A few days ago, I woke up to the announcement that Winston-Salem, North Carolina-based BB&T Corp. has a deal in place to acquire Lititz, Pennsylvania-based Susquehanna Bancshares in a $2.5 billion deal. The purchase price is 70 percent stock and 30 percent cash and includes 0.253 BB&T shares and $4.05 in cash for each Susquehanna share. The implied price of $13.50 per share equates to 169 percent tangible book value, 16.3 times price as a multiple of last-twelve-months earnings per share and a 7.4 percent deposit premium.
While easy to see the deal as being strategically compelling from BB&T's perspective (the deal makers expect to generate cost savings from the combined institution, targeting $160 million annually or 32 percent of Susquehanna's non-interest expense), the announcement had me unexpectedly thinking about valuation issues and Warren Buffet.
Yes, Warren Buffet.
Let me explain the correlation between the two. A year ago, Buffet was on CNBC and took a question from a viewer about how he valued banks. In his words, "a bank that earns 1.3 percent or 1.4 percent on assets is going to end up selling above tangible book value. If it's earning 0.6 percent or 0.5 percent on assets it's not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks."
Keep in mind that for many smaller community banks, book value has been the primary determinant of value on a trading basis. As the lion's share of mergers and acquisitions have involved small community banks over the past few years, talk of book value has been quite prevalent. So the BB&T deal, the second largest so far this year, got me thinking about valuation issues and if an increased focus on price to earnings might be a more appropriate way to value banks.
To get some perspective on this topic, I reached out to Dory Wiley, president and CEO of Commerce Street Holdings. He sees earnings as more important, but was quick to remind me that tangible book value does matter.
John Gorman, a partner in the Washington, D.C.-based law firm of Luse Gorman Pomerenk & Schick, P.C. provided additional context. "Having value driven by earnings is the goal for most publicly traded community banks, and that goal is bearing fruit, but in a discriminating fashion. The market is being selective in terms of which companies it is rewarding with earnings-based valuation on a trading basis. And that reward provides those select companies with a competitive advantage in terms of paying the higher price-to-earnings and price-to-book multiples in the M&A marketplace."
Andy Gibbs of Mercer Capital opined "it is earnings, after all, that are the source of the capital needed to reinvest in the bank (and grow its value), to pay dividends to shareholders, or to repurchase shares. A well capitalized bank can do those things in the short-run, but without earnings to replenish and expand capital, it's not sustainable."
Clearly, a bank that generates greater returns to shareholders is more valuable; thus, the emphasis on earnings and returns rather than book value. To this end, Gorman says: "If a company is a strong earner, and is located in an attractive geographic market, it may be able to obtain a significant M&A premium and thereby realize an earnings-based valuation."
So investors and buyers will always use book value as a way to measure the worth of banks. But as the market improves and more acquisitions are announced, expect to see more attention to earnings and price to earnings as a way to value banks.