Bank Valuation

1
Bank Valuation

• Outline
• Determining the value of the equity of a
  commercial bank
• Using the price-earnings ratio
• Bank merger and acquisition pricing
• Bank earnings and stock prices Which earnings
  matter?
• Deregulation and the value of bank stocks
• Evidence from market responses to bank MA
  announcements

2
Determining the value of the equity of a
commercial bank

• Rate of return Dt (Pt - Pt-1)/ Pt-1, where
  D is for dividends and P is for stock price. The
  value (Pt - Pt-1) is the capital gain on the
  stock.
• Example 1.00 (55 - 50)/50 12
• Price changes tend to dominate dividends in
  determining market rates of returns for most bank
  stocks.
• Determinants of stock price
• The amount of cash flows
• The timing of cash flows
• The riskiness of cash flows
• Present value formula (cash flows CF and
  discount rate r)
• Vo CF1 CF2 CF3 CFn
• (1 r)l (1 r)2 (1
  r)3 (1 r)n

3
Determining the value of the equity of a
commercial bank

• Present value and stock valuation
• Vo 20 20 20 20
  20 100 128.7
• (1.12)1 (1.12)2 (1.12)3
  (1.12)4 (1.12)5 (1.12)5
• Changes in value are due to
• Investor expectations change concerning dividends
  in the future
• Bank risk and market interest rate changes that
  affect the discount rate
• Incorporating growth of earnings
• V0 Div0/(r - r), where g is the nominal growth
  rate of earnings over time.
• Example Assume a bank retains 40 of its
  earnings and its rate of return on equity is 25,
  such that the earnings growth rate is 10. If
  the current annual dividend is 5, and the
  discount rate is 10,
• V0 5/(.10 - .05) 100.
• Note the discount rate equals the sum of the
  current dividend yield (or 5/100 .05) plus
  the growth rate of dividends (or .05).

4
Using the price-earnings ratio

• Price per share/earnings per share
• Top number if forward looking and based on future
  expected growth and earnings.
• Bottom number is backward looking based on
  historical data.
• Merger and acquisition wave is affected P/E
  ratios.
• Bank merger and acquisition pricing
• Merger target bank is absorbed into the buyer
  bank and converted to a branch office (loss of
  bank charter, CEO, and board of directors.
• Acquisition Target bank is incorporated into
  the bank holding company of the buyer bank as a
  separate bank.
• 1994 Riegle-Neal Act deregulating interstate
  banking stimulated the consolidation wave in the
  banking industry.

5
Bank merger and acquisition pricing

• Rhoades study
• Merger premiums paid to target banks dependent on
  target asset growth, growth of its market share,
  and capital/assets ratio of target
• Fraser and Kolari study
• Compared to low premium target banks, high
  premium target banks had
• Higher net income
• Larger fractions of non-interest bearing deposits
  
• Lower loan losses
• Beatty, Santomero, and Smirlock study
• Higher merger premiums paid to target banks with
• Higher net income
• Lower ratios of U.S. Treasury securities/total
  assets
• Lower loan losses

6
Bank earnings and stock prices Which earnings
matter?

• Earnings before securities gains and losses
• Focus on fundamental deposit taking and lending
  activities of banks.
• Securities gains and losses
• More transitory and volatile than other
  components of earnings.
• The market may capitalize operating earnings at a
  higher multiple than securities gains or losses
• Barth, Beaver, and Wolfson study found that bank
  stock prices were positively related to operating
  earnings and negatively related to securities
  gains and losses. Apparently, the market views
  securities gains and losses as an attempt by bank
  management to smooth earnings (which does not
  fool the market).

7
Deregulation and the value of bank stocks

• Visser and Wu study
• DIDMCA of 1980 changed the determinants of P/E
  ratios for banks.
• Growth was less important after the Act.
• Dividend payout ratios became more important
  after the Act.
• Hughes, Lang, Mester, and Moon study
• Interstate banking under the Riegle-Neal Act of
  1994
• Interstate mergers increased financial gains and
  lowered operating risk more than within-state
  mergers of banks.

8
Evidence from market responses to bank MA
announcements

• Hawawini and Swary study
• Price of target banks increases on average about
  11.5 during the week of a MA announcement.
  Cash transactions were more profitable for
  targets than stock deals.
• Bidding bank stock values dropped by 1 to 2.
• Why buy other banks if your stock price falls?
• Managerial agency costs (maximize their welfare
  at expense of shareholders).
• Rolls hubris hypothesis due to excessive
  arrogance on part of bidder management that
  believes they can do a better job managing the
  target.
• Synergy may cause the combined bank to be greater
  than the sum of its parts (due to cost efficiency
  or management expertise).
• Cornett and Tehranian study
• In the long run banks involved in acquisitions
  showed higher than normal cash flow performance
  and greater asset growth. Thus, in the long run
  both targets and bidders benefited from an
  acquistion.

9
The bank megamerger wave

• Motives
• Agency, hubris, and synergy as before but also
  diversification and market power.
• Siems study
• No evidence to support diversification and market
  power motives, as most gains to shareholders from
  agency, hubris, and agency motives.
• Milbourn, Boot, and Thakor study
• Assuming that gains in megamergers are not large,
  the sudden increase in these very large MAs in
  recent years suggests that
• CEOs are seeking to increase their salaries
  (agency cost motive)
• Uncertainty in the competitive environment in
  banking is motivating expansion and
  diversification to reduce risk.
• International banking expansion
• European Union banking directive allowed banks to
  cross national borders since 1993.
• Too big to fail (TBTF) problem increasing in
  importance.