By Aswath Damodaran
Until the banking crisis of 2008, investors had made a Faustian bargain, when it came to valuing and investing in banks. Banks were opaque in their public disclosures and investors often had little information on either the risk of the securities held or the default probabilities of loan portfolios. However, investors were willing to accept this opacity and view banks as “safe” investments for two reasons:
- Banks were regulated in their risk taking: In effect, we were assuming that bank regulators would bring enough scrutiny to the process to prevent banks from taking “rash” risks. (We also assumed that the regulatory authorities had access to far more information that we did and would act accordingly.)
- Assets (and equity capital) were marked to market: The notion of marking to market was adopted much more quickly in financial service firms than at other sectors.
Our distrust of accounting notwithstanding, we assumed that the book values for banks actually were good reflections of market value.
How did this faith in the regulatory overlay get reflected in valuation/investing?
- In intrinsic valuation, banks remained the last holdout for the use of the dividend discount model. Unlike other companies, where our distrust in managers paying out what they could afford to had led us to move on to free cash flows, we retained the faith that bank managers, constrained by the need to meet regulatory capital constraints on one hand and “dividend seeking” investors on the other, would pay out what they could afford to in dividends. (In effect, banks that paid too much in dividends would be punished by the regulators and those that paid too little in dividends would be punished by investors.)
- In relative valuation, the book value of equity in a bank was given more weight than in other sectors, because it was marked to market and subject to regulatory capital rules. Thus, price to book ratios (with returns on equity as companion variables) were widely used in analysis: a bank with a low price to book ratio and a high return on equity was viewed as a bargain. Worse still, risk averse investors were asked to buy the highest dividend yield banks and assured that these yields were secure.
So, what’s changed? First, our faith in both bankers and regulators has been shaken, perhaps to a point of no return. We can no longer assume that having regulatory rules on risk taking will result in sensible risk taking at individual banks. There can be, as there are in other sectors, very risky banks, risky banks, safe banks and very safe banks, as a consequence. Second, the erratic and often ill-thought out dividend policies adopted by banks since the crisis indicates that bank managers, at many banks, use dividends as a blunt weapon. How else can you explain banks with precarious capital ratios that continue to pay and increase dividends, while raising fresh capital in preferred stock at the same time? In fact, it is a sign of the times that the Fed stepped in to stop a major money center bank from paying dividends, as it did with Bank of America a couple of weeks ago.
So, what do we do now?
In intrinsic valuation, we have two choices:
- One is to use a modified version of the dividend discount model, where we estimate future dividends based upon expected growth and the return on equity that we foresee for a bank, rather than the actual dividends in the last period. Thus, if a bank is expected to grow at 8% and has a return on equity of 10%, it can afford to pay out only 20% of its earnings as dividends:
Payout ratio = 1 – Expected growth rate/Return on equity
Thus, we can bring in both the quality of a bank’s investments and expected changes in regulatory capital rules into the valuation. Increases in regulatory capital requirements will reduce the return on equity and by extension, the capacity to pay dividends.
- The other and more complicated route requires knowledge of regulatory capital requirements and involves the following steps. You first estimate the growth in the asset base of the bank (growth in loans, for instance). You then follow up by estimating how much regulatory capital will be required to sustain the asset base – that will depend upon the risk in the asset base and the regulatory capital ratio that the bank wants to maintain. (Note that this ratio will not necessarily be at the regulatory minimum since conservative banks will maintain a buffer.) Changes in regulatory capital from period to period than take on the role that capital expenditures do in a more conventional firm and can be used to compute free cash flows to equity:
FCFE for a bank = Net Income – Change in Regulatory capital required for future growth
These FCFE are potential dividends and can be discounted to arrive at fair value. In fact the cost of equity for a bank can then be tied to its regulatory capital buffer: banks that build in a bigger buffer will be safer and have a lower cost of equity whereas banks that are more aggressive in both their asset holdings and regulatory capital policies will have higher costs of equity.
In relative valuation, I think that the use of price to book ratios, in conjunction with return on equity, still makes sense, but risk now has to be treated as a third dimension. The risk itself can be measured using a variety of measures: regulatory capital ratios (higher ratios are safer), losses on bad loans (higher is riskier) or holdings of toxic securities (higher is riskier). A bargain bank will then be one that trades at a low price to book ratio, has a high return on equity and is well capitalized. I expand on both notions in this paper that I wrote a couple of years ago on valuing banks (which subsequently became a chapter in one of my books).
I think that there are broader policy implications, such as these:
- More transparency in financial statements: Since banks have broken their side of the bargain with investors, we need to respond by removing the opacity from the financial statements of banks. Banks should be forced to provide far more detail about the riskiness of their security holdings and the default risk in the loans that they make. Much more information needs to be provided about regulatory capital requirements and the policies that banks adopt on regulatory capital should be more transparent.
- Regulatory capital has to be common equity: Banks that are under capitalized should be required to issue common stock, and face up to their fears of dilution. We need to scrap the notion that preferred stock (a tax-inefficient mismash) or convoluted hybrids (such as these) will be treated as equity, since it exposes us to game playing and worse.
I am not ready to give up on investing in banks. In fact, I am sure that some banks are great bargains and the payoff to finding these, in this time of greater uncertainty, is higher than ever before. But I will be more careful in my assessments of banks and not take numbers for given, just because they have been rubber stamped by regulators and appraised by accountants. That is more a promise to myself than to you!
Aswath Damodaran is the Kerschner Chaired Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and valuation to MBAs, executives and practitioners.
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