Building Lasting Value

Banks provide the foundation for economic freedom and fuel the entrepreneurial energy that is unique to America. In my view, the highest purpose in banking is to build lasting value for shareholders, employees, customers, and the community, thus fulfilling the historic role of banking as the enabler of individuals to achieve their dreams.

In a world driven by short-term considerations, investing in the long-term takes courage. As a result, building lasting value is both the greatest challenge and opportunity facing management and boards of directors. With success come significant personal and financial rewards.

Even more important, at the end of the journey we all want to leave some footprints as evidence that we were here. For that reason, I believe banking provides more opportunities than any other calling.

The importance of strong earnings

A bank generates earnings to pay dividends and build capital to support future asset growth. Of growing importance is the need for strong earnings to provide the flexibility to take advantage of new opportunitiesu00e2u20ac”which is often more about the ability to absorb additional expenses than the need for more capital.

Strong earnings provide the financial strength to expand, to attract, and retain talented people, to invest in new technology, and to effectively respond to competitionu00e2u20ac”all of which are essential for building lasting value. The long-term rewards are

– superior returns for shareholders
– more opportunities for employees
– better service to customers
– greater participation in building the community
– tremendous personal satisfaction.

America’s banks are the “thousand points of light” throughout the country, enabling individuals to achieve their dreams and free enterprise to flourish.

Valuing a bank today

The classic definition of the value of an asset is the present value of all future benefits to be derived from owning that asset. In purely financial terms, these benefits are the future earnings. The actual valuation of these future earnings, however, is tempered by the risk associated with generating them.

Earnings from high-risk or nonrecurring sources are often discounted in the valuation process. The future value of the institution will mainly be based on sustainable earnings streams. For example, fees from mortgage refinancings often have little future value because they cannot be sustained unless rates continue to fall forever.

Credit risk, from both a valuation and operational viewpoint, is the most critical of the many risks that financial institutions face. Major credit losses can put future earnings in jeopardy, cause a bank to lose its momentum, and, as we all know, actually threaten the long-term viability of the institution. Hence, accurately analyzing and understanding a bank’s credit risk exposure is a major factor in determining its value.

Going concern vs. acquisition valueu00e2u20ac”A financial analyst experienced in banking can value the bank as either a going concern or as a potential acquisition. For most banks, the potential acquisition value will be greater than the going-concern value. However, the stronger the bank’s earnings and projected growth, the more likely that the going-concern value to the shareholders will approximate the value to be obtained from selling the bank.

Subchapter S banks, which have the ability to pay out their pretax earnings as dividends, are in a unique category. Subchapter S banks that are highly profitable and have more than adequate capital are in a very unique category. These banks are often perceived by their shareholders as being much more valuable as a source of current income than for their potential acquisition value.

A well-established, profitable customer base, coupled with a management team capable of consistently achieving high levels of future earnings and asset growth, are two of the most valuable off-balance-sheet assets a bank can have. This powerful combination is most often already reflected in the current earnings of the bank and, hence, its value, whether viewed as a going concern or as a potential acquisition.

Personal considerationsu00e2u20ac”Personal considerations of owners and management always factor into the value of the bank beyond the purely financial value. Financial value can be accurately estimated by analyzing current earnings and projecting future earnings, taking into account the risks associated with those earnings, and determining their long-term sustainability. The challenge is to quantify the impact of personal considerations on value as viewed from the owners’ perspective.

On one end of the spectrum of personal considerations is the tremendous satisfaction of growing an enterprise that produces excellent financial returns, provides career opportunities for employees, enables customers to achieve their dreams, and helps build the community. On the other end of the spectrum is the stress of being in an increasingly complex, highly regulated industry driven by uncontrollable factors such as geo-economic developments, interest rate risk, stronger competition, and new technology, coupled with the ongoing challenge of finding good bankers.

Capital managementu00e2u20ac”For closely held banks, an understanding of value is critical to managing capital levels and providing liquidity to shareholders. Excess capital, although beneficial in the eyes of the regulators, impairs the return on investment. With an accurate value in hand, management may be able to better utilize capital to repurchase shares. This provides a source of liquidity to the selling shareholders, improves the return on equity, and enhances value to the remaining shareholders. Likewise, with an accurate value, directors are in a better position to evaluate internal opportunities for growth relative to mergers or acquisitions.

Management succession

Management succession is an extremely important factor in determining the future value of the bank to its current owners. Management succession for most institutions is both an opportunity and a challenge. The opportunity is to promote or acquire management talent that will build on the institution’s traditional strengths. The challenge arises from trying to find senior management capable of effectively responding to coming changes in the operating and competitive environmentu00e2u20ac”many of which may require new knowledge and management skills.

Steps to building lasting value

The fundamental task for bank management is to preserve and build the institution’s value over the long term. The management team and the board of directors can build shareholder value by looking to our seven-step program as a common sense guideu00e2u20ac”but alas, there are no silver bullets.

The seven steps are listed below. Think of them as steps in a journey but, we hope, a journey without too many character-building experiences.

1. Establish the goals
2. Develop strategies and tactics
3. Manage risk
4. Improve earnings
5. Capitalize on growth opportunities
6. Use the right technology
7. Continually build the team

Never underestimate the power of establishing clear, simple goals to focus the energy, intellect, and enthusiasm of an organization. While it is the first step, it is also the most important.

A business and a public trust

I firmly believe that banking is an excellent business and a tremendous public trust. With a strong focus on building lasting value, bank management and boards of directors can provide excellent returns to shareholders, employees, customers, and the community.

At the end of the day, it’s all about people making a difference. I used to think that success was 90% people and 10% everything else. Today, I know it’s 100% people.