Bank Valuation III
In the last two articles, we covered the following financial condition metrics:
– Net Interest Margin (NIM)
– Return On Assets (ROA)
– Loan Loss Reserve, and losses related to the loan portfolio
– Return On Equity (ROE)
– Profit Margin
We also covered two important ideas in the first article:
1. Keep It Simple
2. Conservative numbers & viewpoint
Again, what I present here are just techniques (qualitative & quantitative) that I have found useful in evaluating opportunities in bank stocks, while helping to avoid risky ones. There are many other techniques and methods out there as well.
Dividends – Are payments a corporation makes to its shareholders. Most banks declare quarterly dividends on a regular schedule, but they can actually declare it at any point in time. The board of directors usually review their quarterly earnings on a regular basis to decide how much, when, and if, a dividend should be paid out from their earnings at all. The remaining portion of their earnings is retained and re-invested in the business. Dividends are commonly in the form of cash, but stock dividends (shares) are not unusual for other industries. They are also taxed at a lower rate than interest income. But unlike interest payments on corporate notes or bonds, corporations are not obligated to pay dividends. There is also no guarantee that future dividends will be at the same level as previous ones. Therefore, if you are buying shares of a bank (or any other company), it is one aspect you must be aware of & factor into your investment decision. Some people invest in a stock with the expectation that a dividend will always be paid, or with the dividend payment as the reason for the investment.
The dividend yield is a percentage calculated as dividend (annual per share) divided by the price of one share. One can often look at this in a similar way as interest payments are expressed as a percentage, except that dividends are not guaranteed. Extremely high yields can sometimes be interpreted as higher compensation for riskier operations or an unstable business. It may also indicate that the price of the stock has experienced a decline and may be at bargain levels.
Other than tracking the stock price and dividend, what other indications are there of stability/sustainability? I only consider banks that have been in operation as a public entity for at least 10 years, and ones that have also continued to pay dividends for a minimum of 10 years (with regular increases in the dividend). The reason for this is partly due to economic & stock market cycles. It may be an indication that the dividend policy of the bank is one that is sustainable & reliable. Anything less than 10 years is too short of a time period for a bank to experience, survive, and handle downturns, as well as properly implementing a dividend policy that is sustainable through such cycles. Although this itself is not a sure fire metric, as we will discuss in the examples below. Dividends also indicate management’s confidence in the sustainable earning ability of the company. If a company declares a dividend one quarter, and eliminates or reduces it in the next quarter, shareholders & the market usually do not react favorably. Management is usually aware of such reaction & tend to avoid it.
The dividend increases over the years, as well as the annualized increase (rate), should also be compared. The higher the better! If I am expecting continual dividends, this means that I am taking the view that the bank is a money making machine, throwing off cash dividends each year for the life of the bank. I personally use a 6% inflation rate (yours may differ), so I want that cash to increase by a minimum of 8% per year (annualized) to even be considered worth my while. However, if I am not expecting continual dividends, I am less concerned with the actual size of the annualized increases, as there would be different reasons for the investment (the bank’s growth/expansion capabilities, or other).
What is likelihood of a bank reducing or eliminating the dividend? Payout ratio, net income, & Cash Flow from Operations will be the indicators. The payout ratio is the percentage of the earnings paid to shareholders in the form of dividends. [Payout ratio = Dividend/EPS]. A ratio of 30-50% is not uncommon. A ratio of more than 1 (100%) means they are paying more in dividends than they have actually earned. Dividend Cover is the reciprocate [dividend/EPS] of the dividend ratio. It indicates how many times a company’s earnings can cover the dividend. For example, if a bank has EPS of $1.00/share, and a dividend of $0.30/share, the coverage is 3.3x. You will have to use your judgment to determine whether the coverage is adequate, but I like to see a coverage of at least 2x.
By looking at the Cash Flow from Operations (per share) & previous quarterly dividend, we can see how much would be left after a dividend payment. We can also check to see if the ratio has gone up considerably (may indicate shrinking earnings), or the cover decreasing. Shrinking earnings may eventually become insufficient to cover the dividend or adequately retain earnings for re-investment into the business. During the credit crisis, it is especially wise to estimate losses (be realistic or even pessimistic). As discussed, in Bank Valuation I, if a bank lost billions in one quarter due to bad debt, it is very likely there may be more (use some common sense, and also look at loan loss reserves). The estimated losses should be subtracted from the estimated Cash Flow from Operations (can use previous quarter’s) in order to produce a picture of how much might be left in the next quarter if more losses were to surface. Similarly, we can estimate potential losses and use that to estimate next quarter’s EPS. If the EPS is low or is negative, management probably won’t use capital to cover & pay out a dividend (ratio too high, coverage too low). If management expects such declines or losses to continue, or earnings to remain at low levels in the coming quarters, the dividend would therefore be unsustainable and a reduction or elimination would be in the cards.
WFC has been public well over 10 yrs, and has consecutively increased their dividends since 1987 (21 yrs). They have also regularly increased their dividend payments at an annualized rate of 10% (last 10yrs). However, investment bank Lehman Brothers which has been in operation for 158 yrs collapsed, while a bank like Umpqua (UMPQ) which has been public just over 10 years is still operating profitably.
Bank Of America (BAC) has been in operation with over 10 years of continued dividends & increases. However, a few days ago (10/6/2008, 2008 3rd quarter earnings) they cut their dividend by 50%. Should investors be surprised? I hope not. BAC has a history and corporate goals of aggressive growth/expansion through huge acquisitions and mergers, which obviously requires a lot of capital and would impact earnings. In 2004 they acquired FleetBoston, in 2005 they acquired credit card lender MBNA. More recently, were LaSalle, Charles Schwab’s US Trust private banking unit, Countrywide Financial, and Merrill Lynch. All of which were large acquisitions made from 2007 to present day.
Lets go back to year end of 2007, their payout ratio was around 72% (WFC’s was 50%), with a quarterly dividend of $0.64 or yearly of $2.40. The ratio was increasing since 2006 from around 46%, to TTM of around 52% by 3Q2007 (even though quarterly earnings fluctuate quite a bit). At various points in 2008 its price was close to $30 per share. This gives us a yield (annual) of around 8%, but with a ratio so high and likely continual decreases in earnings, it was very unlikely the dividend would be sustainable. Lets go back a bit to 2Q2008, where their net income fell to $3.2 Billion or an EPS of $0.72/share, but still had acceptable loan loss percentages and relatively small writedowns. However, the ever hungry Bank Of America had swallowed up Countrywide financial, the results of which would not show up until the next quarter. Countrywide was exposed to have huge amounts of bad debts and losses, including $2.3 Billion in that quarter alone. BAC would definitely see its impact on its balance sheet in the near future. We can already see how a dividend cut would not be out of the question. If we estimate earnings of $3.2 billion and $2.3 billion in losses, that leaves only $0.9 billion. Per share we would be looking at $0.20/share in earnings. For 3Q2008 (a few days ago), their earnings were $0.15/s, and their TTM payout ratio 140%. This quarter BAC devoured the mammoth sized Merrill Lynch.
Without knowing what other future acquisitions the bank would make, it would be likely that large acquisitions would require the dividend policy to change. We wouldn’t want them to pay a dividend out of their capital just for the sake of keeping a dividend. Capital reduction can impair the bank’s ability to operate (as we have seen from the US financial sector failures), as well as to make acquisitions (something this bank wants to do). Investors investing in BAC are probably not focused so much on the dividend, but rather their acquisition & growth ability. BAC also announced they would raise capital targeting an 8% Tier 1 capital ratio, in order to maintain and dominate in both scale & financial strength over competitors during the current economic landscape. I believe that to be a strategically wise decision.
Now if we look the recent bid of WB by WFC, its more difficult now to determine whether WFC might reduce their dividend going forward. We would have to look at their payout ratio, as well as estimate more numbers than we did before. We would estimate its own future losses, WB’s future losses (unknown how much more bad debt they will have), how much of WB will be awarded to WFC (battle with Citigroup), how much capital they will actually raise. Keeping with the keep it simple idea, whenever there are so many what if’s making things that much more difficult than before, I usually pass until things are easier. But lets take a look anyways at just the WB aspect: The deal is worth $15.1 Billion, to be financed by issuing $20 Billion in stock. If we estimate WB will only have $4.9 Billion more in writedowns only, then the picture for WFC might not change all too much. But nothing has been finalized yet, so all those numbers mean little. We should also keep in mind WFC has been quietly acquiring other profitable assets & companies, at undisclosed prices.
From these examples, we can see that using a single metric alone isn’t too useful. We need to use many metrics together, as each one adds to the larger picture.
Next week in the Bank Valuation IV, I will start to discuss what metrics to focus on when looking at earnings.
Data sources from S&P, Morningstar, Reuters, MSN Money, corresponding bank websites & financial reports.
In the mean time don’t forget to check out recent and recommended posts. Feel free to also go through the archives as you’ll find some pretty interesting information considering the current economic landscape.
Thanks & Happy Investing! — The Investment Blogger