Bank Valuation VIII
We have finally reached the end of the info packed Bank Valuation series. Congratulations to all that have made it, I hope you were able to take away something useful. In this last article I will discuss calculating the intrinsic value of a bank. So far we covered the following::
– Net Interest Margin (NIM)
– Return On Assets (ROA)
– Loan Loss Reserve, and losses related to the loan portfolio
– Return On Equity (ROE)
– Profit Margin
– Stock Price & Price/Earnings
– Net Asset Value (NAV), Book Value, Price/BookValue
– Business aspects (qualitative)
– Management aspects qualitative)
What I present here are techniques 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. In addition, many of the techniques can also be applied to non-bank/financial companies as well.
As discussed in one of the previous articles in the series, the majority of average investors automatically believe large stock price declines of a company result in the price becoming undervalued. Another common false belief is that when the stock price of a company has remained at a consistent level for long periods of time, that particular price is an accurate portrayal of its underlying value or worth.
What is the reason for these common myths? People generally confuse or forget, that the current market value (price), and the true value (intrinsic value), are two different things. The price at any moment in time is dictated by what someone is willing to pay for it. The intrinsic value (also called fundamental value) is the underlying worth of the company considering all its business aspects. Its important to note that the intrinsic value may, or may not, be the same as the current market value at any particular point in time. However, there are those who would argue that value is “in the eyes of the beholder” and therefore the current market value (price) is the true value. They state that it is justified as long as there are other investors willing to pay that price, which I must disagree with.
By keeping a business mindset, it puts this into perspective. Thinking about shares of a private business (not publicly traded on the stock exchanges) makes the notion of the intrinsic value much more clear & important. It also becomes quickly distinguishable from the price another investor is willing to pay for the shares.
Example: Suppose a businessman offered to sell you his ownership portion (shares) of a private business. He also makes the same offer to one other investor. As an investor and businessman you do not want to pay more for the assets than it is worth. How do you know what it is worth? Is the value of the investment worth whatever the other investor is willing to pay for it (based on their perception)? Of course not! Perceptions may be all that matters when dealing with home decor or clothes, but investors & businessmen should not purchase investment assets for aesthetic, sentimental, or emotional reasons. Similarly, we should not purchase them at a price justified merely by the potential that another investor may be willing to pay a higher price in the future. The shares of the business should be purchased based on the expected cash flows the company produces from all its business aspects combined. That is the basis for the determining the intrinsic value of a business, project, or asset.
The value is usually calculated using discounted cash flow valuation (DCF). Irving Fisher (“The Theory of Interest” 1930) and John Burr Williams (“The Theory of Investment Value” 1938) first formally expressed the DCF method in modern economic terms. DCF takes the future expected cash flow produced, while considering the time value of money concept. Therefore DCF takes the present value, of the sum of all estimated future income generated. The discount rate used to calculate the present value is usually the cost of capital (cost or rate of obtaining investment capital), and incorporates some judgment on the risk of the estimated future cash flows. In the simplest form the DCF formula is:
VALUE = SUM[t0..tn] (Present value of cash flow for time t)
Present Value = PVt = CFt/(1+r)^t
VALUE = SUM[t0..tn] CFt/(1+r)^t
n = Life of asset
CFt = Cashflow in period t (year)
r = Discount rate reflecting riskiness of estimated cashflows
Note that the cash flows will vary from asset to asset (free cash flow, dividends, coupons/interest and the face value for bonds, after-tax cash flows for a real project). The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects. Typically for most businesses (not all) we can use Free Cash Flow (FCF) for Cashflow in the formula. FCF is operating cash flow minus capital expenditures, and represents cash that a company produces after laying out the capital required to maintain or grow its business and assets. Buffett is also known to use FCF and the DCF when evaluating and determining the intrinsic value of businesses, as he believes that it gives clearer picture of a company’s financial performance. From my background in accounting and finance, I must agree because earnings can be often manipulated by accounting techniques, to present a more rosy picture. However, it is a lot more difficult to do so with FCF numbers. Benjamin Graham’s (Buffett’s teacher) book, The Intelligent Investor, explains how earnings can be manipulated and what to look for, without knowing much about accounting statements (I recommend this book as a good starting point as well).
Now that we understand how banks work & operate (review earlier articles in the series), we know that we cannot use FCF (wouldn’t make sense for this type of business), as cash flow is not a good metric for banks. So how do we calculate the intrinsic value? One method is to use dividends. Virtually all banks pay dividends from their earnings. The dividend discount model is a specialized case of valuation, where the calculated value is the present value of expected future dividends. We can essentially view the bank as a dividend making machine, and value it on such terms. Ironically, we would also use the earnings ability of the banks to calculate the intrinsic value using DCF. Fortunately, even though earnings numbers can be manipulated, the other performance metrics and techniques explained earlier in this series will help raise any red flags in the earnings or other financial numbers (in which case we wouldn’t even bother to calculate the intrinsic value if the bank in question cannot pass all our other previous criteria). That is the importance of realizing that the valuation of banks does not mean just performing DCF, but looking at all the other metrics as well!
The discount rate that reflects the riskiness of estimated cash flows (or dividends, earnings) can be thought of as the risk free rate. It would be the rate you would obtain from a risk free investment. I generally like to use 10% as a conservative number, that already has a certain degree of risk assumed in the non-risk free investment. Like Buffett, I also do not use the risk Beta, and other more complex forms of the formula. My understanding of valuation theory, accounting, and finance, lead me to believe that Warren Buffett’s usage of the DCF in the simplest form is good enough, does not unnecessarily complicate or introduce too many variables, as well as making theoretical sense. Buffett also reminds us that the intrinsic value is merely a conservative estimate, and that it is an adequate estimate as long as we have a large enough margin of safety. He is well known for his ability & patience, to only purchase shares of businesses at large discounts relative to their intrinsic values. One pitfall that he does remind us of is that when estimating average free cash flow growth (or dividends, or earnings) we must be VERY CONSERVATIVE, as lofty and over optimistic estimates will lead to over optimistic intrinsic values. Most professional analysts often fail to remain conservative. Its not that they don’t know how to calculate the intrinsic value, its that they are way too optimistic with their estimates. Benjamin Graham explains very well in his book, several reasons why this phenomenon occurs more often than it should. Much of the reasons occur due to human emotion.
To learn more about valuation theory, and the principles behind the DCF, I suggest either taking Professor of Finance Aswath Damodaran’s course at New York University’s Stern School of Business. Enrolling might be a problem, so I suggest visiting his website, downloading his book (Investment Valuation), lecture notes, problem & answer set and go through the course on your own. Professor Damodaran is one of the leading individuals of knowledge on valuation, corporate finance, and investment management.
I’ll go through a DCF example with Wells Fargo & Co I did a few months back as an example. Any numbers used will probably reflect numbers from a few months back. As an example of the process it won’t matter much, but for real analysis its better to be up to date. We will be using its dividend in this calculation, which means we will have to estimate future dividend growth. We will use a few metrics to do this; the Dividend Growth formula, and our own trending of WFC’s actual dividend history, to help us estimate conservatively.
Dividend Growth (G) = Plowback Ratio * Return on Equity
Payout Ratio = 0.50
(this number is usually available from financial data, review Bank Valuation III)
Plowback = (1 – Payout Ratio) = 0.50
ROE = 0.174 (from financial data)
Dividend Growth Rate = 0.50 * 0.174 = 8.70%
Now we are going to look at the actual dividend history. 12 years of data was readily available:
Avg year to year increase = 14.66%
Avg year to year increase (excluding max & min increases) = 13.03%
Total Increase = 338.71%
Annualized Increase = 10.70% (See Bank Valuation IV for annualized increase/growth calculation)
The lowest in last 12 years was 7% increase. In 2008 the increase was 9.68% in the midst of the economic crisis. They have also increased the dividend yearly in the last 12 years. We can see that the our calculated growth rate of 8.7% is showing not to be way off either, and relatively conservative.
Taking this and the economic situation into account, we can estimate the dividend growth for the next 10 years. Its likely that they will be able to increase the dividend by at least 1% in next two years, 7% in following three years, and 10% in the years after that. This is well below the annualized historical 10.70% increases as well as the average year to year increases. It should be very conservative given Wells Fargo’s current financial strength.
Using a discount rate r (risk free rate) of 10% we can project the dividend, and take its present value:
|YEAR||GROWTH||PROJECTED DIVIDEND||PVt = FCt/(1+r)^t||t||r|
|2009||1.01||$ 1.37||$ 1.25||1||0.10|
|2010||1.01||$ 1.39||$ 1.15||2||0.10|
|2011||1.07||$ 1.48||$ 1.12||3||0.10|
|2012||1.07||$ 1.59||$ 1.08||4||0.10|
|2013||1.07||$ 1.70||$ 1.06||5||0.10|
|2014||1.10||$ 1.87||$ 1.06||6||0.10|
|2015||1.10||$ 2.06||$ 1.06||7||0.10|
|2016||1.10||$ 2.26||$ 1.06||8||0.10|
|2017||1.10||$ 2.49||$ 1.06||9||0.10|
|2018||1.10||$ 2.74||$ 1.16||9||0.10|
|2019||1.10||$ 3.01||$ 1.16||10||0.10|
Now we need to estimate a Terminal Value with stable growth. As a conservative approach we assume that after 2019, things will slow down to a stable and slow rate. We assume that companies can no longer sustain the higher growth past the 10 year mark.
TV = CFt / (r-g)
I usually use 6% for rate r (3% inflation + 3% GDP). Again, you can use whatever number you see fit, but from my knowledge 6% is a good conservative & realistic number:
TV = $3.01 / (0.10-0.06) = $75.27
Calculate PV of TV with stable growth (t=10):
PVt = TV/(1+r)^t = $29.02
Calculate the Intrinsic Value:
Total sum of all PVs (including the PV of TV) = $41.21
WFC as a dividend making machine alone (based solely on dividend payments), is worth at least $41.21.
It is highly suggested that you also calculate the intrinsic value based on earnings as well. For other stocks you may want to calculate the intrinsic value based on dividends AND also based on FCF. Another recommendation is to change the estimates to be more pessimistic, in order to give an idea of how that affects the value, in the event of a negative future outlook! In addition, it is recommended that you also do estimates for possible share increases or decreases. This can be done by multiplying the per share intrinsic value by the number of outstanding shares (will give intrinsic value for entire company), then divide that number by the estimated number of shares. You can instantly see how share buybacks or share offerings increase/decrease the intrinsic value. Its always useful to look at an asset from more than one perspective.
What is our margin of safety? Margin of safety (or safety margin) is the difference between the intrinsic value and the market price of the investment/asset. This is how we gauge if we are overpaying or not, as well as providing a buffer for errors in our estimates.
Current market price = $27.00
Margin of Safety = 1 – (Current Market Price / Intrinsic Value) = 34.49%
There is no set rule for what the Margin of Safety should be. It is something the individual investor chooses when performing their own assessment. It is whatever they may deem to be acceptable, and is often based on the level of risk present in the particular business in question. I usually like Margin of Safety values in the area of 50%. This way the calculation can be half wrong and I still wouldn’t have overpaid for the asset. So assuming nothing material changes, I would wait for the price to reach a level that gives me a good enough margin of safety as well as being relatively cheap!
Now to recap the concept at the beginning of this article: Just because the market price of an investment drops significantly, it doesn’t necessarily mean it is undervalued. We must calculate its intrinsic value or worth, compare the market price with the intrinsic value, and assess the margin of safety, in order to be able soundly ensure we are receiving an adequate discount.
This wraps up the Bank Valuation series. I hope you have enjoyed the articles. They were packed with a lot of information, and I strongly suggest reviewing them, and also continuing to research a bit more on your own. Each topic itself can be studied further and in more detail.
Feel free to browse older articles such as Investment Risk, or How To Start Investing I. The articles related to Warren Buffett and the Berkshire Hathaway portfolio are interesting as well.
Benjamin Graham’s book Intelligent Investor outlines very important investment concepts that can be applied not only to stocks but other investments as well. I highly recommend getting it for yourself or someone you know who is interested in investing.
Thanks & Happy Investing!
The Investment Blogger ©
Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.