ROE vs. COE is the Best Indicator of Bank Stock Value

IDC Financial Publishing (IDCFP) measures relative profitability of bank holding companies by comparing the IDCFP return on equity (NOPAT ROE) to our definition of the cost of equity (COE). Margin between ROE and COE (included in 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; the wider the spread, the greater the value.

If the spread of ROE less COE is negative, management is destroying value. Bank value, in turn, is then determined by comparing its stock price to its book value, i.e. equity market capitalization to book value of common stock, versus the spread between ROE and COE to determine bank rating (see Chart I).

Some critics say the method is flawed because of the various ways ROE and COE can be calculated, which can create inconsistent bank rating practices. As an example, financial institutions 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 financial ratio between ROE and COE. IDCFP uses a nominal NOPAT ROE, as calculated for the bank holding company, and has found this to be most accurate in valuing price-to-book value.

Some financial advisors and analysts use a 10% standard for 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.

On 12/31/18 the long bond U.S. Treasury yield was 3.0% and the average COE for all large bank holding companies was 4.91%, with valuations ranging from 4.30% for PNC Financial Group (PNC) to 6.49% for Bank of America Corp (BAC).

As seen in Chart I, there is a high correlation between Market Capitalization/Book Common Equity compared to IDCFP’s spread of ROE less COE for large bank holding companies. This correlation demonstrates how COE, when defined by long-term U.S. Treasury yields, best determines cost of equity capital, and therefore the value correlation or valuation line.

It is also important to note the downward shift in the current valuation line on Chart I is like the lower valuation seen in the year 2015 through February 2016. The U.S 10-Year T-Note yields declined to 1.5% in 2015, as the German 10-Year fell to zero.

Currently, the fall in the U.S. 10-Year Treasury yield to 2.6% is due to the decline in the German yield to 0.083%. This decline in the U.S. T-Note yield as the Federal Fund interest rate is raised to 2.5%, limits book loan rates and raises deposit costs, reducing bank profitability and asset quality. A reversal in German 10-Year Bond yields in 2019 and 2020 could provide an opportunity for bank stocks to return to the normal valuation line (see Chart I).

Chart I

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John E Rickmeier, CFA, President,

Robin Rickmeier, Marketing Director