When looking at a bank’s value, whether as a going concern or through the merger process, the headline is the price. This can be expressed as a dollar value per-share or as a multiple of earnings or tangible book value (“TBV”). Either way, price is the critical metric for boards to assess management's performance, for shareholders who must approve merger transactions, or for financial advisory firms who must opine on a transaction’s fairness.
It follows, then, that boards should spend time during the strategic planning process evaluating what drives bank value and what steps they and the bank's management can take now to improve the organization’s overall valuation and worth in the marketplace. This process pays dividends in growing share value, improving the bank's perception in the marketplace (especially important for banks with publicly listed stock), and ultimately receiving a satisfactory price in a merger or sale transaction.
The baseline for valuation is the net worth or book value of the company. Typically, buyers and investors look to the bank’s TBV—or the bank’s net worth after all intangibles and hybrid capital instruments are netted out. After TBV, the most critical factor in assessing value is earnings. Earnings grow TBV and they allow boards flexibility in providing benefits to shareholders through stock buybacks and dividends. Plus, they allow management the flexibility to invest in people, processes and new lines of business. Also, in a sale of the company, buyers rely on the acquired company's earnings to repay them for the dilution they take as a result of paying a control premium. More earnings, more premium—and more benefit to shareholders.
In the first of a three part series, we will examine some of the attributes that drive tangible book value and are perceived as valuable to prospective acquirers and merger partners. In this issue’s installment, we will look at the TBV metric in detail and how focusing on TBV is critical to driving shareholder value.
Growing Tangible Book Value
Since the financial crisis in 2008, regulators, investors and prospective purchasers have all migrated toward discounting the capital benefits of so-called Tier 2 capital and other intangibles that make up a bank's “book value.” The use of TBV as the standard metric for assessing a bank's equity and pricing deals should drive boards toward placing a premium on growing TBV through organic growth. This isn't necessarily an argument not to do deals, but deals involve premiums and thus are dilutive—even if only for a time—to the organization's TBV. If boards are eyeing an exit in the short-to-medium term, growing TBV should be an overriding priority.
Consider a simplistic example. If a bank organizes and raises capital at $10 per share and runs a five-year business plan that yields growth in TBV of 15 percent per year, the share value at the end of the business plan will be approximately $20 per share. Assuming an exit at 2 times TBV, the bank's investors will realize a 4 times return on their original investment of $10. Fair enough. Now, take that same bank and grow the TBV at 20 percent instead of 15 percent and the investor will exit at $50—moving the return from 4 times cash-on-cash to 5 times.
The point here is that incremental changes in TBV over the life of a bank's business plan can have a significant beneficial impact on the bank's shareholders. Likewise, poor capital planning—including raising capital at significant premiums or poor M&A strategy—can erode TBV and significantly erode the return to shareholders.
So, how to grow TBV? This is certainly a challenge given the compressed margins and lower earnings in the current banking market. But running the bank efficiently, allocating capital to higher margin businesses, controlling cost of funds, expanding fee income opportunities and careful pricing in the M&A markets can all help push more of the bank's earnings capacity into the company's net worth—and yield a better price for the bank’s shares in the open market or in an outright sale.
In the next article in this series, we will explore several operating metrics that assist in TBV growth and drive higher valuations in open market stock sales and the merger markets.
Lee’s comments are strictly his views and opinions and do not constitute investment advice.