What Drives a Bank’s Valuation?

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With the rise of uncertainty amongst regional banks following the demise of Silicon Valley Bank, it’s an important time to understand how investors may value an institution and when board members should have a clear picture of that value.

“You should always understand what you’re worth,” says Kirk Hovde, managing principal and head of investment banking at Hovde Group. “Most banks say they aren’t for sale, but my view is most banks should operate as if they could be viewed … for sale.”

It can be easy to determine a public company’s valuation since it’s accessible through a brokerage, online resource or a tool like Bloomberg Terminal. For private companies, it’s something that requires further analysis. That can make planning difficult when weighing certain initiatives.

With valuations nearing Great Recession lows among public banks in 2023, according to research from the investment firm Janney Montgomery Scott, recognizing why and what investors use to come up with the numbers can be critical to how an organization responds. For banks, it’s required in many situations, such as when investors want to sell shares or the board needs to approve certain compensation packages.

Tangible book value (TBV) has become one of the most critical benchmarks that investors consider. This metric takes all the tangible assets the bank owns, including loans and buildings. The calculation excludes intangible assets like goodwill and debts — those would be removed from the balance sheet or paid out first during a liquidation event. This gives investors a sense of the value of the assets that can be liquidated if the bank suddenly goes bankrupt. They compare this figure to the stock price to calculate the bank’s price-to-tangible book value, which can be measured and benchmarked over time.

During times of sector strength, investors often look more at earnings growth instead of TBV. If earnings keep growing, then the bank looks stronger. Higher earnings during times of uncertainty can also make a bank look strong when others are weak. With bond portfolios struggling in the high interest rate environment, however, some banks may have to sell securities if earnings slow, says Hovde. This locks in losses.

“[Investors] have started to switch back to TBV currently, as they think about what losses might be recognized,” says Hovde.

Investors may also approach valuation by running a scenario called a “burn down analysis.” Essentially, this shows how quickly the bank would run out of funds if it had to pay creditors and cover liabilities immediately. This is a tactic that investors embraced during the financial crisis of 2008, says Christopher Marinac, director of research at Janney Montgomery Scott, who adds that investors have begun to run this type of analysis again due to the fears in the sector.

Investors often don’t take into consideration that banks typically have two to three years to pay down their entire credit cycle; a burn down analysis assumes the bank must pay all creditors immediately. As a result, it isn’t always accurate and can work to deflate the value of the bank.

“No one wants to see companies go away,” says Marinac. “There’s empathy in the credit risk process. Investors don’t think of it that way.”

While it’s important to understand a bank’s valuation from the investors’ perspective, directors also should have a sense of the institution’s value to weigh certain initiatives that could have sweeping impact across the institution.

It’s particularly important for directors to get a sense of their bank’s valuation in case it faces a potential liquidation event that no one expected. “Directors should be focused on liquidity and capital position to understand what the health of the bank really is,” says Hovde. “No one predicted the failures we have seen.”

Beyond liquidation, “there are a myriad of reasons” for bank directors to understand the valuation of their institution, and they’re not all for planning purposes, says Scott Gabehart, chief valuation officer at BizEquity, a valuation software developer.

Directors should have a sense of their bank’s valuation to make the right call when opting into a long-term plan. One example of this is when a private bank looks to implement an employee stock ownership plan (ESOP). These types of plans can serve as a retention tool by providing employees with a piece of the business that they work for.

When a company offers an ESOP, its employees can receive or buy shares of the organization, even if it’s a privately held. How many shares are available and whether the incentive tool will work depends, in part, on the valuation of the business. If it rises, employees can participate in the bank’s success.

Then there’s the fact that many bank executives receive stock options or grants as part of their compensation package. The options “must be valued at the time of granting,” says Gabehart. The valuation will incorporate other variables beyond earnings and TBV, like interest rates, volatility and other metrics. The perceived value that the executives receive from the options will depend, in part, on the valuation.

Finally, directors need to understand the bank’s valuation if they’re going to properly consider an acquisition or merger. Now, “it may be the best time to undertake an acquisition for expansion in that the multiples or costs to buying a bank [are] lower, all things equal,” says Gabehart. Of course, as Gabehart also acknowledges, it’s more difficult to fund an acquisition now, due to higher interest rates and weakened valuations for the buyer. Bank M&A activity slowed in 2022, with 164 bank acquisitions announced, according to S&P Global Market Intelligence. Through April 30, 2023, just 28 transactions had been announced for the year — down by half compared to the same period the year before.

“Before deciding how to finance an acquisition, it is always first necessary to know what the company is worth,” says Gabehart. Then leaders can determine the best funding tactic.

Beyond planning, there’s also the need for directors, as shareholders, to understand the value of the bank simply to sell their own shares. Understanding this valuation will ensure that whenever any other director sells shares, they will receive the best possible price — which benefits the entire organization.

The higher the valuation, the higher the sale price.

That’s not just good for the director. It’s great for the other bank investors as well.

Building the Board’s Ethical Backbone

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An ethical foundation is vital to a healthy, successful financial institution, and it starts with the board of directors.

“Ethics is something that you carry with you every day,” says Samuel Combs III, CEO of the management consulting firm COMSTAR Advisors and the governance committee chair at $2.7 billion First Fidelity Bancorp, based in Oklahoma City. “It begins with the leadership team, of course, [and] boards.”

As a guiding principle for the organization, a code of ethics provides a pathway to govern. And the rise of environmental, social and governance (ESG) initiatives, with their emphasis on customers, employees and communities, puts additional pressure on corporate behaviors. While a bank’s regulators require a certain level of ethical standards, some organizations have taken the lead in driving an ethical approach to banking to garner consumer trust. The board should be at the forefront of these discussions, yet, incorporating an ethical approach to banking does not come with a paint-by-numbers guide. Instead, it’s driven by management, and shaped by the questions and insights boards can bring to the conversation.

Organizations often go wrong with their ethical duty not on the personal level, but due to a systemic breach, says Steve Williams, the president and co-founder of Cornerstone Advisors. “When people get caught up in something, it’s seen as normal when it shouldn’t be,” he adds. “Systemic pressure, that can happen in any place; you have to believe it can happen here, in order to protect against it.”

Board members have a limited opportunity to peer into the day-to-day of the organization and understand how it’s operating from an ethical standpoint. Combs advises directors to look for “signals,” and ask questions about the gray areas of finance and the business’s success.

“To mutually arrive at a standard, the board must set the expectations,” says Combs. “It’s up to the management to live up to those standards.”

When financial reports are produced, if results prove far better than expected or end up very true to estimates quarter after quarter, it’s important to inquire as to how the bank achieved the numbers. It doesn’t mean something has gone awry, but you should ask to ensure liberal accounting tools or untoward sales practices are not being used. Another sign? Maybe there’s a sense that employees’ engagement has dropped significantly. Boards must seek to answer why. It requires asking further questions about sales processes, deposit efforts and the management of the institution. “It’s a signal that you should look further,” adds Combs.

This doesn’t mean that the board needs a separate ethics committee to manage this process. “I believe it should be engrained in all committees,” says Williams. Ethics should be the backbone for all deliberations in the audit, governance, compensation, risk and other committees of the board, informing how members analyze, question and provide guidance.

This thread should also trickle down to how the board makes decisions and evaluates performance. Reevaluating the code of ethics, whistleblower policies and other internal documents should be conducted once a year, and should be done with some “degree of visibility,” says Williams.

What Should a Code of Ethics Address?

Sources: Office of the Comptroller of the Currency, Federal Deposit Insurance Corp.

  • Prohibitions and monitoring relative to conflicts of interest, insider activities and self-dealing
  • Confidentiality of bank, customer and employee information
  • Maintaining accurate and reliable records
  • Compliance with applicable laws and regulations
  • Fair dealing, including the use of privileged information and misrepresentation of facts
  • Protection and use of bank assets
  • Expectations that employees, executives and directors deal honestly with the bank’s auditors, regulators and legal counsel
  • Screening the backgrounds of potential employees
  • Whistleblower policy, which allows employees to safely report concerns about bank practices
  • Periodic ethics training
  • Updating ethics policies to reflect new business activities
  • Consequences that could occur if executives, employees or directors breach the code of ethics or otherwise participate illegal behaviors Process.”

When looking at these documents, hold them up to the board’s actions and performance. How did the board make decisions, based on the code of ethics? When tough issues arose, did the board make the easy decision or take a tougher route that was more in line with the code of ethics? Did the board, in its decision making, represent the bank’s core values? Consider incorporating these questions into the board’s performance evaluation. You may not have a perfect score, but regularly revisiting the board’s deliberating process will ensure that living to the bank’s values becomes second nature, says Williams.

Failing to have this ethical background can lead to a significant backlash against the company, both from a legal perspective as well as harm to its reputation. The board at Wells Fargo & Co., for instance, received significant criticism for not questioning gray areas in its results and sales processes, which led to more than $3.7 billion in fines levied by the Consumer Financial Protection Bureau. Damage to its culture and reputation promises to be longer lasting.

An emphasis on ethics should also be found in how the board evaluates management, and how management evaluates the rank-and-file. Williams says it should even bleed into how a director may compliment an executive on a social site like LinkedIn. Has the director complimented the manager based on reaching some sales target? Or does the compliment reflect that the person lived up to the ethical core of the organization? It’s often telling when ethics isn’t emphasized in what directors publicly acknowledge.

That said, it’s important for potential directors to consider avoiding certain opportunities, even if the challenge of reshaping a poorly run organization may be an initial draw. Combs says he once considered joining the board of a non-bank entity that had some questionable ethics, which had become public. At the time, he felt he could have the opportunity to change what the organization would look like moving forward.

However, he eventually passed on the role because he wouldn’t have the levers to make change from the board position. “If you like a challenge, it’s fun to do the work,” says Combs. “You have to know [the organization] is willing to do the hard work.”

The same diligence and decision making must occur when the board is presented with possibilities, some that could improve the bank’s bottom line but would be counter to the institution’s ethical framework. It’s in those moments where the decisions made by the board could determine whether the bank experiences an ethical failure down the line.

Sometimes the right decision will be the hard one, even if the easy one is technically legal.

“Regulatory compliance does not cover all our needs for ethics,” says Williams. “Be much broader and active in that reflection.”