The Cost of Flawed Capital Decisions

For decades, banks have made capital allocation and capital stack decisions based on flawed metrics, leading to billions in lost shareholder value.

Many executives are unknowingly unable to effectively evaluate decisions. Blind spots lead to suboptimal performance and, in some cases, significant destruction of shareholder value. To illustrate the problem, let’s focus on mergers and acquisitions.

When evaluating transactions, three metrics dominate discussions:

• Internal rate of return (IRR).
• Tangible book value (TBV) earn-back.
• Earnings per share (EPS) accretion.

These metrics aim to answer key questions: Will this transaction create shareholder value? By how much and over what timeframe? What alternatives exist, and how do they compare? While each metric offers insight, none provide a complete picture.

Capital Allocation Principles
All executives should embrace four foundational principles when allocating capital:

1. Consider multiple possible future scenarios over a reasonable time horizon.
2. Measure all cash flows associated with a decision, not just short-term cash flow.
3. Ask, “Compared to what?”  to appropriately evaluate alternative uses of capital.
4. Look back later to measure outcomes relative to expectations.

Let’s put M&A’s key metrics to the test against these four timeless principles.

IRR counts all the cash flow, measuring earnings to a horizon date and assigning a multiple to calculate the value of earnings beyond that horizon. Because it considers all cash flow, it supports “compared to what” questions among alternatives. It also facilitates an objective lookback. However, as used in bank M&A, it is usually limited to considering a single scenario.

Consider this: Will earnings be the same if rates move up or down 200 basis points as if rates stay unchanged? Would pro forma TBV per share be affected by different earnings outcomes? Certainly it will be, as well as by shifting marks on assets and liabilities.

IRR, as used in bank M&A, is straightforward but potentially dangerous.

EPS accretion also has flaws. It’s not calculated across multiple rate scenarios, and doesn’t count all cash flows, ignoring the value of EPS beyond a horizon, making it insufficient to compare alternatives with different cash flow timelines.

TBV earn-back also does not stand up to the foundational principles. TBV earn-back offers no consideration to potentially wide-ranging EPS accretion outcomes in different future rate scenarios. Additionally, all cash flow is not counted, earnings are ignored beyond the “cross-over” point.

A Widespread, Costly Problem
Flaws in decision-making processes may seem theoretical but suboptimal performance, in an environment absent a credit cycle, is painfully real.
Between Jan. 1, 2018, and Jan. 1, 2025, the average bank in the KRX Index grew assets by 95%, yet share prices appreciated just 8.25% — an anemic 1.2% annualized return. Among smaller public banks ($1 billion to $10 billion in assets), the median bank delivered a 1.6% cumulative per-share value growth over the same period, according to data from Bloomberg and S&P Capital IQ Pro.

These issues are widespread, although not universal. Banks that embraced these four disciplined principles have bucked the trend.

Recent Capital Decisions
This problem extends well beyond M&A decisions. Think of capital decisions made over the past seven years or strategic plans for 2025. How many were examined against the four foundational principles?

The second half of 2024 and the first quarter of 2025 saw public banks raising significant equity capital, often for securities restructures. Was this the best use of that capital? Applying the fundamental principles would have provided clarity. And if a securities restructure was in fact the best use of capital, was equity the optimal form of capital?

Executives must challenge outdated metrics, examine decision alternatives and ensure capital decisions are based on reality — not tradition.

Performance Trust has been advising community banks for 30 years and is a registered broker/dealer, member of FINRA/SIPC. This is intended for educational and informational purposes only and is not intended to be legal, tax, financial, or accounting advice or a recommended course of action in any given situation. This is not an offer or solicitation to purchase or sell securities. The Information is subject to change without notice.