What drives bank stock valuations? Is it asset size, growth, profitability—or a combination of factors acting in concert? Keefe Bruyette & Woods Managing Director Jeffrey Wishner presented an extensive study recently at the Crowe Horwath Bank Growth & Profitability Conference in San Diego in which he examined how a variety of factors influenced the stock prices of 381 publicly held banks traded on the Nasdaq or NYSE exchanges during the first quarter of 2015.
For starters, size would seem to have a positive impact on valuations—although it is by no means a linear relationship. Wishner divided the universe of public banks into seven asset size categories, beginning with institutions having $500 million in assets or less, and ending with $50 billion in assets and above. Banks in the $5 billion to $10 billion category traded on average 1.8 times their tangible book value (TBV) in the first quarter of this year, which was the highest of any of the asset groupings. Interestingly, banks in the $10 billion to $50 billion and $50 billion and above categories had lower price-to-TBV (P/TBV) ratios—1.69x and 1.56x on average, respectively—an indication that the benefits of size dissipate as banks grow larger.
Wishner also looked at the impact that profitability had on stock prices. Banks that had a return on average assets (ROAA) of 1 percent or better traded on average 1.59 times TBV in the first quarter. Those that had lower ROAAs had correspondingly lower P/TBV ratios. The same relationship was observed with return on tangible common equity (ROTCE): Banks that had a ROTCE of 10 percent or better traded at 1.6 times TBV while those institutions below that mark all had lower valuations.
As one might expect, banks that had solid loan growth also tended to have higher stock prices. Those that grew loans by at least 10 percent also had P/TBV ratios on average of 1.55x, while those that had lower loan growth also had lower P/TBV ratios. Loan growth became even more powerful when combined with higher efficiency, which only makes sense since more of the economic benefits are falling to the bottom line. Banks whose five-year loan compound annual growth rate (CAGR) was 10 percent or better, and also had an efficiency ratio of 60 percent or lower, traded on average 1.9 times their TBV.
Strong loan growth combined with a high ROAA produced the highest returns of all. Banks that had a five-year loan CAGR of 10 percent or higher, and a ROAA of at least 1 percent, had a median P/TBV ratio of 2.09x.
Wishner’s study uncovered some other interesting findings as well. Commercial real estate has accounted for a significant percentage of commercial loan growth in recent years, but too much of a good thing can depress valuations. Banks that had between 25 percent and 50 percent of their loans in commercial real estate traded at 1.61 times TBV, but banks that had higher concentrations also had significantly lower P/TBV ratios. Capital is another factor where having too much can negatively impact a bank’s stock price. Institutions whose ratio of tangible common equity (TCE) to tangible assets ranged between 6 and 8 percent had a P/TBV of 1.58x. Bump the TCE ratio up to a range of 8 to 10 percent and the P/TBV ratio drops to 1.4x. Increase it to 10 percent or greater and the P/TBV ratio plummets to 1.2x. Why? The higher the TCE ratio, the less leverage the bank has—which in turn drives down return on equity.
Although the banking industry tends to be obsessed with growth, it’s not what investors value the most. “The market values efficiency and profitability a little more than growth,” says Wishner.
It would be possible from Wishner’s study to construct the ideal bank from a valuation perspective. That would be a bank with assets of $5 billion to $10 billion, with strong loan growth, high efficiency, enough commercial real estate exposure to help drive profitability but not so much that it distorts the bank’s risk profile, and a TCE ratio of between 6 percent and 8 percent. Any bank that has these characteristics occupies a sweet spot in the bank stock market and should enjoy a higher valuation than many of its peers.