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 M&A 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 M&A announcements • Hawawini and Swary study: • Price of target banks increases on average about 11.5% during the week of a M&A 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). Roll’s 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 M&As 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.