Valuation Methods - Part 2

Using relative valuation to help to triangulate a target price

Greetings and welcome to another issue of Conversion Confidential. I am currently spending my weekend time jumping through the required hoops in order to renew my real estate license so I’m going to be succinct with today’s post.

A couple weeks back, I wrote about liquidation valuations where each line item of the balance sheet is marked upwards or downwards to current fair value. The end result is a conservative estimate of the shareholder proceeds were the bank to close its doors and sell its remaining assets, net of the liabilities paid off. Also in that post, I mentioned it’s important to apply various techniques to estimate a reasonable range of potential values for a bank. As such, today, I’m going to summarize the comparable and acquisition methods which in my mind are both close cousins underneath the relative valuation framework.

The idea of relative valuation is to take a subject asset (or company) and derive a sense for its worth based on the analysis of what other market participants are currently paying for similar assets, or what are otherwise known as “comps” or peers”. Hopefully, one of the main problems of this approach has already jumped out to you…relative valuations are largely dependent upon what someone else might pay. As markets have proven recently, this figure can swing wildly in short periods of time due to investor psychology. A relative valuation may also ignore significant under or over-valuation of the entirety of the comparison group, thereby making it less informative.

Many folks will be familiar with the relative valuation approach given their experience buying a personal residence. In residential real estate, the most common/heavily weighted appraisal approach will be what’s known as the sales comparison technique. The appraiser will seek out similar properties in a relatively close proximity to your home and then make adjustments to compensate for differences in the various homes. The end result is an estimate of the underlying property’s worth based on the transactions of other comparable properties. This same principle can be applied to other assets such as banks and thrifts.

Peer Comparisons

In public markets, investors have the benefit (or curse) of always knowing the price of a given security. As a result, the appeal of a relative valuation becomes apparent as it is simple, quick, and easy. One is first looking to establish a relevant peer group list that is appropriate for the bank under evaluation. In this regard, the most relevant factors are size (total assets), location, and lending operations. When possible, you want to compare small thrifts with other small thrifts, not Wells Fargo etc. Similarly, if the comparable banks are in the same region and have a similar lending profile, this makes them a better comp for each other. Access to pricey data providers such as SNL Banker makes it even easier to peers and as such, this approach is frequently used by Wall St. analysts.

The second step of the peer comparison is simply to compare the subject bank’s high level valuation stats (such as P/TBV, P/E, & core deposit premium) to that of your newly established peer group. Often times, thrifts won’t have much in the way of earnings so their stocks may valued more on book values and deposit premiums, but you’ll quickly notice certain banks have higher or lower valuations relative to the others. In short, your job is to assess why the valuation gap exists in the first place and then to determine whether or not you believe it is warranted. You do this by comparing the banks on the key indicators of quality that we frequently discuss here at Conversion Confidential such as returns (ROA/ROE), capital levels, cost efficiency, lending practices, asset quality, deposit franchises, and management/insiders. If a bank has redeeming qualities vs. the average of the group, it warrants a premium to their overall valuation. If the opposite is true and the bank compares poorly to the group, then it deserves to trade cheaper than the rest. Exactly to what degree is largely a matter of subjective opinion and experience.

To illustrate a simple example, if you find Bank XYZ trading at 0.8x TBV and other banks in the area trade at to 1.2x TBV on average, then you may have something worth considering. However, if subsequent analysis reveals the subject bank has a TCE ratio of only 6% and generates net losses more often than earnings while the others are adequately capitalized and net income producing, you would probably be wise to conclude that the discount to the peer group is in fact warranted and there is little investment appeal (at least on a relative basis).

While were on the topic of capital levels, I should also note that you may want to normalize them for better comparison. The thrift landscape has a wide range of equity ratios due to the unique go-public transaction and many investors are unwilling to pay much of a premium on “excess capital” since it often can’t immediately be deployed to earn a satisfactory return. You can normalize equity levels across banks by assuming a certain TCE ratio, say 10%, and then considering all capital at each respective bank above that threshold to be “excess”.

One other point. If you look at banks enough, you’ll notice a big correlation between valuation and return on assets/equity. All else equal, the more net income a bank can generate on their asset or equity base, the higher a valuation it deserves. That is of course, assuming the bank isn’t taking on extremely risky behavior or generating results through unsustainable financial shenanigans that make near term earnings look better than they otherwise would.

Takeout (Acquisition) Values - A Subset of Comparable Analysis

I’ve already profiled the frequent nature of acquisitions among thrift conversions and small banks. Estimating a takeout value simply takes the precedent of a peer comparisons analysis and applies it to banks which have actually been sold. Once again, the investor takes the average multiples paid for comparable institutions and applies an adjustment to the subject bank in order to capture differences in profitability, deposits, capital, and assets. As I have mentioned in past posts, my single favorite metric to estimate takeout value is to use core deposit premiums.

It is also important to find transactions that have occurred relatively recently (within a few years) because various market conditions can have a big impact on what acquirers will pay. The M&A environment that existed five years ago may or may not be wildly different from the present so you will want to eliminate that noise if you can.

One quick trick to help find relevant takeout values is to pull up the proxy from a known acquisition that has already been announced or occurred. Within it, you will often find what are known as “fairness opinions”. This is where the investment bank involved in the transaction finds relevant comparables (transactions) so shareholders can better evaluate whether the proposed acquisition price is a fair deal to them. The fairness opinion will have a neat table listing recent transactions. In short, you as the investor can benefit by leveraging all the work others have already done. And best of all, it’s free!

Okay, that’s all for this week folks. I’m hoping to get back to a specific thrift writeup next week. Thanks for reading!