ALEXANDRIA, VA (May 4, 1998) -- Today we continue with our look at the variables in the spreadsheet I use to look at financial services companies. For anyone that has missed past entries in this category, I have set up a page called "Spreadsheet Guide and Definitions," which I'll update as we go along.
Market Cap -- The equity market capitalization of the company. This 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 that 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 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.
Price/Book and Price/Tangible -- Price-to-book value has always been an important valuation consideration in looking at a financial services company. Book value is defined variously as shareholders' equity less intangible assets and other asset adjustments, but some just treat book value as shareholders' equity. We look at two measures of book value for valuation purposes: book value and tangible book value. Book value is shareholders' equity and tangible book is shareholders' equity minus goodwill (I leave other intangibles, such as excess servicing rights or core deposit intangibles in book value).
Since financial services companies have traditionally been very highly regulated entities, their shareholders' equity has been a deciding determinant in a company's asset growth potential and leverage potential. A price-to-book multiple of "X" on a company with low leverage is not the same as a price-to-book multiple of "X" on a company with a very high amount of leverage (see the leverage section below for definitions). An investor contemplating various price/book multiples would want to look at the company's current leverage and also the company's other capital productivity measures to assess whether the current price/book ratio offers value.
A highly leveraged bank or financial services company with a low return on equity (there are various ways to measure ROE -- see below) and a high price/book offers less value than a company with lower leverage and a higher ROE. There are some investors that look at low ROEs these days and think that offers good return potential because some other bank will come in and shape up the company. Here's the rationale:
A company priced at 3.0 times book generating an ROE of 13% would be priced at 23.1 times earnings.
The same bank acquired at a 15% premium (or 3.45 times book) that could then generate a 20% return on equity would sell at 17.25 times earnings assuming the equity base had not grown.
The price/book ratio is only one way to look a company's valuation, though. Since return going forward is a function of price-to-tangible book value per share and return on equity, it is an important metric to look at. As banks travel further down the road of deregulation, however, book value may lose some of its importance as a valuation metric, since growth and return may not continue to rely so heavily upon the amount of shareholders equity and excess equity on the balance sheet, but for now it's still an important factor.
BVPS (Book Value Per Share) -- Book value per share, or book value divided by 1) shares outstanding, or more preferably, 2) diluted shares.
Price/Assets -- Market cap divided by assets. Since we want to compare price/book with return on equity, we also want to compare price/assets with return on assets (ROA). Bank managements run different business lines for return on assets. ROE is a function of ROA because one level of ROA will yield different ROE results depending upon how much equity is invested (or allocated to) in a certain business line. For instance, if a bank has $1 billion in assets and generates a 1.3% ROA ($13 million in earnings), its ROE will depend totally upon the leverage it chooses to operate with.
With earnings of $13 million and a leverage ratio of 10 (assets of $1 billion/owners' equity of $100 million), ROE would equal 13% (earnings of $13 million / equity of $100 million).
With the same amount of earnings and a leverage ratio of 12.5 (assets of $1 billion/owners' equity of $80 million), ROE would equal 16.25% (earnings of $13 million / equity of $80 million).
Operating management runs business lines by ROA while the board of directors and top level management design leverage strategy across an enterprise to target enterprise-wide ROE. While operating management is aware of ROE and does work with these targets, too, ROA is still the target throughout a bank for compensation and business unit goals.