanced)

Correct for some perpetuity flaws

Simplified example, COE = 10%, g = 4%

Year ($m) 2007A 2008F 2009F 2010F 2011F

Equity $53,000 $61,484 $70,859 $73,803 $76,755 (=$73,030 x 1.04)

Earnings $7,834 $8,931 $9,868 $10,904 $11,341 (=$10,904 x 1.04)

Dividend $447 $493 $7,960

Earnings growth 14% 11% 11% 4%

Year 2007A 2008F 2009F 2010F Total

Dividend 447 493 7,960

Discount rate 1.1 1.21 1.33

PV of dividends 406 408 5,981 6,794

Calculate present value of dividends over next three years ($)

FFAS 2009


14/2014 FFAS 2009

Prospective book (as of end of 2011) $76,755m

Fair value at end of 2010 $145,835m

Number of shares (m) 5,000mFair value per share ($) (end of 2007) $23.29

Discount factor (at end of 2010) 1.33

Present value at end of 2007 $109,650m

Plus present value of dividends (end of 2007) +$6,794m

Total PV (2007) $116,444m

Discount future perpetuity fair value back to PV

Self-adjusting models linked to price data

Multi-stage models (cont)

FFAS 2009

Equity at the end of 2010 $73,803m

Forecast net income 2011 $11,341m

ROE = [ 11,342/73,803 ] 15.4%

Fair value PBR [ = (15.4% - 4%)/(10% - 4%) ] 1.90

Payout ratio = 1g/ROE = 14%/15.4% = 74%


15/2015 FFAS 2009

Value of future growth (opportunities)

Capitalise earnings to get value of earnings as annuity

= Net income/COE

Equivalent to (Book value x ROE)/COE

Value of future growth (opportunities) =

Market value Value of bank stock as annuity

VFO/VFG

Useful way to look at how much the market is pricing in forearnings growth

Fair value PBR multiple for bank when ROE less than COE given byPBRfair value = ROE/COE


16/2016 FFAS 2009

Premiums to intrinsic value

Weight of money

Mutual fund inflows & redemptions

Asset allocation

Liquidity & free float

Excess capital but may also lead to discount

Index issues

Takeover speculation

Other speculation

Management quality

FFAS 2009

Flight to quality


17/2017 FFAS 2009

Discounts to intrinsic value

Size

Liquidity & free float

Asset quality exposureto higher risk sectors, NPLlevels, sub-prime loans

Balance sheet structuree.g. liquidity (wholesalefunding), interest ratemismatch

Ownership, corporate

governance & transparency

Holding company discount

Conglomerate discount

Regulatory, country risk e.g.mis-selling practices, political risk,capital controls

Management quality e.g. acquisition history

FFAS 2009

Capital raising expected Exposure to markets with poorgrowth prospects


18/2018 FFAS 2009

HSBC vs. RBS Price Chart (March 2008)

Down 15% yoy Down 50% yoy

HSBC RBS


19/20

19 FFAS 2009

Royal Bank of Scotland (RBS) vs HSBC March 2008

HSBC

Net profit attributable to shareholders (2007) $19,133m

Total reported Tier 1 ratio 9.40%

Tier 1 equity* $89.3bn

RWAs $1,123bn

Tier 1 equity ratio 8.0%

Annuity value at 12% COE $159bn

Market capitalisation (March 6th) $174bn

VFG (%) 9.4%

Historic PBR (NTA) 1.78x

Historic PER 9.3x

Historic dividend yield 6.0%

RBS consolidated ABN Amro on October 17th 2007 wrote-down 2.8bn sub-prime in 2007

Market pricing in capital raising, dividend cut for years to come at RBS, further write-downs

26 February 2008 RBS management claims can avoid capital raising (earn way out orthrough asset disposals) increases dividend for 2007 by 10% as signal of its confidence

RBS

7,303m

7.30%

4.6bn

257.2bn

1.8%

61bn

31bn

-49.1%

13.3x

4.6x

9.9%

22 April 2008 RBS announces 12bn rights issue

*Tier 1 equity used here = Reported equity Intangible assets, no other adjustments made

S i Obj ti


20/20

20

Explain the differencesbetween book, economic, market

and intrinsic value.

Explain the main features andassumptions of the perpetuitydividend discount model.

Give three common measuresused to compare bankvaluations.

Explain how to value a bank asan annuity.

Give examples of factors leading tobank stocks trading at a premium ordiscount to intrinsic value.

Explain how to use two stageDDM models in valuing banks.

Session Objectives

bank valuations

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