Drip
Portfolio Report
Thursday, April 30, 1998
by Dale Wettlaufer
([email protected])
ALEXANDRIA, VA (April 30, 1998) -- Today we'll look at the valuation parameters that I use in looking at the banking industry. There are currently about 2,000 data points in the spreadsheet I maintain on a daily basis. Looking at a bank in as many different ways as possible doesn't really fragment my thinking. On the contrary, it improves my understanding of a company's business model, as well as how the industry works overall. If you're interested in lifting the data that I include in these reports, go right ahead and put it in a spreadsheet. The data will probably help you understand things better and provide a starting point for the framework you use to look at the industry.
Be forewarned, though, I am constantly changing this spreadsheet -- it's definitely a chore keeping up with all this data. Most companies, too, don't present the data you need in their quarterly press releases. For much of it, you'll need to pull up the 10-Qs and 10-Ks. In addition, I am constantly adding new data points as I think about things differently, so between the time that we introduce the companies and get into a deeper look at them, I will have made changes to the data and organization of the spreadsheet. When we do get into the final couple passes on what we're looking at, I will stick with one presentation format so that no one is confused by the format of the data.
So, on we go with defining and explaining some of the terms below. If I've defined these in the glossary in the past, I'll just skip by those and go on to the ones we haven't looked at in the past.
Market Cap -- The equity market capitalization of the company. It is defined as diluted shares multiplied by the current share price. I don't use the basic share count because the diluted share count takes into account options that could be converted into common shares as well as the potential issuance of new common shares in exchange for securities such as convertible preferred stock or convertible notes. The prudent investor should use the diluted share count figure because it accounts for all outstanding shares (minus treasury shares) in addition to contingent ownership claims which have not yet actually become common stock.
Enterprise Value -- This figure is arrived at by adding the company's market cap to long-term debt (including preferred stock) and subtracting from that product the cash and highly securities held for short-term purposes on the balance sheet. Randy defined this last year.
I take a shortcut to enterprise value for banks because I deal with the large-cap regional banks. For smaller banks, one would use the basic share count for the market cap part and then add all long-term debt and subtract cash. I would recommend not using this all that extensively in looking at banks because part of the cash & equivalents on a bank's balance sheet is represented by statutorily-required reserve balances, which can't be taken out of the business by an acquirer. In addition, bank capital isn't all long-term, so long-term debt just doesn't capture the total economic cost of acquiring a bank or financial company. For non-financial companies, this expression of a company's capitalization is infinitely more useful. If you don't feel like using enterprise value, you can forget about it.
Average Equity/Average Assets Avg. Assets/Avg. Equity (Tangible) -- These are both measures of leverage a bank employs. As part of looking at bank's basic business model, I look at three components of return on equity (ROE) -- leverage, margins, and asset turnover. Together, these determine the company's return on equity. The formula for average equity to average assets is:
((shareholders' equity at beginning of the year + shareholders' equity at end of the year) / 2) / (assets at beginning of year + assets at end of year) / 2)).
For the second measure, I want to look at leverage without including goodwill in the shareholders' equity base or the asset base. We've talked about the meaning of goodwill and its amortization before, so we'll skip the basics on that and talk about why we take goodwill out of this leverage ratio. Goodwill is not an asset that is counted as capital by bank regulators here or elsewhere, according to the dictates of the Bank for International Settlements in its 1988 Basle Accord. As such, goodwill cannot be used as collateral in taking on loans or as reserve capital in lending out money. In assessing the true leverage of a bank, then, investors want to wipe out the asset in their leverage models. The formula for average assets to average equity (tangible) is:
((assets at beginning of year + assets at end of year - goodwill at beginning of year - goodwill at end of year) / 2) / ((equity at beginning of year + equity at end of year - goodwill at beginning of year - goodwill at end of year) / 2 )
Asset Turnover -- This is an asset activity ratio. Ever wonder why a supermarket can do well on net margins in the 2% area? Because they turn over their inventory so many times per year. That's why you always see stocking and inventory checks going on in a supermarket. Investors place too much emphasis on margins and not enough emphasis on asset and capital turnover. Those are the measures that help you spot a Home Depot (NYSE: HD) early, in fact. Anyway, in this application, we're looking at very low asset turnover. Banks turn their assets very, very slowly, but they use a lot of leverage and have very good margins, as we explained in the Amex ROE conundrum in an article titled "ROE2" that appeared here last week. The best bank in the world would have very high asset turnover, like American Express (NYSE: AXP), very high margins like NationsBank (NYSE: NB) or US Bancorp (NYSE: USB), and average leverage. To really juice up such a bank's returns, you'd increase the leverage, but also increase risks.
We'll continue with this on Monday. In the interim, Jeff will report in tomorrow on Touchstone Friday.
Have a great weekend.
Dale
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