Are Your Bank s Returns Exceeding Your Cost of Capital?

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1 4th Quarter 2016 Are Your Bank s Returns Exceeding Your Cost of Capital? There are different ways to frame this question. Are you maximizing shareholder wealth? is one we often hear. Are you maximizing the value of the firm? is another. In past articles, we have written about this important issue. In the corporate world, there is an existential threat to any firm in a situation in which returns to the providers of capital fall short of costs. Think of great companies in the past such as Kodak, Sears, and more recently, Yahoo. Each one of these has its own unique story explaining its decline, but the bottom line is that at a point in time their business models were no longer capable of generating returns that exceeded their cost of capital. When this occurs, a business will eventually wither and die, unless it is rescued by another firm. Do you know whether your bank s returns are exceeding your cost of capital? Measuring accounting profits is fairly straightforward, as we re dealing with revenue and explicit costs. Sure, we have accounting rules that seem to be ever-changing to complicate the matter, but any competent CPA can arrive at reasonable estimates of accounting profits. Furthermore, bankers rely heavily on accounting-based metrics, such as return on assets (ROA) and return on equity (ROE), but the problem is that these metrics do not capture risk. If you are not examining whether your bank is generating sufficient returns to compensate shareholders for the risk assumed, your analysis is incomplete. As Brealey, Myers, and Allen say in their popular MBA textbook Principles of Corporate Finance, a business that breaks even in terms of accounting profits is really making a loss [as] it is failing to cover the cost of capital. In the corporate world, there is an existential threat to any firm in a situation in which returns to the providers of capital fall short of costs. To know whether a bank is generating returns exceeding its cost of capital and creating shareholder value, we need to make a careful distinction between accounting and economic profits. We tend to overemphasize accounting profits and underemphasize economic profits, yet the latter is every bit as important perhaps more so. Here s the challenge. Estimating Return on Invested Capital In theory, it sounds easy to assess whether a firm is generating returns that exceed its cost of capital. In a previous research article, our colleague, Joe Blake, specifically discussed how to measure a bank s cost of capital using the capital asset pricing model (CAPM). Recently, we worked with a small community bank that had an investment bank estimate its cost of capital, and the process they used was rather involved. The CAPM can be used, as Blake described in his article, but various assumptions and nuances are inherent to the model. continued on page 2 AmbassadorAlert 4th Quarter 2016 Are Your Bank s Returns Exceeding Your Cost of Capital? 1

2 As Ross Perot loved to say when he was running for president back in the 1990s, The devil is in the details! Answering the question, Are your bank s returns exceeding your cost of capital? is not a simple exercise there are many details to consider. Bloomsburg University Professor Dr. Victoria Geyfman and I have recently completed two working papers on the topic of building shareholder value. Geyfman was an analyst at the Philadelphia Fed before entering academia, and as many of you know, I worked with hundreds of banks during my more-than-decade-long career in industry before joining the faculty at Kutztown University. We both continue to research community banks. If you re interested in receiving copies of our working papers, please feel free to contact me using my Ambassador address (JWalker@ambfg.com). Both papers provide extensive details not included in this article that you might find helpful. Our first paper deals with how to go about estimating a bank s return on invested capital (ROIC). Bankers are used to calculating ROA and ROE, but the reality is, what we really want to know is, how much is the bank returning on invested capital? In the literature, there is debate as to whether deposits should be counted as part of the bank s capital stock. We are in the camp that believes deposits are part of your operation, not part of your capital. Primarily, the stakeholders you need to please are your stockholders. Yet, banks do employ other forms of capital, and they need to ensure sufficient returns to cover those costs, too, with enough left over to cover the implicit cost of equity. A book we found helpful for our research is titled Integrated Bank Analysis & Valuation, by Sandy Chen. This book was published in The author provides what I will term a recipe for calculating a bank s ROIC. He shows all the additions and subtractions needed to arrive at adjusted equity, such as the treatment for goodwill, amortized intangibles, pension liabilities, and minority interests. Likewise, Chen shows all the additions and subtractions needed to arrive at adjusted net profit, such as goodwill/ intangibles amortization, exceptional items, and unrealized fair value gains/losses. His analysis is geared toward large multinational banks, as he shows the application of his recipe to Citigroup, Barclays, and several other megabanks. (The book includes a copy of his Excel workbook that helps you better understand his calculations.) In our first working paper, Geyfman and I adapt Chen s model to community banks. The computation of ROIC for a small bank is simpler than for a megabank. However, the numerator and denominator for ROIC are distinctly different than the numerators and denominators for ROA and ROE. In our paper we discuss how we arrived at the determination of both. Below we show the numerator (Equation 1) and denominator (Equation 2) we suggest for an ROIC calculation for a community bank: Equation 1: Adjusted Net Operating Profit after Taxes = Earnings before Taxes (1 Tax Rate) + Provisions for Loan Losses Net Charge-Offs + Interest on Borrowings Equation 2: Invested Capital = Total Equity + Loan Loss Reserves + Total Debt In accounting and finance, we often refer to net operating profit after taxes as NOPAT and earnings before taxes as EBT. Equation 1 represents the profits after taxes that can be dispersed to all the providers of capital to meet their required returns. Any residual profits serve to increase the value of the firm. Equation 2 represents a bank s total invested capital, excluding deposits. Estimating Weighted Average Cost of Capital The exercise to determine whether a community bank is generating returns that exceed its cost of capital becomes particularly challenging when calculating the weighted average cost of capital, often referred to as WACC. A bank s WACC captures the overall cost of debt, preferred stock, and continued on page 3 AmbassadorAlert 4th Quarter 2016 Are Your Bank s Returns Exceeding Your Cost of Capital? 2

3 common stock. Brigham and Houston s textbook titled Fundamentals of Financial Management provides the following equation: Equation 3: WACC = w d r d (1 T) + w p r p + w c r s where w d, w p, and w c are the target weights of debt, preferred stock, and common equity; r d, r p, and r s are the costs of debt, preferred stock, and common equity; and T is the firm s marginal tax rate. Given the tax deduction and low interest-rate environment, debt is currently a very attractive form of financing for banks to consider. Given the tax deduction and low interest-rate environment, debt is currently a very attractive form of financing for banks to consider. The reason that calculating WACC is challenging is it requires the difficult task of finding an estimate for the cost of common equity (r s ). Our research explored the use of the CAPM, as discussed by Blake in an earlier research article. (See Ambassador s website for past research articles.) To use the CAPM, you need to decide on an appropriate risk-free rate, a market risk premium, and the beta for your bank. Recall that the beta measures a stock s relative risk to the market. Theory suggests that the higher the beta, the greater the required return, which needs to be incorporated into the WACC estimate. In our working paper, we discuss the various assumptions and where to find values for the CAPM variables. Our research into WACC calculations for community banks extends work done by Blake and Chen, as they rely solely on the CAPM for the cost of equity estimate. There s what is termed in the valuation literature as a size premium that some believe is an important add-on to CAPM-based cost of capital estimates. This is where the WACC estimation process starts to feel like religion some believe and some don t. Some argue that a size premium should be added to cost of capital estimates for small firms the size of community banks. Then you have others, most noteworthy valuation expert Dr. Aswath Damodaran at NYU, saying that size premiums don t make sense. Because experts are on both sides of this argument, it leaves us scratching our heads asking, what is appropriate? Should you add a size premium when estimating the cost of equity financing for a community bank? Unfortunately, this question is left unresolved. Results for a Sample of Community Banks Based on the finance literature and practitioner reports we obtained from investment banks, it seems that most are applying a size premium to cost of capital estimates for community banks. Keep in mind that the size premium applies specifically to cost estimates for common equity. Thus, if a bank has a sizable amount of debt and preferred equity financing, the costs for those components are blended into the WACC estimate, diluting the impact of the size-or-no-size-premium decision. Nevertheless, when we estimated the WACC for 37 community banks (shown in Table 1), the estimates with the size premium were noticeably higher than those without the premium. Without the size premium, the range in WACC is 3.2% to 5.7%; with a premium, this range shifts up to 6.6% to 9.1%. Table 1: WACC Estimates without size premium with size premium Avg. 3.2% 5.7% 6.6% 9.1% Min. 6.0% 12.4% 11.5% 15.1% Max. 0.5% 2.0% 3.3% 4.3% Based on WACC estimates with size premiums, we estimate that roughly half of the sample of community banks we analyzed have ROICs below their WACCs. Think about that for a second. Half the banks in our sample are generating returns below their cost of capital. What we are left wondering is: Are the executives and boards of directors at these banks aware of this? The sample of banks that Geyfman and I selected is from Pennsylvania, so we do not know if we can infer from our findings that half the community continued on page 4 AmbassadorAlert 4th Quarter 2016 Are Your Bank s Returns Exceeding Your Cost of Capital? 3

4 banks nationwide are currently generating returns under their cost of capital. On the other hand, are Pennsylvania banks that much different than banks in other states? Probably not. Thus, the evidence we collected might signal trouble for many community banks in the United States. The next step for us is to create a national sample of banks to see if we generate similar results. Final Thoughts Many years ago I had a conversation with the CEO of a small community bank who was curious about the various performance ratios used for financial analysis of banks. He said, It would be nice if there were just one number that could tell us whether our bank is doing great or not. Unfortunately, finding that one number is like looking for the Holy Grail. Each ratio seems to have worthwhile informational content, but each has its shortcomings. I do not want to leave the impression that ROIC is necessarily a better metric When measuring financial performance, using only metrics that are blind to the risk the bank is taking can be misleading. than ROA or ROE. However, what I like about it is that it can be compared to WACC, and WACC captures the cost of capital adjusted for risk. When measuring financial performance, using only metrics that are blind to the risk the bank is taking can be misleading. If you do your best to estimate ROIC and WACC as accurately as possible to see that returns do in fact exceed costs, we believe this provides management and the board with important information about the bank s overall performance and likelihood for survival as an independent community bank. John S. Walker, Ph.D., CFA Chief Economist AmbassadorAlert 4th Quarter 2016 Are Your Bank s Returns Exceeding Your Cost of Capital? 4

5 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA Executive Blvd. Suite 503 Rockville, MD Chicago Mercantile Exchange 30 South Wacker Drive 22nd Floor Chicago, IL Joshua A. Albright, CFA Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Ryan G. Epler Heidi Frey Administrative and Trade Settlement Coordinator Charles Gorman Associate Strategic Analyst Mike Harrison Vice President Karl J. Ostby Investment Banking Robert J. Pachence, Jr. Co-Founder & Managing Principal Jack E. Payne, CFA, CFP Finance & Operations John D. Putman Senior Vice President Michael Rasmussen Investment Banking Matthew T. Resch, CFA Co-Founder & Managing Principal Jay Shah, CFA Vice President, Capital Markets Eric R. Tesche Managing Director Mark B. Trinkle John S. Walker, Ph.D., CFA Chief Economist Ryan Walker Associate Strategic Analyst Rick Weiss Senior Bank Strategist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at Ambassador Financial Group, Inc. Important Disclosure: Ambassador Financial Group does and seeks to do business with companies included in this report. As a result, readers should be aware that the firm may have a conflict of interest that could affect the objectivity of the report.