This paper was awarded an Honorable Mention by The AFG Journal of Equity Valuation & Selection in the
2009 AFG Research Summit Competition.
The objective of this paper is to illustrate, explain and critique the four most relevant approaches to valuing community bank stocks, and to discuss other issues germane to the community bank stock valuation process in an effort to provide practitioners with insights for future investment decisions.
Valuing Community Bank Stocks: Introduction
The process of assigning a value to a share of common stock involves more art than science – or at least more than securities analysts would like to admit. This, of course, is due to the significant impact that expectations regarding future profitability and earnings growth have on current stock prices, and the attendant uncertainty surrounding such expectations. As Niels Bohr (and later, more famously, Yogi Berra) noted, “It’s hard to make predictions, especially about the future.”
This paper focuses on the valuation of community bank stocks (herein just “bank stocks” for purposes of simplicity) as opposed to the stocks of “regional” and “money center” banks. While there is certainly a great deal of overlap between the valuation processes for the various classes of banks, regional and money center banks tend to have considerably more complicated businesses (as a result of their larger size, wider product offerings, and extensive off-balance sheet instruments), and thus more complicated valuation issues, than community banks, which tend to focus on the core blocking-and-tackling banking strategy of gathering deposits and underwriting loans.
The best approach to valuing bank stocks – or any other type of stock for that matter – is to employ multiple valuation techniques that encompass both sound financial theory as well as current market realities, as the latter are often wholly disconnected from the former. Although, hopefully, in most cases the analyst will find that the values derived from both “theory-based” and “reality-based” techniques aren’t too far removed from one another.
The four most relevant approaches to valuing bank stocks are (1) peer group comparisons, (2) dividend discount models, (3) takeout values, and (4) liquidation values.
Most analysts – of the banking variety and others – simply apply a price-to-earnings (P/E) multiple to a company’s estimated earnings in order to come up with the company’s projected stock price. Apparently, these analysts would have investors believe that the P/E multiple is an independent variable, and the derived value is the dependent variable, in determining the value of a share of common stock. Clearly, this should not be the case. The value of a share of common stock, after all, is the estimated present value of its future dividends (or free cash flow), and the P/E multiple is derived by dividing this value by the company’s earnings. In other words, the P/E multiple is the dependent variable, not the independent variable, in the valuation process.
Many analysts would reply to the above criticism by suggesting that their projected P/E multiple captures the effect of discounting estimated cash flows, and that the aforementioned reproach is to some degree a matter of semantics. This, in fact, may be the case. Nevertheless, the number of valuation analyses involving economic profits and/or discounted dividends/cash flow that most investment professionals run across over their careers is rather small as a percentage of the total research that ultimately ends up at the local landfill. At the end of the day, it is important to “check” market prices using a discounted dividend/cash flow framework (i.e., theory) while, at the same time, acknowledging that relative peer group valuations (i.e., current realities) are the driving force behind most stock prices in the short run.
Peer Group Comparisons
To say that Wall Street is fixated on peer group comparisons is an understatement. A bank’s valuation relative to its peers is the single most important element in determining the company’s value in the short term. The vast majority of Wall Street research reports reach their conclusion regarding valuation with verbiage resembling the following: “We believe that Bank X should trade roughly in line with its peers, which are trading at 13x EPS, yielding a price target of Y.”