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 tangible 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, or improving, management is creating value; the wider the spread, the greater the value.

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

On 03/31/19 the long bond U.S. Treasury yield was 2.8% and the average COE for all large bank holding companies was 5.81%, with valuations ranging from 4.13% for Raymond James Financial (RJF) to 8.89% for Bank of America Corp (BAC). As seen in Chart I, there is a high correlation between Market Capitalization/Tangible 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 and bank-specific risk, best determines cost of equity capital, and therefore the value correlation or valuation line.

Chart I

It is also important to note the significant decline in the 30-year T-Bond yield since October 2018. The sharp decline in the US 10-Year T-Note yield from 3.22% to 2.2% at the end of May 2019 reduced the 30-Year T-Bond yield from 3.4% to 2.7%. This was a result of the US 10-Year yield reacting to a collapse of the German 10-Year yield from a positive 0.6% to a negative 0.18% in May 2019. The German 10-Year yield also fell to -0.18% in March 2016. Bank ROEs tends to be limited by declining long term yields, reducing interest income from loans. The high level of the federal funds rate and, therefore deposit costs, further reduces bank margins.

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John E Rickmeier, CFA, President, jer@idcfp.com

Robin Rickmeier, Marketing Director