Time to Take Another Look at Managing Your Cost of Capital

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1 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital I m pleased to introduce an article written by Joe Blake, a colleague with whom I ve enjoyed working for years. It is an update to an article that he wrote several years ago. The concepts in and the point to his article are timeless, and the advice he gives should be understood and followed carefully by bankers when they make decisions about the balance sheet and formulate growth strategies. Corporate finance courses, regardless of whether they educate undergraduates or MBAs, spend a lot of time discussing capital budgeting. Students learn that, in order to begin the capital budgeting process, a firm must estimate its cost of capital. Often the cost of capital is termed the weighted average cost of capital (WACC) because capital comes from various sources, including equity and bond financing. Joe discusses how a firm can arrive at a suitable estimate for the cost of equity. For banks, WACC also derives from many sources of funding, not just equity. For example, we like to think of demand deposits as having zero cost and being the best source of funding. Yet, marketing costs are associated with obtaining those funds, plus you pay deposit insurance. So the cost of demand deposit accounts (DDAs) is not zero; the overall cost of raising, insuring, and servicing DDAs contributes to the bank s WACC. Likewise, negotiable order of withdrawal (NOW) accounts, savings accounts, money market deposit accounts (MMDAs), and CDs have associated costs. And don t forget about Federal Home Loan Bank (FHLB) borrowings. Once a bank has estimated its WACC, all top-level managers and the board should think like corporate financial managers. Specifically, they should achieve returns that exceed their WACC to create shareholder value, typically, by calculating internal rate of return (IRR), modified internal rate of return (MIRR), and/or net present value (NPV) to ensure that they meet or exceed their hurdle rate. If the primary capital budgeting tool is NPV, then the goal is to fund positive NPV projects while having the discipline to step away from negative NPV projects, no matter how tempting it may be to push forward with a pet project. If a manager fails to adhere to this discipline, then he is destroying shareholder value rather than creating it. To the extent that management repeatedly makes poor decisions regarding capital allocation, shareholders will become more disgruntled because the stock price will reflect poor choices, and the more likely that an activist investor will show up on management s doorstep. continued on page 2 AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 1

2 I encourage you to read Joe Blake s article carefully. Joe has a unique ability to blend theory with practice and to tell an interesting story as he drives home his points. Banks that can implement value-enhancing capital budgeting decisions going forward will be healthy enough to survive the ongoing mergers and acquisitions (M&A) activity that will consume the banks that don t understand these basic financial principles. John S. Walker, Ph.D., CFA Director of Research & Chief Economist Several years ago, we discussed the cost of equity for banks. As someone once said under different circumstances, That was then and this is now. Let s take another look in the context of today s conditions. Since 2009, the economic recovery has been sluggish, marked not just by slow growth and no increase in real household income but also by weak loan demand and ultimately weak asset growth for many banks. What was once a sector marked by fragmentation and regulation that made mergers very difficult is now marked by frequent mergers and acquisitions. In the past five years, the number of banks has declined by 3.5% annually. Projecting that rate until 2018, the number of banks is expected to be around 5,000. Likewise, in terms of performance the sector has lagged well behind the S&P 500 Index. Since the recovery began in March 2009, the total return with dividends reinvested in the S&P 500 Index has been 21.05% annually versus 12.61% for the NASDAQ Bank Index. Stated differently, a $100 invested in the S&P 500 Index would now be $ versus $ for an investment of $100 in the NASDAQ Bank Index. The pressure to increase returns has rarely been so relentless but against a becalmed economic environment. These factors make the subject of this paper the cost of equity very relevant for all bankers who are committed to building value for their shareholders while maintaining or increasing their equity capital to satisfy regulatory requirements. There are three ways to increase equity capital relative to assets: 1) boost the level of earnings retention by raising the earnings retention rate or increasing income, 2) issue new shares, or 3) reduce assets. The cost of equity becomes the benchmark to be considered if you want to issue new shares or increase your share price relative to its book value. Investors expect your actual returns to exceed expectations if the share price is to increase. In response to the economic crisis of 2008, government programs such as TARP and then the Small Business Loan Fund (SBLF) were established to help banks maintain their regulatory capital with low-cost preferred stocks that also enabled them to maintain lending. Most banks paid off TARP funds in 2013 when the dividend increased from 5% to 9%. In 2011, SBLF offered preferred stock at 5% that could go as low as 1% depending upon the increase in small business lending the bank was able to do. Nonetheless, even this program will become less attractive in 2015 when the dividend increases to 9%. At this cost, the preferred stock will cost more than the banks common equity. Because SBLF targeted community banks with riskweighted assets of $10 billion or less, the managers of these banks must carefully consider the options to replace the SBLF preferred equity. To do this, they will need to increase profits to increase retained earnings or issue new shares of common stock at favorable multiples to its book value. continued on page 3 AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 2

3 As we noted previously, the recovery has been sluggish. The rest of the decade is likely to be unremarkable in terms of growth. Since the financial crisis, the Federal Reserve s quantitative easing policy has maintained historically low rates.¹ The average yield on the 10-year U.S. Treasury since the financial crisis has been 2.69% versus an average of more than 4.72% in the previous decade. That means the risk-free rate normally used in cost of equity models such as the capital asset pricing model (CAPM) will be lower. Continuing slow growth will also result in lower earnings for many banks. Traditional Cost of Equity Methods Among the models frequently used to determine the cost of equity, CAPM and dividend discount model are very commonly used for community banks. DIVIDEND DISCOUNT MODEL Value of stock = dividend per share / (cost of equity less dividend growth rate) The cost of equity is derived thus: Cost of Equity = (dividend per share / price per share) plus growth rate. For example, assume the share price is $25, the dividend is $1, and the growth rate is 4%. The Cost of Equity = ($1 / $25) plus 4% = 4% plus 4% = 8% Because intermediate bond yields have been below 4% since 2008, some investors have focused on holding higher yielding stocks with stable dividends but potential for modest growth as an alternative. Some community banks satisfy this objective. Assuming a yield of 4% to 5% and growth of 2% to 3% each year, these stocks offer a better yield than bonds and offer potential for modest price appreciation. However, for a bank with a good yield and the intention to grow the dividend at 5% or more, the bank must also grow its assets at that same rate to be able to sustain the dividend growth or otherwise cut its non-interest costs or overheads. This is hard to do when economic growth is well below 5%. Also, if the growth rate is higher than the cost of equity, it has to be modified for multistage periods until a future period when the growth rate will be less than the cost of equity. For purposes of this discussion, that adds a complexity that does not help bankers to focus quickly on the job at hand. continued on page 4 ¹ Many argue that the principal reason for the recovery of the equity markets has been the abnormally low interest rates since late This has benefitted the top income group but has been inadequate as a stimulus for economic growth. AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 3

4 THE CAPITAL ASSET PRICING MODEL The cost of equity using the CAPM can be used whether the bank pays a dividend or not. The model formula is: Cost of Equity = Risk-Free Rate + Beta (Market Risk Premium) In this paper, the risk-free rate is assumed to be the 10-year Treasury yield because it corresponds to the long-term time horizon of an equity investor. The model assumes that an investor can diversify the equity portfolio to eliminate company-specific risk or non-systematic risk. If an investor owns only one stock, the investor has all the eggs in one basket. As the investor adds more stocks (between 20 to 30 individual stocks) to the portfolio, the portfolio begins to perform like the broad market such as the S&P 500 Index. This broad market risk we call systematic risk, and the measure of a stock s price volatility to the broad market is called its beta. The market has a beta of 1 and individual stocks have betas that are usually more or less than one. In a diversified portfolio, the market risk premium is the extra return the investor expects to receive from a diversified equity portfolio for its greater risk versus the risk free rate. For example, let s assume Stock A has a beta of 1.2 and Stock B has a beta of 0.80 and that the historical market risk premium is 5% and the risk-free rate is 2.5%. Based on the CAPM, the cost of equity is as follows: Cost of Equity = Risk-Free Rate + Beta (Market Risk Premium) Stock A = 2.5% (5%) = 2.5% + 6% = 8.5% Stock B = 2.5% (5%) = 2.5% + 4% = 6.5% Now let s adjust this for the expected environment for the next five years. If interest rates continue to remain low, the risk-free rate will be 2.5% to 3.5%. That compares to the average treasury yield of 4.72% for the decade before the financial crisis. Likewise, let s discuss the market risk premium for equity investors. In a well-developed discussion of equity risk premiums (ERPs), Aswath Damodaran of NYU s Stern School of Business notes that there are three ways to measure equity risk premiums.² Equity risk premiums can be based on surveys of CFOs and portfolio managers, historical average premiums based on actual equity returns, and implied equity risk premiums based on the current market index. The ERP can be determined in several ways depending upon time period used, arithmetic versus geometric averages, and the maturity of the risk-free rate used. Based on using the geometric average for the years between 1928 and 2013 and assuming a risk-free rate based on long-term yields, the average risk premium is 4.20%. Historical averages are backward looking and not forward looking. The historical average also may not reflect investor expectations based on the current environment or for shorter periods. The ERP for the decade ending August 2014 is 4.99% and for the five-year period ending the same date the ERP is 14.27%. continued on page 5 ² Under Research and Papers download the 2013 version of Equity Risk Premium. AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 4

5 ERPs are valid if one believes that over time returns revert to a mean and also the risk premium by implication. However, that means the use of the historical geometric average will at various times produce valuations that are over- or undervalued depending on actual investor expectations for return versus historical returns. We often talk about 10% as the long-term rate of equity return and 6% for bonds, but both of these expected returns would make little sense in the current environment. Equity risk premiums based on surveys vary between 3% and 4% depending on who is asked. CFOs responses are usually lower than portfolio managers. That may reflect the different perspective of each. A CFO is really thinking about returns of his own company, while the portfolio manager is probably reflecting a market outlook that influences stocks selected and the allocation to asset sectors. The most recent Campbell and Harvey Survey of CFOs is 3.83%. The implied equity risk premium is derived from the current market index, such as the S&P 500 Index, based on growth in earnings, long-term bond yields, and dividend yields. It is currently 3.65% versus the average implied premium since 1960 of 4.00%. The implied equity risk premium is market neutral and more forward looking than the average historical risk premium. However, because it is market neutral it does not reflect a market outlook. In the next few years, it may be best to try to shape your expectation for the cost of equity on the expectations of value investors who will be looking for stocks that will outperform the index in a sluggish economy. Based on CAPM, a risk-free rate of 2.5%, and an implied market risk premium of 3.65%, the expected return of the market would be 6.15% and the cost of equity for a stock with a beta of 1.0 would also be 6.15%. If we use the beta of the NASDAQ Bank Index of 0.95, the cost of equity is the risk-free rate of 2.5 % plus %, or 5.97%. That may seem like a low expectation but the times have been sluggish. Nonetheless, interest rates have been abnormally low thanks to the Federal Reserve. We can readily expect that long-term rates may rise later in the second half of 2015, thus causing an increase in the risk-free rate. In terms of value creation for investors, what does this mean? Expectations drive what investors assume they will make from a specific security or portfolio. In the case of equity, a specific level of return must be exceeded for the share price to increase. If the return is achieved then the share price should remain the same, and if the return is less than expectations, the share price will decline. For bankers who want to improve their regulatory capital levels, this means that expectations must be exceeded to increase the share price or make it likely that new equity can be issued at prices higher than the book value of equity. If rates do increase later next year and cause expectations to increase, now is the time to implement action plans to increase returns. This brings us to the excess returns model (ERM), which will help bankers understand what they must do to improve their share price relative to the traditional metric of return on equity (ROE). Again, Aswath Damodaran has written an analysis of ERM in his paper Valuing Financial Service Firms.³ In short, the value of a bank can be written as the sum of the equity invested in the bank s current capital plus the present value of expected excess returns to shareholders. Thus, excess returns will be earned if the bank s ROE (assume 10%) is more than its cost of equity (K) based on the capital asset pricing model (assume 5.97%).⁴ continued on page 6 ³ Professor Damodaran s 44-page paper may be found at the Web site: Click the section titled Papers and scroll to Valuing Financial Service Firms to download the paper. There is also a more detailed paper at the same link written in 2009 addressing issues raised by the 2008 financial crisis. ⁴ In simple terms, management creates value in excess of book equity if the bank s ROE is more than its cost of equity capital (CAPM). AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 5

6 This concept can be summarized as a formula: Value of Equity = Equity Capital invested currently + Present Value of Expected Excess Returns. The ERM formula assumes that the bank will generate returns that are consistently above the shareholder expectations in the future. The next step is to add the value of future excess returns to the bank s current invested equity capital (generally assumed to be the same as generally accepted accounting principles [GAAP] equity) to obtain the value of the bank s equity capital. Discounted excess earnings is defined as the difference between earnings earned on invested capital (assumed to approximate GAAP equity) based on CAPM as a proxy for the expected return and the ROE as the actual return on invested capital. The critical assumption is that ROE is more than the required return found from CAPM (k e )and therefore the difference will always be positive to generate excess returns. If not positive, the bank may still be profitable but is not earning excess returns. To bring the concepts together, the value of equity is: Value of Equity = Invested Equity Capital + the Present Value of Expected Excess Returns to Shareholders Now a few words need to be added about invested equity capital. Banks are unusual businesses to value for two reasons: 1. The value of their assets is usually close to the book value because, unlike manufacturing firms, few of the assets are depreciated over long periods. The assets frequently change as loans and securities generate cash flows from the payment of principal and interest or are sold. Also, many of the assets can be readily marked to market value and changes in their value reflected in the equity of the bank. 2. Also, most financial institutions employ high amounts of leverage as part of their capital strategies. Consequently, including deposits or borrowed funds in the total capital is problematic since the leverage strategy is essentially one of the key elements of the bank s operating strategy. continued on page 7 AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 6

7 If we assume a bank has a beta of 0.95, we noted above that the cost of equity was 5.97%. Since the financial crisis, many community banks have earned an ROE below this cost of equity. It should come as no surprise that they still have a share price that is less than book value. This is consistent with returns well below the S&P 500 Index for investors holding bank stock portfolios that have performed like the NASDAQ Bank Index or similar indexes since the recovery began. Many of these banks must improve performance or they will be unable to replace their SBLF preferred in 2015 when the dividend yield increases to 9%. If our example bank has 75% of its equity capital in common stock with a cost of 5.97% and 25% in SNLF preferred at 5%, its current cost of equity is 5.73% ( %) but it increases to 6.73% ( % %) in Realistically, in order for a bank to replace that SBLF preferred next year, it must be making an ROE of 8% or more to earn profits that will sustain a higher share price, more retained earnings, or new equity capital. That ROE might well be more than 8% if interest rates increase and expected returns increase with the risk-free rate. Yes, there are banks that do this. One community bank in our region has earned ROEs better than 10%, has no SBLF preferred, has a dividend yield of 4.30%, and sells for % of its book value. If a bank is making an ROE below or equal to its CAPM cost of equity, then it cannot improve its share price, increase retained earnings quickly, and will only be able to issue new equity that dilutes the ownership interest of existing shareholders or not at all. We have noted that the banking industry is steadily and continuously consolidating. That process will continue because the increased regulatory burden placed on the sector since the financial crisis is an incentive for all banks to grow to carry those costs over a larger asset base. This means that banks that cannot justify a reason for investors to hold their shares based on proven performance may well be candidates for acquisition at low multiples. If Canada has more than 90% of its bank deposits with five banks, then we could easily do the same with 50 banks. Today, the four largest banks hold 45% of all bank deposits.⁵ That concentration may not be desirable, but it shows the clear trend of consolidation. continued on page 8 ⁵ AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 7

8 HERE ARE SOME SUMMARY POINTS TO REMEMBER:» The cost of equity for the next year will be less than it has been in the past 20 years. That is consistent with the prevailing level of low-interest rates but that may well change in late 2015 consistent with smaller security purchases by the Federal Reserve as quantitative easing comes to an end. That means investor expectations will be higher just beyond the horizon we see today.» If your bank has SBLF preferred, it faces an increased cost of equity in 2015 when the dividend increases substantially from a range between 2% and 5% to 9%.» If your bank wants to increase its share price and grow its equity capital base, it will need to earn an ROE well above its cost of equity. Based on the prevailing current cost of equity, it means that the ROE must be more than 8% or more than 2% higher than the cost of equity. As rates increase later next year, the expected return will also increase in the subsequent years.» Your strategy must quickly move to achieve these targets or seriously consider a merger with another bank whose shares offer a better value proposition than yours.» Finally, as part of your strategy improvement, look for those low-yielding assets that offer potential to be redeployed in higher yielding assets to improve net interest margins and in turn the ROE. Joseph G. Blake, CFA Financial Consultant and Adjunct Professor AmbassadorAlert 4th Quarter 2014 Time to Take Another Look at Managing Your Cost of Capital 8

9 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA (toll-free) East West Highway Suite 305 Bethesda, MD (toll-free) Joshua A. Albright, CFA Senior Vice President, Fixed Income Trading Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Christopher B. Donahue Financial Analyst Jacob Eisen Head of Capital Markets Ryan G. Epler Senior Vice President, Fixed Income Trading Tad Gage Managing Director Heidi Geist Administrative Assistant James R. Gillen Business Development Belle Gutschick Administrative Assistant Mike Harrison Vice President Karl J. Ostby Investment Banking Robert J. Pachence, Jr. Co-Founder & Managing Principal John D. Putman Senior Vice President Michael Rasmussen Investment Banking Matthew T. Resch, CFA Co-Founder & Managing Principal Eric R. Tesche Managing Director Mark B. Trinkle Senior Vice President, Fixed Income Trading John S. Walker, Ph.D., CFA Director of Research & Chief Economist 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.