The banking industry is poised for a rebound in merger and acquisition activity, which raises the fundamental question of what a bank is worth and how the board and its advisers should derive that number. The art of valuation can be mystifying and the terminology confusing. Every director at one time or another has seen industry data on values, but converting that data into a meaningful picture of a bank’s value requires an understanding of what drives value and how the process works. Understanding the valuation process can help bank directors and top managers better understand the valuation report.
Levels of Value
When determining the value of your bank, you need to consider the purpose of the valuation and the type of value you need for that purpose.
A controlling interest value is what an outside party would pay for ownership of the bank. It is often defined as ownership of more than 50 percent. In banking, however, control is typically the result of an acquisition or, in more recent years, a significant recapitalization.
A marketable minority interest is the value of a bank’s publicly traded stock on an exchange or other over-the-counter market. A marketable minority interest can be traded without restrictions. Since it is a minority interest, the ownership level is below 50 percent or is such that the owner can’t effect changes that a controlling owner would be able to.
A non-marketable minority interest does not have a readily traded market, and transferring the shares takes time and, potentially, can result in a price reduction. To determine a valuation for a non-marketable minority interest, some sort of discount for lack of marketability is applied to the marketable minority interest.
To arrive at this discount, two sources of data are often relied on. The first set of data stems from restricted stock studies. Restricted stocks are shares of public companies that are restricted from public trading under SEC Rule 144. Although they cannot be sold on the open market, they can be bought by qualified institutional investors. Restricted stock studies compare the price of restricted shares of a public company with the freely traded public market price on the same date. Price differences are attributed to liquidity. Many consider the discounts a reliable guide to discounts for the lack of marketability.
A second set of commonly used reference data for determining lack-of-marketability discounts is derived from pre-IPO stock studies. A pre-IPO transaction is one involving a private company stock prior to an initial public offering. Pre-IPO studies compare the price of the private stock transaction with the public offering price. The percentage below the public offering price at which the private transaction occurred is a proxy for the discount.
There are several approaches to determining a valuation.
The income approach to valuation indicates the fair value of a bank based on the value of the cash flows that it can be expected to generate in the future. A discounted cash flow (DCF) analysis is one widely accepted method of the income approach.
The DCF technique measures intrinsic value by reference to a bank’s expected annual free cash flows. Typically, this involves the use of revenue and expense projections and other sources and uses of cash. Factors that form the basis for expected future financial performance include the bank’s historical growth rate, business plans, anticipated needs for capital, and historical and expected levels of operating profitability.
An alternative method is the market approach, where a bank is valued by comparing it to publicly traded banks as well as market transactions involving banks with similar lines of business. Factors to consider when determining the comparability of publicly traded banks include asset size, products, markets, growth patterns, relative size, earning trends, loan quality and risk characteristics.