In discussions of potential bank sales or acquisitions, bank valuation is always one of the first items to come up. While a number of valuation drivers might come into play, buyers ultimately want to achieve an acceptable return on their investment. This means acquisition pricing typically is driven by the institution’s current and future earnings power.
Analyzing data sets that focus on loan growth and asset quality can help quickly frame up an understanding of how a bank may be received and valued in the market. In recent years, we’ve reviewed these data sets against a broad range of transactions, with the asset size of target institutions ranging from less than $100 million to greater than $1 billion, and the relationships appear consistent throughout the data.;
The Federal Deposit Insurance Corp. reports that community banks saw an uptick in loan demand in the second quarter of 2015, posting loan growth of 8.8 percent compared to the second quarter of 2014. However, many banks report concerns about their prospects for continued growth and profitability, which puts them on the lookout for opportunities to enter markets with growing loan demand.
When building their valuation model, buyers want to understand the target institution’s loan growth opportunities. If a prospective buyer can reasonably project high annual loan growth levels, it may be able to project higher future earnings, reduce the payback period and increase its return on investment.
Driven by future loan growth opportunities, these factors could help a prospective buyer rationalize a higher valuation for the target bank. These higher valuations can be seen in the national bank transaction data over the past three years and for year-to-date (YTD) 2015. Banks with three-year loan growth in the bottom quartile—those posting portfolio declines of greater than 16.9 percent—transacted at an average deal value to tangible book of 0.95 times. Banks in the second quartile transacted at an average of 1.17 times tangible book, while banks in the third quartile transacted at an average of 1.41 times tangible book. However, banks in the fourth quartile—those posting three-year loan growth of greater than 9.84 percent—transacted at an average of 1.62 times tangible book.
The ratio of nonperforming assets (NPAs) to total assets has declined steadily in the past few years in the banking industry, falling to 1.12 percent as of June 30, 2015, after reaching a high of 2.76 percent on March 31, 2010. While this decline is positive, this ratio is still above levels seen prior to the Great Recession, and continues to significantly affect valuation in bank transactions.
As said earlier, banks are looking for strong earnings in an acquisition to achieve an acceptable return on investment. The inherent risk in a target bank’s assets likely will affect future earnings, either positively or negatively. High NPA levels push the seller’s projected future earnings down in a buyer’s valuation model, often leading to a lower valuation for the target bank.
While there are a number of measures of asset quality, this trend toward lower value for banks with asset quality issues is clear in the national bank transaction data in the past three years and for YTD 2015, broken out by NPAs to total asset quartiles. Banks in the fourth quartile—those posting NPAs to total assets greater than 3.61 percent—transacted at an average deal value of 0.94 times tangible book. However, banks in the first quartile—those posting NPAs to total assets of less than 0.56 percent—transacted at an average of 1.55 times tangible book.
Clearly, other key value drivers can affect valuation and even make or break an acquisition, including asset size, competitive and geographical considerations, management teams, asset/liability management strategies, deposit pricing and many more. Loan growth and asset quality are just two of the key value drivers that acquirers and potential sellers should consider. However, sellers should be very aware that acquirers are looking for access to earnings. Banks that focus on improving earnings drivers likely will position themselves to achieve higher valuations in the marketplace.
This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.