Bank Valuation

Marc Rubinstein
London Business School
October 2018
 About Me
• 12 years as sell-side equity research analyst, focused on
European banks
• Ran European banks research group as Managing Director
at Credit Suisse, London, until 2006
• 10 years at Lansdowne Partners, US$20bn long/short hedge
fund firm based in London
• Senior analyst & portfolio manager, Lansdowne Global
Financials Fund
• Lansdowne Global Financials Fund managed US$4bn at
peak, winning EuroHedge Long Term Performance Award
(Equity Strategies) for 2009
• Sloan MSc at LBS in 2017

1
 Why bank valuation is different

Debt is their • Customers provide most of their ‘debt’

• Impossible to separate operating cash flows from
‘raw material’ financing cash flows

• Banks are forced to hold capital by regulators

• What banks have in terms of capital, what they
Regulation need, and what they must have, are three separate
considerations

• Mark to Market
Accounting • Costs can come many years after profits

2
 Jamie Dimon’s take
“As you know, we believe tangible book value per share is a good measure of the value we have
created for our shareholders. If our asset and liability values are appropriate — and we believe they
are — and if we can continue to deploy this capital profitably, we now think that it can earn
approximately 17% return on tangible equity for the foreseeable future. Then, in our view, our
company should ultimately be worth considerably more than tangible book value. The chart on the
bottom of page 3 shows that tangible book value ‘anchors’ the stock price.”
JPMorgan annual report, 2017

3
 Tangible Book Value Per Share: the ‘anchor’
Excerpt from Citigroup 3Q earnings release

• Tangible book value represents the value of the net assets of

bank excluding any goodwill or franchise value.

4
 An anchor, but is it a floor?
• 48% of European banks trade at a discount to tangible book
value (31 banks out of 64)
• Greek banks 0.20-0.30x tangible book value
• Barclays 0.70x TBVPS
• Three reasons for a bank to trade at a discount to book value:
1. Asset and liability values are not appropriate
2. Insufficient capital adequacy
3. Capital can’t be deployed profitably (above the cost of capital)

5
 1. Asset and Liability values
Feb 2009. US
banks had taken
US$374m of
writedowns and
credit losses
through 4Q08. Yet
Bridgewater
expected losses to
amount to
US$1,390bn, of
which
US$1,064bn on
non-marked to
market assets
(estimate on that
piece had been
US$435m in Apr
2008)

Source: Bridgewater Daily Observations, February 2009 6

 Stress testing book value
• Remember book
value is just assets
less liabilities
• A small change
in asset values
will have
leveraged impact
on book value
• Book value can
be adjusted to
incorporate
prospective losses
• Since crisis, this
exercise has been
integrated into
regulatory stress
tests

Source: Fox Pitt Kelton, December 2008 7

 2. Insufficient capital
UK Banks: Projected core equity tier 1 capital ratios under 2017 stress test scenario

• Eg. HSBC’s core capital

ratio end 2016 was 13.6%
• Under BoE stress scenario
it would drop to 8.9%
• HSBC systemic reference
point is deemed 8.0%
• So no capital shortfall

Source: Bank of England 8

 3. Capital can’t be deployed profitably
• It can be useful to think of bank equity like a perpetual bond
• Assuming no growth, then: P/BV = ROE/r
• So if ROE is less than the cost of capital, banks will trade at a discount to book
• Consider Deutsche Bank:
• Core tier 1 ratio 13.7% Jun-18, versus 10.6% regulatory requirement and 13.0%
internal target

Deutsche: P/TBV vs forward 2 year ROTE Deutsche Bank: ROTE forecasts

4.2%

2.0%
0.6%

-2.0%
-3.2%
2016 2017 2018E 2019E 2020E

Note: r denotes cost of capital. Source: Bloomberg, Credit Suisse 9

Will Deutsche Bank ever earn its cost of capital?

Long term average RoTBV

just 5%, on constant
leverage

Note: Deutsche
Bundesbank concluded in
2017 paper that only 20%
of 1,733 German banks
would meet their cost of
capital in 2018.

Poor track record of

hitting targets

Note: Deutsche Bank RoTBV excludes one-off items and assumes constant leverage of 18x adj
10
assets/TCE. Source: Autonomous Research, Deutsche Bundesbank Discussion Paper 01/2017.
 Why don’t banks liquidate?

• Deutsche Bank is fifth most systemic bank globally

• OTC derivatives book US$43trillion
• Major Euro and Dollar clearer
• €1.3trillion of assets
• €22bn of less liquid ‘level 3’ assets
• 95,400 employees

11
 Relationship between P/BV and ROE

European Banks
3.00

MTRO
KOMB
Price / Adjusted TBVPS

2.00 SWEDA
BCVN
SHBA KBC
SEBA
PKO
PEO UBSG EBS
DNB KN
NDA RBI PAG LLOY
HSBA
SRBANKCABK ABN VM/
SYDB
1.00 ARL AIBCSGN ISP ACA SAN
DANSKE
BBVA
INGAMBRBS
BKIASAB JYSK BNPBIRG
BCP STAN RBI GARAN
UCG BARC GLE AKBANK
UBI BPE
DBK CBK
BAMI YAPI
ALPHA EUROB

0.00
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Adjusted RoTBV (%)

Note: TBVPS = Tangible Book Value Per Share. Source: Autonomous Research 12
Different measures of earnings

Wells Fargo 3Q18 earnings breakdown, US$m

Net interest income 12,572
Noninterest income 9,369
Total income 21,941
Noninterest expense (13,763)
Pre-provision profit 8,178

Net charge-offs (680)

Reserve release 100
Reported PBT 7,598

Adjustments:
Gain on sale of Pick-a-Pay PCI mortgage loans (638)
Gain on sale of debt securities (57)
Accrual for issues related to auto collateral protection 241
Other remediation expenses 364
MSR hedges (30)
Adjusted PBT 7,478

13
 Loan loss provisions are highly cyclical

Source: Goldman Sachs 14

 Earnings power and Normalised earnings
Select European Banks’ P/E ratios (2019E) using a normalised provisioning rate

10.5x
9.8x

6.6x
5.2x 5.6x

3.7x 3.8x 4.0x

3.3x
2.3x 2.0x

nk

i
nk
es

nk
a
M

ce

i
e

ed
nt
eu
nc

es
BP

gu

ee

Ba
ba

ba
ra

Kr
llin
Ba

ra

Ga
tu

Gr
ro

Ak
o

a
Pi

pi
lte
nc

ph
or

Eu

Ya
of
E
Ba

lP
BP

Va

Al
k
cia

an
ito

lB
er
ed

na
Cr

Co

ti o
o

Na
nc
Ba

P/E 2019E P/E 2019E based on normalised provisions

Source: Autonomous Research 15

 Pr
ov
id
en
Ha t Fi

10.0%
15.0%
20.0%
25.0%
30.0%

0.0%
5.0%
nd na
els nci
ba al
nk
No en
AB rde
N a
Am
PK ro
Jy O B
sk
eB P
an
k

Source: Autonomous Research

KB
S C
Ba RBa
n n
Vi k P k
rg ek
Ll o in a
yd M o
sB on
an Ba ey
k in w
g ag
M G ro
et u
ro p
R B
B a an
St an i ffe k
Na an k
t io da o f isen
na r d Ir e
l B Ch lan
Cr an ar t d
ed k o er
it f G ed
Su r
is ee
Co se c e
m Gr o
m
er up
zb
an
Cl
os k
e B UB
ro S
t
OT her
P s
B
Ba Un ank
nc icr
oC e
om Ak dit
er Ca an b
c ia ix a k
l P Ba
o r nk
European Banks: Basel 3 core tier 1 ratio, 2018E

BP tu g
ER u e
Cr B s
ed N B an
it o P P ca
V a
Cl alt r iba
yd el s
es lin
d a es
le e
Sa Ban
nt k
an
d
Pir er
ae
us
16
The issue of leverage: The right amount of capital
Adjusting valuations to take account of leverage
US Banks: P/E ratios adjusted for excess capital (July 2017)

Source: Autonomous Research 17

 What is the cost of equity?

EBA survey of European bank executives

Source: European Banking Authority Risk Assessment Report, November 2017 18

 Recent trends in cost of equity

Source: Goldman Sachs 19

What about growth?

20
 What about growth?
US Banks: Risk-weighted asset growth by decade (CAGR)

• Industry not showing same growth as it was

• Financial assets as % GDP peaked in 2006
• Convergence trades
• Unlike other industries, growth seen as a risk factor
• Clearly some institutions capable of showing high growth

Source: Autonomous Research 21

 Free cashflow-based approach
• Think of regulatory capital as ‘capex’
• So to fund US$1bn risk-weighted asset growth, a bank would
need to set aside US$120m core capital
• FCFE = Net income – Reinvestment in regulatory capital
• Better than dividend discount model because takes into
account regulatory constraints on dividend payouts
• Negative FCFE takes into account prospective capital raise

22
 Free cashflow: Historical perspective
US banks free cashflow through the years
Free cashflow as % net profit

Source: Autonomous Research 23

 Diversified Financial Institutions
• Universal banks consist of different business segments:
– Wealth management
– Retail/corporate banking
– Asset management
– Investment banking
• The business segments can have different risk/return/growth
profiles

24
 Sum of the Parts
Sum-of-the-Parts valuation of UBS

• Basic (ROE-g)/(r-g) model still employed

• Wealth management: high growth, low cost of capital
• Investment banking: low growth, high cost of capital
• Excess capital explicitly captured and valued at 1.0x book value

Source: Credit Suisse 25

 Summary: Key questions
• Where are we in the cycle?
• Are assets and liabilities marked appropriately?
• How much capital does the bank need?
• Does the bank have excess capital or a capital deficit?
• Are earnings a fair reflection of the bank’s earnings power?
• What is the underlying ROE?
• What is the realistic rate of growth, taking into account
business mix?
• What is a good estimate for the cost of equity capital?

26
Valuation approach depends on the environment

Source: Goldman Sachs 27

Thank You

@MarcRuby