Every investment banker has shown clients canned charts of nationwide bank M&A multiples. The fallacy with these charts is that they show industry medians and averages, not the multiples that a specific bank should expect in a sale. Banks vary across important characteristics that drive these multiples—size, capital and returns, to name three—and each potential seller should understand its market value relative to a comparable group of banks. Unfortunately, community bank executives and their boards often become anchored to the industrywide multiples they see time and again. The price-to-earnings (P/E) sale multiple can be particularly troublesome. Strongly performing banks often tell me they would be happy to sell for that median or average multiple. It’s then my job to explain why doing so may not be as simple as it seems.
The price a buyer pays for a seller is a function of many things, but in particular, it is based off of a projection of the seller’s stand-alone future earnings, plus synergies. Revenue synergies often can be difficult to estimate and are even more difficult to achieve for buyers, whereas cost savings can be more reliably estimated and implemented, and are usually much greater in dollar amount. As such, cost savings are more likely to be priced into the transaction.
The bottom line: The more cost synergies that are available, the more a buyer can afford to pay and still achieve an economically attractive deal. Buyers will give poor earners some level of credit in the purchase price for efficiencies that are not yet implemented. On the other hand, higher performing banks, whose earnings are typically superior due to cost efficiency, have fewer cost savings opportunities to offer buyers and, paradoxically, this can negatively affect pricing multiples paid for those higher earning banks. As a result, the “P” in the P/E multiple is much closer between efficient and inefficient banks than their respective stand-alone earnings would suggest is fair. The result is a higher P/E ratio for a poor earning target that offers greater cost savings opportunities to the buyer. This is why industry-wide median and average M&A multiples reflect an elevated P/E multiple compared to what is available for a high performing bank. In other words, poor-earning targets inflate the P/E multiple due to their low stated “E”.
As an example, let’s assume a high-performing target bank that has $200 million in assets and earns a 1 percent return on average assets, and apply the approximate nationwide P/E sale multiple of 20, which would equate to a $40 million deal value, based on median and average P/E multiples of bank and thrift deals announced between January 1, 2016, and September 30, 2016, according to S&P Global Market Intelligence. Assuming 8 percent capital, or $16 million, passing to the buyer, this would equate to a premium of $24 million ($40 million price less $16 million capital). A buyer must justify the premium paid, but without an ability to extract sufficient synergies, it could be very difficult. Assuming the seller had a 2.5 percent noninterest expense-to-average assets ratio, which is in line with a fairly efficient bank, the buyer would only have $5 million in noninterest expense from which to extract cost synergies. If the buyer could achieve just 15 percent pre-tax expense savings (as opposed to 30 to 45 percent with a less efficient bank), the incremental net income to the buyer would be the seller’s stand-alone earnings of $2 million plus roughly $450,000 of cost savings (15 percent of $5 million, tax-effected at 40 percent), for a total of $2.45 million. Take the $24 million premium paid and divide it by the $2.45 million incremental net income from the deal, and the tangible book value payback period for the buyer would be barely under 10 years! Sellside analysts typically only bless deals with a payback period under five years, and investors usually want it closer to three years. In this example, the buyer could pay no more than 14 times P/E for the seller to stay below a five-year payback.
The P/E multiple paid for strong earning sellers is almost always lower than the national median and average multiple because these high performing banks have already done the heavy lifting by keeping costs low, and it is reflected in their standalone earnings. Since buyers have less ability to increase pro forma earnings through synergies, there is less upside for buyers to reward in the purchase price.