IDC Financial Publishing (IDCFP) measures stock price performance of bank holding companies by comparing the return on equity (ROE) to its definition of the cost of equity (COE). Margin between ROE and COE (also the “M” in IDCFP’s unique CAMEL analysis) is a key measure of management. If the spread of ROE less COE is positive, management is creating value. If the spread of ROE less COE is negative, management is destroying value. Bank value is determined by comparing its stock price to its book value, i.e. equity market capitalization to book value of common stock (See Chart I).
Some critics say the method is flawed because of the various ways ROE and COE can be calculated. As an example, banks have insisted returns should be measured on tangible equity, excluding goodwill, and other intangible assets. This exclusion generates a higher tangible ROE, but lower tangible book value. It also distorts the spread between ROE and IDFP’s COE. IDCFP uses a nominal four quarter NOPAT ROE, as calculated for the bank holding company, and has found this to be most accurate.
The second piece of the equation is cost of equity (COE). Some analysts use a standard of 10% COE. The COE, as defined by IDCFP, however, is the 30-year T-Bond yield plus one-half of this yield, plus individual bank risk, calculated as 20% of the standard deviation of the bank’s operating profit margin. In today’s market, a long bond U.S. Treasury yield on 03/31/2018 was 3.0% and the average COE for the large bank holding companies was 4.8%, ranging from 4.25% for Raymond James Financial (RJF) to 6.45% for Bank of America Corp (BAC).
The high correlation of Market Capitalization/Book Common Equity compared to IDCFP’s spread of ROE less COE for large bank holding companies in the enclosed chart demonstrates how COE, when defined by long-term U.S. Treasury yields, best determines price to book value.
The wider the spread between ROE and COE, the higher the valuation of price compared to book value. For example, the value of increasing a positive spread (ROE less COE) by 100 basis points adds an estimated 12.5 basis points to the market capitalization to equity ratio. Additionally, the low valuations of BAC and C, with narrow ROE to COE spreads, confirm the valuation trend, as does EWBC and RJF with high valuations to book value.
Static Valuation Versus Dynamic Change in Bank Stocks
In addition to the image in Chart I, representing a point-in-time, or static valuation of bank stocks, Table I illustrates how dynamic change can happen over time in holding company valuations.
The spread between ROE and IDCFP’s calculation for COE shows how price to book value can be calculated accurately both at a static point in time, or demonstrate how changes in the ROE to COE spread creates dynamic changes in bank valuations over time. As noted above, the KBW NASDAQ Bank Index increased 66% from 5/15/14 to 5/17/18. In comparison, bank holding companies such as Bank of America and JP Morgan rose from 123% to 135% respectively, due to a widening spread between ROE and COE over 4 years. Wells Fargo, on the other hand, provided only a 24% price change due to a negative change in the ROE to COE spread, reducing its relative valuation from 1.69 to 1.48 times book value over the same 4 year period.
Security analysts value bank stock using price-to-earnings ratios. IDCFP values the P/E components using reported price to book value, return on equity and our cost of equity. As shown in Table I above, the significantly higher stock price appreciation of Bank of America and JP Morgan was due to a major decline in the COE, as well as, an improvement in ROE. Also worth noting, JP Morgan’s ROE less COE spread reached 4.5% by the first quarter of 2016, prior to the major increase in stock price. Analysis of bank stocks without a correct cost of equity (COE) limits the ability to differentiate success from failure.
John E Rickmeier, CFA
IDC Financial Publishing, Inc.
700 Walnut Ridge Drive, Suite 201
PO Box 140
Hartland, WI 53029