Acquiring a bank is among the most widely discussed topics in the banking sector. Banks recognize that they need to engage in this discussion, particularly in light of today’s low interest rates, challenging organic growth environment and significant regulatory and technology headwinds. If structured correctly, M&A can create significant value for both the buyer’s and seller’s shareholders. However, M&A activity since the financial crisis has been marked by an increased focus on a variety of financial metrics—earnings per share (EPS) accretion, tangible book value per share (TBV) dilution and TBV earnback—whose connection to actual value creation is unclear. While banks aim to announce “acceptable” M&A transactions that meet the guidelines set forth by investors, research analysts and investment bankers, it’s worth asking how these metrics relate to value creation for shareholders.
In order to answer this question, it is important to understand what drives bank stock valuations. Corporate finance theory holds that a company’s value equals the present value of expected future cash flows. Bank investors receive two forms of cash flow: dividends and proceeds at sale. While dividends are fairly easy for investors to model, projecting a bank’s stock price is a more challenging task. A good place to start is TBV, which represents the bank’s liquidation value. Since banks are going concerns, however, they are valued at greater than TBV if they can grow TBV at a rate that exceeds investors’ required return (the discount rate). In other words, banks that produce greater returns on tangible capital (ROTCE) are valued at higher multiples of TBV. This explains, for example, why Home Bancshares—which has been posting above average returns—trades at a much higher multiple of TBV than the average bank. This also explains why P/TBV multiples in post-crisis M&A transactions are meaningfully lower than they were before the crisis. Banks today are less profitable and operating with more capital, both of which depress ROTCE and merit lower P/TBV multiples. Simply put, P/TBV multiples are not comparable without considering shareholder returns.
The M&A dilemma for banks lies in the tradeoff between current TBV dilution and higher future returns. Investors quantify this tradeoff by calculating a TBV earnback period, which is the number of years it takes to earn back the deal’s TBV dilution through incremental earnings. It is currently acceptable to do transactions with TBV earnback periods of up to five years, although it is unclear how or why this benchmark was established. In fact, the link between TBV earnback and value creation is tenuous. Transactions that are accretive to earnings and earnings growth should result in higher future returns and hence P/TBV multiple expansion. Fully earning back the transaction’s TBV dilution is sufficient, but not necessary, to create value since the bank will trade at a higher multiple of its diluted TBV. Banks with significant excess capital highlight the issue with arbitrary TBV earnback thresholds. For these banks, the financial impact of an M&A transaction should be compared with alternative uses of capital, including organic growth and share repurchases. If the bank has difficulty growing organically and the share repurchase math results in an earnback period over five years, the bank should seriously consider a transaction with a longer than five-year earnback period. In this scenario, the alternative uses of capital—organic growth, share repurchases and dividends—are unlikely to produce better long-term value for investors.
This is not to say that TBV is irrelevant. A bank that dilutes TBV in exchange for modest returns will be penalized by the market when there are other alternatives—organic growth, share repurchases or other M&A transactions—that would have produced the same or better returns with less risk. This is why banks always need to consider the alternatives to deploying or raising capital before pursuing a transaction. Importantly, not all banks are created equal. A bank with limited organic growth prospects in a weak demographic region may benefit from a deal with a 10-year TBV earnback period if the transaction puts it on a better growth trajectory. Conversely, a bank that does an acquisition in a market with weaker growth prospects using its higher P/E multiple could see value deteriorate as its P/E multiple contracts to reflect its lower long-term growth prospects. And just as a bank that leverages its capital through a transaction should compare the financial impact with a share repurchase, a bank that adds capital through a transaction should compare the financial impact with a capital raise. Raising capital is dilutive to EPS before the capital is deployed; acquiring an overcapitalized bank can thus serve as a substitute for a capital raise that also enhances franchise value. Banks that are interested in long-term, sustainable value creation for their shareholders would benefit from evaluating M&A transactions from this perspective.
This article was originally featured in Bank Director’s 2016 3rd Quarter print magazine.