Keep this in mind when valuing banks

May 09, 2023
Aswath Damodaran is a professor of finance at the Stern School of Business, New York University. Here he explains the banking model, the parameters to look at when considering risk, and finally through investor eyes, where price takes center stage.

The banking business, when stripped down to basics, is a simple one.

A bank collects deposits from customers, offering the quid quo pro of convenience, safety and interest income.

The bank lends this money to borrowers (individuals and businesses), charging an interest rate that is high enough to cover defaults and leave a surplus profit for the bank. In addition, banks can also invest some of the cash in securities, usually fixed-income, and with varying maturities and degrees of default risk, again earning income from these holdings.

The profitability of a bank rests on the spread between its interest income (from loans and financial investments) and its interest expenses (on deposits and debt), and the leakages from that spread to cover defaulted loans and losses on investment securities. To ensure that a bank survives, its owners have to hold enough equity capital to buffer against unanticipated defaults or losses.

3 rules when using the PE ratio

Key metrics that can help gauge current risk and exposure to future risk. 

  • Deposits

Every bank is built around a deposit base, and there are deposit base characteristics that clearly determine risk exposure.

To the extent that some deposits are not interest-bearing (as is the case with most checking accounts), banks that have higher percentages of non-interest-bearing deposits start off at an advantage, lowering the average interest rate paid on deposits.

Since a big deposit base can very quickly become a small deposit base, if depositors flee, having a stickier deposit base gives a bank a benefit.

As to the determinants of this stickiness, there are numerous factors that come into play such as deposit size (bigger and wealthier depositors tend to be more sensitive to risk whispers and to interest rate differences than smaller ones), depositor homogeneity (more diverse depositor bases tend to be less likely to indulge in group-think) and deposit age (depositors who have been with a bank longer are more sticky).

  • Equity and Regulatory Capital

Banks that have more book equity and Tier 1 capital have built bigger buffers against shocks than banks without those buffers. Within banks that have high accumulated high amounts of regulatory capital, I would argue that banks that get all or the bulk of that capital from equity are safer than those that have created equity-like instruments that get counted as equity.

  • Loans

While your first instinct on bank loans is to look for banks that have lent to safer borrowers (less default risk), it is not necessarily the right call, when it comes to measuring bank quality. A bank that lends to safe borrowers, but charges them too low a rate, even given their safer status, is undercutting its value, whereas a bank that lends to riskier borrowers, but charges them a rate that incorporates that risk and more, is creating value.

To assess the quality of a bank's loan portfolio, you need to consider the interest rate earned on loans in conjunction with the expected loan losses on that loan portfolio, with a combination of high (low) interest rates on loans and low (high) loan losses characterizing good (bad) banks.

Banks that lend to a more diverse set of clients (small and large, across different business) are less exposed to risk than banks that lend to homogeneous clients (similar profiles or operate in the same business), since default troubles often show up in clusters.

  • Investment Securities

Banks with safer and more liquid holdings are safer than banks with riskier, illiquid holdings.

Another component that determines risk exposure is duration of these securities, relative to the duration of the deposit base, with a greater mismatch associated with more risk. A bank that is funded primarily with demand deposits, which invests in 10-year bonds, is exposed to more risk than if invests in commercial paper or treasury bills. The second is whether these securities, as reported on the balance sheet, are marked to market or not, a choice determined by how banks classify these holdings, with assets held to maturity being left at original cost and assets held for trading, being marked to market. As an investor, you have more transparency about the value of what a company holds and, by extension, its equity and Tier 1 capital, when securities are marked to market, as opposed to when they are not.

What to be aware of when valuing younger companies

Looking at it from a valuation perspective.

While differentiating between good and bad banks can be straightforward, it does not follow that buying good banks and selling bad banks is a good investment strategy, since its success depends entirely on what the market is incorporating into stock prices.

An investor who buys a good bank at too high a price, given its goodness, will underperform one who buys a bad bank at too low a price, given its badness.

So much of what we do in conventional valuation does not work with banks. And, a crisis or panic can upend even the most carefully done bank valuation.

With most non-financial service businesses, you face a choice in how you approach valuation. You can value the enterprise or the entire business, focusing on valuing the operations or assets of the business, and consider capital as inclusive of both debt and equity. Alternatively, you can value just the equity in the business, focusing on cash flows left over after debt payments and discounting back at a rate of return that reflects the risk that equity investors face.

While you have a choice between valuing equity and valuing the entire business with most firms, with banks, you can only value equity. Debt and deposits to a bank are raw material not a source of capital.

Debt to a bank can be expansively defined to include deposits as well, making it effectively raw material for the bank's operations, where the objective is borrow money (from depositors and lenders) at a low rate and lend it out or invest it at a higher rate.

Consequently, you can only value the equity in a bank. By extension, the only pricing multiples you can use have to equity-based (PE, PBV). Price to Book works better at banks than at other firms because of mark-to-market rules and the link between book equity and regulatory capital.

The notion of computing a cost of capital for a bank is fanciful and fruitless, and any attempt to compute an enterprise value for a bank is destined to end in failure.

With equity valuation, estimating free cash flows to equity, i.e., cash flows left over after reinvestment and debt payments, for a bank is complicated by the difficulties in estimating capital expenditure, working capital and debt cash flows.

Analysts valuing banks fall back on using dividends as free cash flows to equity. But with a dividend discount model, you are implicitly assuming that banks are run by sensible people & that the regulatory framework works. After 2008, I have little faith in either assumption (sensible people or regulatory oversight). I use a a bank-specific version of free cash flow to equity, where reinvestment into regulatory capital takes the place of net cap ex and working capital.

The above information has been taken from the blog of Aswath Damodaran Decoding the banking crisis and Banks at the right price.

Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter
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