Bank Valuation IV
In this article I will discuss what to look for in some earnings metrics.
So far in this series we covered the following 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
Again, what I present here are just techniques (qualitative & quantitative) that I have found useful in evaluating opportunities in bank stocks in particular. They will help you to become aware of certain risks & situations affecting banks that you will have to weigh, while helping to avoid problematic ones. There are many other techniques and methods out there as well.
Earnings – Is the amount of after tax profit or net income a company produces. For publicly traded companies, this is usually expressed quarterly (3 months) & annually. Earnings Per Share (EPS) is the earnings divided by total number of shares outstanding. Earnings and the contributing factors to them, help to indicate whether the business is profitable & successful. It is usually compared by most investors to analyst estimates/expectations, as well as guidance (if provided) by the business itself. However, I find it wise to ignore analyst estimates, and to focus on the one the business gives and perhaps one produced by your own research. There is also no one more familiar with the company, than the company itself. Businesses do not make operational decisions to please expectations of analysts. They run their business, based on their company business model & corporate goals.
Other than the earnings itself, or in relation to the dividend, we also want to look at the earnings trend. For banks & financial companies I generally want to see no earnings deficits (losses / negative earnings) in the last 10 yrs. With junior companies in other industries, it is common to see a company sit on a pile of cash (capital), and draw down on it heavily due to the large capital expenditures or acquisitions that typically arise during the early years of a company. That creates losses each year, until the company becomes more mature, when less capital investments are needed. For banks, we are hoping they are mature enough and have figured out how to operate profitably. But for any company, losses better be for a good reason (For banks there are very few). For other companies the expenditures should be ones that help build & position the company.
Total earnings growth over the years should be observed. I like to see total growth over the last 10 yrs to be well into the triple digits. Compare the most recent year end earnings with the earnings from 10 yrs ago (quarterly earnings mean very little in this type of comparison). Total growth shows that the company is growing, expanding, & increasing profits. If a company’s earnings are flat over many years, it is basically losing money to inflation. We can calculate this by taking earnings in say 2007 minus earnings from 1998, and then dividing the result by the earnings from 1998.
However, total earnings growth does not indicate how it is doing year to year. We need to look at the annualized growth of earnings. I like to look for annualized earnings growth of around 10% or higher (double digit earnings growth). One way to think about this is, if a company earns 10% a year, indirectly you earn 10% a year by holding shares. We can calculate the annualized increase over 10 years with the following formula:
( TotalGrowth^(1/10) ) – 1
We should keep in mind that earnings growth will likely be more impressive for high multiplier P/E stocks, but is especially impressive if it has a low P/E. We will discuss P/E later, but as you can see again we cannot simply look at one area/category of data.
Earnings stability and the stability of a company can be measured by the max earnings decline in any one of past 10 years. We can compare the declines with the S&P as well as with other banks. What we want to do is look to see if declines were a sector wide event (will give possible insight into reasons/causes of decline), or company specific. If a company has never had a decline in earnings, it means it is 100% stable up to the current date. Even though the future is not guaranteed, it adds to build confidence in our view of the company in question. 100% stable earnings are very hard to find, but we want as close as we can get to it (small and very few declines over 10 years or more). Note, that both total & annualized earnings growth does not take into account any losses or declines in earnings within the middle years. It only looks at the end years (ex: 2007 and 1998).
– Wells Fargo & Co (WFC) has not had an earnings deficit in the last 10 yrs, with a total earnings increase of approx 313%. Its annualized increases for the last 10 yrs is 12%/yr. WFC had earnings declines in both 2001 (-15%) and 2007 (-4.3%). After comparing with several banks and the S&P we know that these declines were sector wide as a result of the tech bust, and in 2007 the credit crisis. We can expect 2008 annual earnings will decline as well, and so far we have seen consecutive quarterly earnings lower than those of the the prior year.
– Umpqua Bank (UMPQ) has not had an earnings deficit in the last 10 yrs, with a total increase of approx 1439%. Its annualized increases has been 30%. Its interesting to note that its largest earnings growth was in late nineties and early part of this century (2000 at 82%, 2002 at 157%) and not during the housing boom of the last 5yrs. UMPQ had earnings declines in both 2001 (-3.6%) and 2007 (-25%). Again sector wide events. We can expect 2008 annual earnings to decline as well.
– Canadian Imperial Bank of Commerce / CIBC (CM) has had an earnings deficit/loss in 2005 of -$26.3 Million or -$0.38/share. Its 10 yr total earnings increase is 321%, which is an annualized increase of 12%. Significant declines are visible in 1999 (-4%), 2001 (-21%), 2002 (-62%), and 2005 (-101%). Looking the year to date (2008) earnings, CIBC is already in the red with a net loss of -$853.9 Million (-128%). Unless they can earn $854 Million in the next 3 months, they will have a huge loss. We can expect the 2008 annual earnings to be worse than the current -$853.9M. Comparing with other banks & the S&P, we can see that CIBC’s declines and losses are due to problems that are both sector wide events, and internal mismanagement.
– Citigroup (C) has had no earnings deficit in the 10 years up to end of 2007, with total earnings growth of -37%. Because its earnings in 2007 ($3.617B) is lower than in 1998 ($5.807B), it does not have a positive annualized earnings increase, and hence the formula does not apply. Significant declines are visible in 2004 (-4.5%), 2006 (-12.4%), and 2007 (-83.21%). Year to date (2008) net income, excluding today’s (10/16/2008) 3rd quarter losses of -$2.8 Billion is -$15.227 Billion (-520%)! Adding on the 3Q2008 quarterly net loss, we can also expect the 2008 year end net income to be even lower. Comparing with other banks & the S&P, we can see that Citigroup’s declines and losses throughout the years are both due to sector wide problems, as well internal ones.
Next week in the Bank Valuation V, metrics related to the price will be discussed. In the mean time feel free to browse older articles such as Investment Risk, or How To Start Investing I. The articles related to Warren Buffet and the Berkshire Hathaway portfolio are interest as well. Other articles in the Interesting Notes section are interesting to look back on, especially in times like this.
Thanks & Happy Investing!
The Investment Blogger
Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.