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Drivers of Bank Valuation, Part III: Size and Diversification

June 5th, 2013 |

6-5-13_Commerce.pngA critical function of any bank’s board of directors is to regularly assess whether their activities and those of the bank’s management are driving value. This may be defined as value for shareholders, value for the community and the perception of strength among the bank’s customers and regulators. 

In the last two installments of this series, we explored the concept of tangible book value (TBV) and its relationship with bank valuation. We also looked at internal steps, such as promoting efficiency and growing loans, which boards could take to drive more revenue to the bottom line and drive bank value. 

In this final installment, we’ll look at two additional factors that drive value in both earnings production and market perception. 

Size

The first of these is size. A bank's size has a direct bearing on its value. The data show clearly that larger banks are perceived to be more valuable, according to the tangible indicators of open market trades of bank stocks and in bank merger pricing. In 2012, for example, there was a clear disparity in the public markets between banks with less than $1 billion in total assets (which traded below tangible book value on average) and those above $1 billion (which traded, on average, at a substantial premium to TBV). Regarding whole bank sales in 2012, banks with more than $500 million in assets sold  at a higher valuation, as a function of price to TBV, than banks smaller than $500 million in total assets (122.3 percent of TBV versus 113.6 percent). Likewise, banks with more than $1 billion in total assets sold at 129.3 percent of TBV versus 113.1 percent of TBV for banks below $1 billion in assets.

There are a number of reasons for this. Certainly greater scale means greater efficiencies, the ability to expand the customer base through a higher legal lending limit, the ability to spread the cost of carrying regulatory compliance over more assets, and the ability to offer products that smaller banks cannot afford to offer. 

A key consideration for a bank’s board should be a regular assessment of the institution’s size relative to market and the steps needed to achieve a critical mass that drives value. Small banks can achieve scale through raising capital and expanding the balance sheet organically—or pursuing mergers with compatible institutions. Either approach allows banks to grow in size, improve efficiency and grow value.

Diversification

Another approach to growing value is to diversify the balance sheet and the income statement. The data shows that more diversified banks earn more and grow TBV faster. In 2012, banks with a real estate concentration of less than 60 percent earned as much as 90 basis points more on assets than peers more concentrated in real estate. 

Community banks, in particular, are more heavily concentrated in real estate by their very nature. The recent crisis points out the limits to this business philosophy, however, and should prompt some soul searching at the board level on how to avoid putting all the bank’s eggs in lower margin baskets. Commercial and industrial loans along with consumer lending have risks, to be sure, but prudent diversification into these areas offer opportunities for higher margins, more fee business, and more low cost deposits, all of which increase a bank's overall valuation.

The Role of the Board

Driving shareholder value, whether on an ongoing basis or in a sale, is the key rationale for running the bank in the first place. Boards should aggressively work on all fronts to drive earnings, drive efficiency, drive margin and drive value. This is hard work and not without risks. But managing risk is central to a bank board's obligations. Setting limits and managing tradeoffs within the market environment should be active rather than passive board activity. 

This work is hard and requires careful planning and execution. But the benefits to boards, management and—importantly—shareholders, of such efforts are considerable. 

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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