How to Value Bank Stocks ?
Unlike any other industry, stocks in the financial services industry is valued different than DCF or common comparable companies multiples such as; EV/EBITDA or P/E. Furthermore, the financial statements structure is not the common type, Revenue less COGS less SG&A order, instead it begins with Interest Income, equivalent of but not total Revenue and Interest expense. In this Bank Valuation series, I will try to explain how an equity research analyst values the bank stocks.
Before we begin, let’s question the basics; what drives the bank revenues, trends in capital, credit and liquidity, the impact from regulation, and interest rate spreads.
Key driver of revenue: Net Interest Income
Net interest income is the basic source of revenue, even though banks try to diversify their revenue base by adding fee based revenues, such as M&A advisory services, the net interest income still represents about 65% of the total revenue. (According to Deutsche Bank Securities)
Efficiency will be the Driver
No surprise that the economics of scale plays a crucial role here, the bigger banks operate better since they have the economics of scale. Many banks target the Return on Assets which is around 1.25% (not sure whether that is an optimistic target) However I remember from Jan-Mahrt Smith, the Finance Professor at Rotman School of Management who taught the Mergers and Acquisitions course in 2011, stated that in one of his research he found that there is negligible synergy impact on “cross-border” acquisitions for banks, who sought 100% of a big fish, or gained a minority stake and expanded to the region. However if there is a “know-how” benefit that is mainly due to cultural and socio-economic differences. Such as for countries where the inheritance, and strong family orientation is the core value, the house is bought usually by parents for new married couples, in some countries that is purely financed through mortgages.
Bank stocks and interest rates
There has been weak correlation between daily changes in interest rates and bank stocks. However bank stock usually underperform when rates rise materially and outperform when rates decline sharply. So in this environment where QE III is a buzzing word in the street, we may expect the same performance from banks with strong balance sheet and Tier I ratios. Eh-herm, (proudly) don’t look far, those are the Canadian banks.
This series will be continued…
Source: Deutsche Bank, US Large Cap Banks Special Report, Matt O’Connor.