Bank valuations

Bank Financial Statement Analysis

2
FFAS 2009
Explain the differences
between book, economic, market
and intrinsic value.
Explain the main features and
assumptions of the perpetuity
dividend discount model.
Give three common measures
used to compare bank
valuations.
Explain how to value a bank as
an annuity.
Give examples of factors leading to
bank stocks trading at a premium or
discount to intrinsic value.
Explain how to use two stage
DDM models in valuing banks.
Session Objectives
3
FFAS 2009
What is value ?
Book value
- What accounting standards say
- Reported and NTA
Economic value
- Market value of assets less
market value of liabilities
( Market value
- Stock prices, what investors say
& Intrinsic value
- What analysts estimate
should be fair value
Market value = intrinsic value
Market value intrinsic value
- Growth and profitability
expectations
- Cost of equity
- Premiums and discounts
- Over- & under-valued
stocks
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 markets
will be efficient and investment analysis will not produce returns in excess of
market
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 over
time
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
FFAS 2009
Equity discounted cashflow valuations
Uncertain future dividends
Long-dated risk-free rate
Equity risk premium
Required return discount rate
( )
N
n
n
n
Cf
PV
RR =
=
+

1 1
Equity intrinsic value =
Cf
n
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
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 year
earned
Earnings growth at rate of g for ever
As n
Giving
where Book
1
= Book
0
x (1 + g)
PBR
Prospective
=
With g = 0
PBR
Prospective
= Annuity form
FFAS 2009
Equity grows at same rate as earnings gearing unchanged
and ROE given by
0
1
Book
income Net
ROE =
( ) ( )
( )
( )
( )
...
COE 1
g 1 D
...
COE 1
g 1 D
COE 1
g 1 D
P
n
n
0
2
2
0 0
+
+
+
+ +
+
+
+
+
+
=
( ) ( )
...
COE 1
D
...
COE 1
D
COE 1
D
P
n
n
2
2 1
+
+
+ +
+
+
+
=
g COE
g ROE
Book P
1 value Fair

=
g COE
g ROE

COE
ROE
7
FFAS 2009
What value for equity to use?
Accounting
policies &
practices
Reported
book
Legal solvency
status
Capital
allowable as
Tier I
Basel/Regulatory
requirements
Ability to pay
dividends
Need to raise
equity
Impact on
intrinsic value
Ability to meet
requirements
FFAS 2009
Regulatory
focus and
management
target
Other Tier 1 capital (minorities and preference shares) complicate matters
8
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 $10.16
Prospective 2008F EPS ($) $2.45
Fair PER prospective 11.35x
Fair-value Price-Book
Prospective
-Ratio 2.74x
Prospective 2008F book ($) $10.16
Intrinsic value per share ($) = $27.8
Price in March 2008 $28
9
FFAS 2009
Strengths of DDM framework
Communicability & basis
Absolute valuation targets
Comparability
Sensitivity double edged sword
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
3.0x
3.5x
3%
4% 5% 6% 7%
PBR
8% 9% 10% 11% 12%
PBR
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
3.0x
3.5x
13% 14% 15% 16% 17%
PBR
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
3.0x
3.5x
ROE 15%, COE 10%
ROE 15%, growth 5% Growth 5%, COE 10%
Growth
COE
ROE
Flexibility
Speed
Effort
FFAS 2009
10
FFAS 2009
Assumptions Cost of equity
Cost of equity = Risk free rate + Stock beta Equity risk premium
Beta - information providers
(e.g. Bloomberg)
Stability time & periodicity
Business composition &
acquisitions/ divestments
Changing market composition
FFAS 2009
Risk-free rate
Current 15-year yields? 20 years?
Expectations of future yields?
US$ swap rates in developing
markets? 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
i
m , i i
r
o
o
| =
11
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
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
g
POR 1
ROE
=
Interpretation of actual payout ratio
FFAS 2009
Stock buy backs
13
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
FFAS 2009
Prospective book (as of end of 2011) $76,755m
Fair value at end of 2010 $145,835m
Number of shares (m) 5,000m
Fair value per share ($) (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 = 1 g/ROE = 1 4%/15.4% = 74%
15
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 for
earnings growth
Fair value PBR multiple for bank when ROE less than COE given by
PBRfair value = ROE/COE
16
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
FFAS 2009
Discounts to intrinsic value
Size
+ Liquidity & free float
Asset quality exposure
to higher risk sectors, NPL
levels, sub-prime loans
Balance sheet structure
e.g. liquidity (wholesale
funding), interest rate
mismatch
m 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 poor
growth prospects
18
FFAS 2009
HSBC vs. RBS Price Chart (March 2008)
Down 15% yoy
Down 50% yoy
HSBC RBS
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 6
th
) $174bn
VFG (%) 9.4%
Historic PBR (NTA) 1.78x
Historic PER 9.3x
Historic dividend yield 6.0%
RBS consolidated ABN Amro on October 17
th
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 or
through 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
20
FFAS 2009
Explain the differences
between book, economic, market
and intrinsic value.
Explain the main features and
assumptions of the perpetuity
dividend discount model.
Give three common measures
used to compare bank
valuations.
Explain how to value a bank as
an annuity.
Give examples of factors leading to
bank stocks trading at a premium or
discount to intrinsic value.
Explain how to use two stage
DDM models in valuing banks.
Session Objectives