Does Your Dividend Policy Make Sense?

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1 1st Quarter 2015 Does Your Dividend Policy Make Sense? Recently, there was a lot of debate over the rollback of various aspects of the 2010 Dodd Frank law. We know that bank regulation is an ongoing burden for community banks. Policy makers are concerned about whether regulations are sufficient and whether they are dealing with the right issues without being excessive. The hope is that, through time, the government will move toward a more community bank-friendly regulatory environment. Indeed, it was recently reported in the December 11, 2014, edition of The Wall Street Journal that Sen. Richard Shelby (R-Ala.), who will likely steer financial-services legislation as the new head of the Senate Banking Committee, could consider a number of policy shifts to ease the regulatory burden on smaller community banks. Yet, as we read debate pieces regarding the efficacy and burden of current regulations on banks, we think about the fact that while regulatory costs have been and will continue to be a drag on banks profitability, less-than-optimal capital management is just as devastating. The difference is, a bank CEO has more power to ensure that his bank has an optimal capital plan than to materially influence the regulatory landscape. Our colleague, Joe Blake, wrote an article recently that discussed the importance of making asset/liability decisions based on meeting or exceeding your bank s cost of capital. In this article, we want to look at the issue of your bank s dividend policy. While we can continue to lament the burden and inefficiencies of bank regulations, let s work on something we can fix: dividend policy inefficiencies. In 2013, a survey by a leading bank publication found that many community banks that ranked in the top 200 based on return on equity (ROE) were delivering ROEs that were below their cost of capital, which was estimated to be north of 9%. In fact, only 133 of the 200 top community banks had a three-year average ROE of 9% or higher. That left the remaining 34% of the banks below their cost of capital with all the other thousands of community banks that didn t make the top 200 list. The longer a bank s profitability falls short of its cost of capital, the more enticing the invitation for an activist investor to step in! What Is Your Business Model and Is It Capital Efficient? When management thinks about which business model to pursue, there are various ways to answer the question. For example, will the bank be more of a bricks-and-mortar institution or more of an Internet bank in terms of the delivery of services? While these marketing models are important to consider, we like to look at a bank s model from a financial perspective using the DuPont formula. The formula is given by equation 1: ROE = ROA EM, where ROA is return on assets and EM is the equity multiplier. Mathematically, the EM is the reciprocal of the equity-to-assets ratio. Suppose a bank wants to achieve a 10% ROE. That is a level that narrowly exceeds the cost of capital bogie suggested above. If a bank s ROA is 1%, that means the EM must be 10. In turn, an EM of 10 correlates to an equity-to-assets ratio of 10%. continued on page 2 AmbassadorAlert 1st Quarter 2015 Does Your Dividend Policy Make Sense? 1

2 Let s suppose that another bank s ROA is not as high say, 0.8% but it, too, wants to achieve an ROE of 10%. This bank requires an EM of 12.5, meaning that its equity-to-assets ratio should be 8%. So when we ask, What business model are you pursuing? we are asking management for its ROE goal, as well as what ROA it expects to achieve and what capital structure it will employ. They all tie together. ratios. If a bank s ROE is moving higher, let s say from a mediocre ROE to a peer-beating ROE, that is good volatility. Therefore, there are periods of transition when bank ratios are improving, and certainly nothing is wrong with volatile bank ratios if the changes are consistent with expectations. The concern arises when bank ratios unexpectedly deteriorate. Wall Street abhors unexpected bad news. Is Your Dividend Payout Consistent with Your Business Model? In an earlier research article, we discussed the mathematics behind what s termed the sustainable growth rate (SGR). SGR is the rate of asset growth that will maintain a steady equity-to-assets ratio for the bank. An estimate of your SGR is given by equation 2: SGR = ROE RR, where RR is the earnings retention ratio. Two extreme possibilities would be to (1) retain 100% of your bank s earnings or (2) pay out 100% of your earnings. If you retain 100% of your earnings, your SGR would be equal to your ROE. Conversely, if you pay out 100% of your earnings, then your SGR would be zero. Of course, most banks RR will be between 0% and 100%; thus their SGR will be more than 0% but less than their ROE. If your bank s business model is set (i.e., the ROA and EM are where you want them to be), the major task at hand is to grow your assets at a rate consistent with your SGR and to achieve a marginal ROA on new assets that matches your ROA goal. If you fail to grow assets at a pace consistent with your SGR, then your ratios and business model will be jumping around and doing what we ll term the Wall Street Shuffle. The lyric that comes to mind from this classic 10cc song is If you wanna make money, you need the luck to make a buck. Your shareholders deserve better than for you to base your future returns on luck! If a bank maintains a steady ROA, which is desirable presuming that it s a healthy ROA, then the challenge is to grow the bank s assets consistently at a rate equal to the SGR. By doing so, the bank s EM a key component of the bank s business model will remain steady. Just as important as avoiding a downward drift in the bank s ROA, it makes sense to avoid a downward drift in the EM. If the EM falls, a higher ROA will be required to produce the same ROE. As management starts to feel pressure to offset a lower EM with a higher ROA, that pressure creates an incentive to take greater risks, such as lowering the bank s credit standards. The Numbers Tell the Story Let s return to the top 200 banks from 2013 based on a three-year moving average ROE. The number 1 bank had a three-year average ROE of 17.8% the highest in the country. This ROE far exceeded the bank s cost of capital. Likewise, for the three-year period, the bank s average ROA was 1.55%. Based on the average ROA and ROE, the bank s average EM was 11.5 (corresponding to an equity-to-assets ratio of 8.7%). Certainly, the bank s numbers justified its top ranking in the 2013 survey, as its performance was spectacular. It would have been nice if management could have locked in the bank s performance and maintained the business model indefinitely. But that did not happen. For the period 2009 to 2013, the top-performing bank s compound annualized growth rate for assets (CAGR) was 5.8%. If the bank were growing at its SGR, the CAGR for equity would also have been 5.8% but that was not the case. Rather, equity grew by 10.6%, which was 82.8% faster than asset growth! Now management might argue that its goal Volatility can be either good or bad, depending on direction. If a stock price is surging higher, that produces higher returns and, in this case, volatility is good and vice versa. The same applies to bank continued on page 3 AmbassadorAlert 1st Quarter 2015 Does Your Dividend Policy Make Sense? 2

3 was to raise its equity-to-assets ratio; if that was the objective, then it was successful. Nevertheless, the extreme shift in the bank s ratios reveals how fluid a bank s business model can be if it grows at a rate materially above or below its SGR. Basically, this bank was drowning in capital during the period examined ( 09 to 13). The bank s ROE slipped from 17.6% to 14.9%, which represents a staggering 15.3% drop. Because equity grew almost twice as quickly as assets, the bank was growing the balance sheet well below its SGR, and this resulted in the equity-to-assets ratio rising from 8.4% to 10.1%, for a 20.2% increase. With equity growing so quickly relative to assets, the bank s EM slipped 16.8% from 11.9 to 9.9. This analysis illustrates that banking is a numbers game. If a bank s EM is volatile, that suggests that growth plans are not being realized or that the bank s dividend policy is inconsistent with the bank s business model. Is your dividend policy consistent with your business model? Indeed, if a bank s EM weakens, that means that a higher ROA is required to maintain a steady ROE. Yet, adding a basis point (bp) or two to ROA is not always an easy task. The number 1 bank for 2013 based on ROE was able to add 9 more bps to ROA during the period examined. Considering that the bank was at an ROA of 1.42%, a 9-bps advance is commendable. Unfortunately, the 6.3% improvement in ROA was not nearly sufficient to offset the 16.8% erosion in the bank s EM. When the top 200 banks for 2014 were identified one year later, it was not surprising to see the bank s rank slip from number 1 to number 6. Banks ROEs rose from 2012 to 2013 and then again from 2013 to Yet, this high-performing bank s ROE had dropped 17.9% since peaking at 18.1% in 2010, while its 2010 ROA (1.50%) and 2013 ROA (1.51%) were nearly identical. But Then There s the Regulator is fierce, and the community bank is not exempt from those pressures. Each business has to have its priorities, and pleasing the shareholder should be at the top. Nevertheless, banking is a regulated industry, and as discussed at the opening of this article, regulations have been intensifying. It s not just Dodd Frank; it s also Basel III. When we look at what has transpired at the 2013 top-performing bank, the shift in capital structure while a headwind on ROE might be just what regulators wanted to see. Simply stated, regulators want industry capital ratios to be rising not falling. Our article conveys the need for banks to become as capital efficient as possible, suggesting that excellence in capital management will be rewarded through gains in your bank s share price. However, it would be naïve to ignore the fact that the regulatory environment is 180 degrees opposed to relentless pursuit of value maximization. Seemingly, regulators singular focus is on the safety of the banking industry and each individual bank. Therefore, you will not hear regulators talk about SGR or higher returns to shareholders. Rather, they want banks to grow capital and reduce risk as much as possible, even if it means that shareholders realize materially lower returns. Stated more bluntly, it seems that regulators do not care about shareholders. Perhaps management s attempt to balance shareholder and regulatory concerns explains why many banks EMs have fallen recently. Since the Great Recession, many banks have driven their capital levels up, while ROAs have fallen, creating lower shareholder returns. This is because the regulatory environment has been extremely difficult, and boards and managers have (generally) managed to the regulators instead of shareholders. This, then, creates a perplexing situation for managers. Should they grow capital and reduce risk at the expense of shareholders or maintain efficient capital and grow the institution to the benefit of shareholders? The best banks have been able to balance the interests of both shareholders and regulators and offer returns higher than their cost A community bank has many stakeholders. Finance professors like to drum into their students heads that the number 1 goal is to maximize shareholder wealth. We will go so far as to say that banks that don t perpetuate a culture of growing value at their institutions will likely fade away over time. Competition in the financial services industry continued on page 4 AmbassadorAlert 1st Quarter 2015 Does Your Dividend Policy Make Sense? 3

4 of capital with low risk. Yet, achieving this healthy balance is extremely challenging. The good news for a bank such as the top-performing bank discussed above is that, despite the huge mismatch between asset and equity growth, it still ranked high in the 2014 survey (number 6) and was producing returns above its cost of capital. Each business has to have its priorities, and pleasing the shareholder should be at the top. Finding a Dividend Policy that Works In conclusion, each community bank has a monumental task: to craft a dividend policy that unlocks the full value of the bank for shareholders. Miller and Modigliani argued in their seminal work that capital structure doesn t matter and later that dividend policy is irrelevant. But then subsequent research showed that the M&M model needed to be modified to capture the real world. For community banks, dividend policy does matter! The dividend policy determines the retention ratio, and the RR, as shown earlier, is one of the factors that determine the SGR. SGR is a key component used in intrinsic valuation models to estimate the fair value of your bank. Each bank needs to have a checklist as it devises its policy: 1. What is the bank s ROA goal, and what is the likely range of outcomes for ROA? 2. What is the bank s ROE goal, and what is the likely range of outcomes for ROE? 3. How quickly will the bank grow assets? 4. What is the planned RR (for earnings)? 5. Based on the expected ROE and planned RR, what is the expected SGR? 6. Is the SGR consistent with expected asset growth? 7. If SGR and expected asset growth are mismatched, how quickly will the bank s capital structure drift higher or lower? 9. If the bank s capital structure drifts higher, can the bank achieve incremental improvements to ROA to offset the lower EM? 10. Will the bank employ special dividends to help maintain an efficient capital structure? 11. Is the bank intentionally building or maintaining a high capital level for planned merger and acquisition (M&A) activity? 12. If so, is the rest of the balance sheet being structured properly so as to ensure that capital can be deployed in a timely fashion when an M&A opportunity presents itself? The above list is not exhaustive, but sets the tone for board discussions. The professionals at Ambassador have been talking with community banks about capital and related topics for more than 20 years. If you d like us to meet with your board to review and discuss some of the capital-related hot button topics relevant to today s business environment, please let us know. In recent years, there has been a lot of debate about the future viability of community banks. One thing is for certain optimal capital planning is more important now than ever before and should be at the top of every banker s do to list for Robert J. Pachence, Jr. Co-Founder & Managing Principal John S. Walker, Ph.D., CFA Director of Research & Chief Economist 8. If the bank s capital structure drifts down, how quickly will it reach a point that is alarming to regulators? AmbassadorAlert 1st Quarter 2015 Does Your Dividend Policy Make Sense? 4

5 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA (toll-free) Executive Blvd. Suite 503 Rockville, MD (toll-free) Joshua A. Albright, CFA Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Jacob Eisen Head of Capital Markets Ryan G. Epler Tad Gage Managing Director Heidi Geist Administrative and Trade Settlement Coordinator 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 John S. Walker, Ph.D., CFA Director of Research & Chief Economist continued on page 3 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., AmbassadorAlert a current member of FINRA/SIPC. 1st Quarter For more 2015 information contact us at Ambassador Why Treasury Financial yields Group, can Inc. continue to stay low and October move 2014 lower 222