Valuation Methods - Part One
The general approach and application of liquidation valuation
Greetings and Happy Mother’s Day to all the wonderful Moms out there!
Valuation is one of several topics in investing that combines both art and science. An investor needs to know which valuation technique to apply in a given scenario, how to implement it, and how to balance the various considerations that may be relevant to that approach. In Analyzing and Investing in Community Banks, author David B. Moore dedicates a chapter to the various valuation approaches that help triangulate intrinsic value in bank investing. My initial idea with this post was to highlight each of the primary valuation methods, but I decided it would go on longer than I’d like so I’ll be sticking to just one today, liquidation value. Now I know what you’re thinking, why do I need to know how to evaluate a bank liquidation? Well, there will likely come a day when bank failures are more commonplace than they have been in recent years. I can’t tell you exactly when this might occur, but feel strongly that cycles will eventually repeat.
Liquidation Value
What it is: A valuation based on the assumption that the subject bank is no longer a going concern. Investors are left to sell off the various pieces of the bank - or liquidate it - in an effort to recoup and distribute as much of the net proceeds to shareholders as possible.
The procedure: Working through the bank’s balance sheet line by line and conservatively applying discounts/premiums to each asset and liability, or what’s otherwise known as “marking to market”. At the end, the adjusted liabilities are subtracted from the adjusted asset total to calculate the residual equity value. As is probably intuitive, the liquidation valuation will result in the lowest estimate of intrinsic value of the methods I’ll mention in this series.
Why/when you use it: No group of investors is willing to recapitalize the bank and no outside acquirer is willing to buy the bank. Typically, the need for a liquidation arises when a bank has gotten itself into serious trouble relating to credit quality. Be careful when using this approach because if you overestimate with your assumptions, you may see value in a bank when its equity is actually worthless.
For starters, let’s hope you never have to utilize this approach if you’ve already made an investment in a bank. Nobody wants to go from assuming their bank is an ongoing entity only to have to switch gears and see what percentage of shareholder’s equity they can hopefully get back. When a bank is in deep trouble and it is believed the market value of liabilities exceeds asset values, the FDIC will usually step in to liquidate the bank and get as much of depositor’s funds back as possible. Inside the FDIC: Thirty Years of Bank Failures, Bailouts, and Regulatory Battles highlights this process for any readers who may be interested. If the opposite is true and assets should cover the liabilities, the liquidation will likely be carried out by an investment bank. Don’t forget to account for their fees in your estimate!
Cash and securities can usually be safely assumed to be worth close to par, or the stated book values. However, if a large move in interest rates has recently occurred, you may want to consider applying a premium/discount for the investment portfolio depending on the direction and severity of the rate move.
The most critical assumptions will be regarding the loan book, REO, and other longer term assets. For one, loans usually make up the largest component of balance sheet (so any change in the assumed mark down here can move the estimate a lot), but they are also likely what got the bank into liquidation mode in the first place.
Assumptions relating to the performing loans are tricky. On the one hand, a properly underwritten loan could warrant a premium because the ultimate buyer of it will not have any costs associated with originating the loans, therefore it is more profitable to them. In reality, I think a bank may be hard pressed to find a bank achieving premium pricing when they’re a forced seller in a liquidation. This may be a hint for further research in itself though. It’s worthwhile to investigate any third-party bank that comes in and is able to buy assets on the cheap from a distressed seller.
Performing loans also warrant a discount to their reported value in the scenario where they are priced below average market rates or if the pricing doesn’t appropriately reflect the underlying risk in the loans. As an outside analyst, it may be hard to get a true sense for this, but I’d argue if the bank got itself to this point you can probably bet even their performing loans may have more risk in them than they should.
Nonperforming loans should get a material haircut, say of at least 50% and probably more. The loan loss reserve can be assumed to be worth its stated value because it will simply be applied to specific trouble loans and reflected in the sale price of those loans.
Real estate owned (REO) is another debatable asset. After all, it’s already supposed be on the balance sheet at a figure which reflects its market value. Again though, the point of a liquidation valuation is to be conservative and find as close to a worst case scenario as possible. And since were sitting on an illiquid asset that may be worth much less in the case of an extended economic downturn sold by a distressed seller, discounts of 20-50% are potentially warranted.
As a general rule, the further down the balance sheet you go, the more significant the discount to stated asset value should be. Goodwill and other intangibles should be valued at zero, because they are all but worthless in a liquidation. Any other assets such as equipment or furniture should be heavily discounted as well (75%+).
The one exception in PP&E might be hidden land or building value. Accounting rules will have these (typically) appreciating assets on the balance sheet at their historical cost. This may or may not be representative of the true underlying value for your purposes. Try checking county tax assessor records for a better indicator of potential hidden value (and accordingly an asset worth applying a premium to).
So far, we’ve only gone through the assets. You’ve probably noticed the underlying theme is to mark down these values to something less - often much less - than the reported book value. In liabilities, there’s a different standard assumption. In short, your base assumption should be that each liability is worth the stated amount or more. Remember, the goal is to be conservative…the bank has very little bargaining power at this stage.
The most important question relating to the liabilities is what kind of premium would the deposits be worth. As I’ve discussed in other posts, deposits have value to a bank as well as suitor banks, particularly in a rising rate environment. A high quality deposit franchise can help an acquirer fund itself at a lower cost than it would otherwise be able to. If a buyer of the distressed bank’s deposits can fund themselves at a lower rate than they’d otherwise be able to, they may be willing to pay a premium on non-time deposits. And just to be clear, since we’re dealing with the liability side of the balance sheet, when I say “premium” the adjustment would actually be to reduce the liability value on the balance sheet (thereby increasing resulting equity all else equal). Just don’t assume a premium value will be assigned to CDs, brokered deposits, etc.
The last point to make is that the estimates for realizable values in a liquidation will vary a lot. Don’t get too attached to any of your assumptions regarding asset and liability mark-ups/downs. Any numbers I’ve suggested are just loose rules of thumb or starting points for your analysis. With the benefit of hindsight, they will be off the mark and as a levered entity, small errors in the value of assets or liabilities will also lead to large movements in the remaining value of the bank’s equity. The two best things to keep in mind to protect you in this regard are to be conservative and consider a range of possible outcomes. That should help protect you from thinking there is some residual value in a liquidation when in reality the bank’s equity is worthless.