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Drivers of Bank Valuation, Part II: Growing Loans and Becoming More Efficient

April 10th, 2013 |

4-10-13_CK_Lee.pngBanks are in business to drive value—for the community, for customers and for shareholders. In our previous article we explored the concept of tangible book value (TBV) and its importance as a baseline for defining shareholder value. Growing TBV inspires confidence in the bank’s relative strength among shareholders, customers and regulators. 

We recommend boards regularly assess their internal operations and take affirmative steps to ensure more of a bank’s revenue production capability turns into TBV growth. In this article, we’ll explore two critical areas that can drive greater earnings and greater growth in the bank’s value. 

Become More Efficient

It is a truism that more efficient companies are more attractive—to investors as well as potential purchasers. If it takes less to make a dollar, greater earnings result. The earnings are then available to provide shareholders a current return on investment, through dividends or to enhance capital and support future growth. Looking at the industry data, there is a direct relationship between banks' efficiency ratios and their earnings. In the third quarter of 2012, for example, banks with efficiency ratios of 80 percent to 100 percent earned an average of 35 basis points on assets. This compares with 84 basis points on average for banks with efficiency ratios between 60 percent and 80 percent, and a whopping average of 148 basis points on assets for banks with efficiency ratios less than 60 percent. This same pattern holds true going back several years. 

The obvious benefits to earnings of running an efficient organization is certainly payback enough for the effort involved. But controlling this process within your own boardroom is preferable to having inefficiencies dealt with through pressure from third parties, whether they are disgruntled investors, analysts or regulators. This sort of pressure can result in disruptive cost-cutting that could result in the company taking a step backwards before it can move forward. Addressing efficiency on an ongoing basis can head off these challenges, drive greater shareholder value and improve the organization’s overall strength and discipline. 

Grow Loans

The current yield curve has had a painful impact on margins at smaller banks, particularly banks with lower loan-to-deposit (L/D) ratios. So, how do you drive margin in this challenging rate environment? One answer is to make loans.

The disparities within the margin data are interesting. If you look back to the third quarter of 2009, there was little disparity in average margin between banks with higher loan balances and those with lower L/D ratios. Since then, however, margins have expanded, on average, for banks with more than 50 percent L/D (driving margins well above 4 percent), while the banks with less than 50 percent suffer margins in the low 3 percent range. This incremental disparity is a key driver of the industry's depressed earnings profile and the low valuation placed on banks with lower loan balances.

Now, the interesting question is how to grow loans? The overall economy isn't exactly helping. But there are steps boards and management can take to improve their ability to grow loans. These include growing the overall bank to allow access to additional customers and products through a higher legal lending limit. Other options include acquiring loan portfolios through M&A, aggressively pursuing lending staff with solid track records and books of business, partnering with nearby institutions on participations, and upgrading your pursuit of loan business within the reach and scope of the bank. Like anything else in the bank, growing loans must be a priority if the board desires to drive margin and earnings, and the managers need to be held accountable in this regard, as in any other bank priority. 

In our final article on the drivers of bank valuation, we will explore the impact of size and business diversification on bank valuation.

Lee’s comments are strictly his views and opinions and do not constitute investment advice.

cklee

C. K. Lee is a managing director in the financial institutions group, capital markets division of Commerce Street Capital, LLC.  In that capacity, Mr. Lee assists financial institution clients with M&A, capital raising, balance sheet restructuring, business plan development and regulatory matters.

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