Sticking to Quality
Valuations of distressed banks are something I can’t claim to do well because leverage is involved. Even with average banks, I’m a little skeptical, as it’s pretty easy for any bank to lose its footing and zoom all the way to zero. So, if I’m valuing a bank, I’m valuing the ones that meet my criteria of being a good bank. There’s always a non-zero chance that you’re going to lose your entire investment, which is why banks, even the good ones, need more of a margin of safety than other investments. Fortunately, since they’re a boom and bust industry with an enormous amount of fear and greed attached, good banks’ stock prices often fall to a margin of safety more often than normal companies.
What’s my Earning Power, Again?
Bank earnings can be pretty lumpy, so averages are your friend. The kind of earnings we like best are ones without too many peaks and valleys, but sometimes that’s not the case, even for well run banks if they’ve had a number of acquisitions or found their Fannie Mae preferreds worth a whole lot less than expected. (Management got an F- for the quarter for that one. DARN you Valley National (NYSE:VLY)! Didn’t own any at the time, but they were on my good list. Still are, I suppose, but I’m keeping one eye on them.)
The best way to get a handle on a bank’s normalized earnings, is by finding the ten-year average ROAA and multiplying it by the present assets. Ten-year ROAA generally gets a complete business cycle (boy, it does for this past decade, for sure) and should be a pretty good metric of how much a bank can presently earn on its assets. I focus on banks that have at least a ten year ROAA above 1.0%, and usually a bit more than that.
Growth is Good. Slow, Steady Growth is Better.
Once you have your normalized earnings, you have half of what you need for a DCF calculation. So, what about growth? Simple. Don’t go over 8% short term. And long term, don’t go over 6%. This is not a growth industry. You’re going to see times when good banks will be able to take advantage of financial carnage and grow at some pretty decent clips for a year or two, but these are met with long periods where nothing is on sale, loan margins are tight due to greedy empire builders, and a bank will have a tougher time drumming up quality business. The best banks understand that growth for growth’s sake is a bad idea.
Growth is good, but not at the expense of quality or profitability.
Also, since we’re using DCF, I find that using growth rates above 8% leads to some rather large differences when you change a single value by a little bit, so I generally try to keep my growth levels pretty low when using it. DCF is not a very good model for higher growth companies. (But then again, what is?)
Ultimately, I usually use 6% short term (first five years) growth and 6% long term growth for a great bank in a good area. Less if I’m worried about the area’s prospects. If a bank has some great growth prospects, I’ll bump the short term growth up to about 8%.
I use 15% as my discount rate as 15% is a return I am very happy with and is a good bit more than a decent bank’s cost of capital. This helps me build in an initial margin of safety. I then look for a 20% margin of safety once I run the DCF calculation. This may seem low, but remember I’m using a 15% discount rate, so I consider a lot of safety already built in.
This ultimately leads to liking normalized bank P/E ratios of about 9.5 to 10.5. Which means, if it’s a good bank, my buy threshold is around 10 times normalized earnings, and if it has some great growth prospects, I’ll go to 11. (Feel free to insert your own “Spinal Tap” reference here.)
A Little Bit of Fudging
Banks that keep some extra dry powder should be rewarded in their valuation. Here’s how I do it:
Under certain circumstances, if I think a bank has some extra cash on its balance sheet, I’ll subtract the excess cash from the market cap to give it a pseudo enterprise value. To figure out if I think bank is overcapitalized, I’ll take the amount of tangible common equity and loan loss reserves that are over 10% of tangible assets, and I’ll treat it as excess cash on the balance sheet. For example, for a bank that has $15 million in tangible common equity and loan loss reserves against $100 million in tangible assets, if I know the bank is a fabulous underwriter, and management has shown they are not the sort to let excess cash just sit without returning to shareholders, I’ll subtract $5 million from the bank’s market cap. The condition of it being a great bank with prudent management is a requirement before we can enter this excess capitalization into a bank’s value. Every now and then, this adjustment lets me buy a great bank I think is selling for 12x or 13x earnings.
The Requisite Example
Hmm. What’s a great bank on sale right now? We’re right on the threshold for many, but we’ll stick with my usual favorite, US Bank. US Bank’s 10 year ROAA is about 1.66%. Given the last decade, that’s a pretty awe inspiring number. USB has about $311 billion in assets, meaning a normalized earnings of about $5.16 billion. USB is a little light on the capitalization side (as it’s always been), and it’s not something I’m going to hold against it, but I wouldn’t say it has excess cash on it’s balance sheet with $26 billion in tangible equity (Note, that the real ratio would use tangible common equity, which is even less than tangible equity. Oy vey.) and loan loss reserves versus the $300 billion in tangible assets they have.
So, with a market cap of about $44 billion, USB has a normalized P/E of about 8.5. Prices for a bank this stellar are pretty spectacular, even if the macroeconomic world we’re facing gets worse.
The 10-10-10 Method
Know what I usually do to value a bank quickly? I call it the 10-10-10 method. I ask myself three questions: What is the rough average ROA for the past ten years? Is the market cap less than ten times the normalized earnings? And, is there any excess capital over 10% that I need to figure in? This method makes it pretty easy when you’re scanning through your list of great banks, looking to see what’s on sale without having to pull up a spreadsheet.
Now that your armed with the banking analysis series (parts 1, 2, 3, 4) and a quick means of valuation, by all means, go out and clean up in the market. There are some bargains on fantastic banks to be enjoyed, so happy hunting.
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Full Disclosure: I own USB (surprise, surprise). I have no position with VLY.