Consider the following: P/E, P/B, EPS, EVA, WACC, CAPM, ROE, RAROC, ROIC, NPV, DCF. And those are just the ones that trip off the tongue.
What do the acronyms have in common? They are statistical tools used by companies or outsiders – such as investors or Wall Street analysts – to figure out what a company is worth, how correctly assets are being priced, whether risk and reward are being adequately juxtaposed, whether a firm is allocating capital effectively, and so on. They’re valuation metrics: some simple, some more complex. (See below to find out what the acronyms stand for.)
Of course, different valuation methodologies, like a clutch of political commentators, gravitate toward different data and parse information in different ways.
To address capital allocation and performance measurement issues specific to the banking industry, The Wharton Financial Institutions Center in mid-May hosted a conference called “Measuring and Managing the Value of Financial Institutions: Integrating External and Internal Valuations.”
The conference didn’t solve the valuation riddle, but it explored how companies think about shareholder value and capital allocation. It also examined how financial institutions are valued from the outside. Since 1980 banks have traded at an average 40% discount to the S&P 500, as measured by the PHLX/KBW Bank Index.
Figuring out what a bank is worth is difficult. The reasons vary. Chief among them are that banks are credit-sensitive, they are opaque institutions, they hold illiquid instruments and they are vulnerable to sudden regime shifts. A valuation gap typically exists between what a bank’s valuation methodology says it’s worth and the value placed on it by the market.
Todd S. Thomson, Citigroup’s CFO and the conference headliner, set the tone when he observed that investors are becoming more educated and interested in economic capital and capital allocation issues – and that firms shouldn’t forget this.
“We must deliver GAAP returns to shareholders,” he said. One way Citigroup tries to ensure this is by tying valuation metrics to strategy. If the firm is weighing an acquisition, it looks at whether that will make the mothership more competitive and help it grow faster in the future than it does today.
Any new deal or acquisition must be a “credit to our earnings per share in the first year and get to 20% return on equity in three to five years,” he said. This rule is intended to make the relevant business groups accountable, inject a large dose of discipline into the process and help produce reasonable returns.
To keep attention fixed on shareholder value, Thomson further argued that economic capital should drive decisions. There’s a good case made for economic value-added (EVA) metrics, he said, but “the more you complicate the tools, the harder it is to get managers to understand [them] and do the right things, and the harder it is to tell if they’re doing the right thing. The ability to make it simple is important.” He added that Citigroup CEO Sandy Weill holds a more extreme view, believing that companies have used EVA too prescriptively and that it often “takes away managers’ judgment.”
Value Drivers
Diane Glossman, most recently managing director and head of U.S. bank and brokerage research at UBS Warburg Equity Research, pointed out that a bank’s management always struggles over how to maximize value. The answer is straightforward: Generate consistently high returns with regular growth.
This isn’t easy of course. The metrics investors find most compelling have shifted over the years, she noted. In the early 1990s the P/E ratio was emphasized, and the way to maximize it was to announce a cost savings program so more of every dollar could drop to the bottom line. That remains important, but revenue generation that doesn’t dilute EPS has now taken center stage.
W. Keith Smith, former vice chairman of Mellon Financial Corp., provided a case in point. He was part of the new management team brought on in July 1987 after the bank suffered walloping losses in its loan portfolio. After moving $1 billion off Mellon’s balance sheet and raising $525 million of new equity capital, the bank began a stream of acquisitions, absorbing The Boston Company in 1993 and mutual fund firm Dreyfus Corp. a year later.
“The balance sheet was the driving force – we were always focused on P/E, P/E, P/E,” Smith said. At the time, the bank could justify $40/share for Dreyfus, but paid $50, taking a 19% dilution in the first quarter after the acquisition. He compared Mellon’s earlier emphasis on the P/E ratio with Citigroup’s current demand that benefits from an acquisition be accretive, pointing out that Mellon regularly overpaid for acquisitions because it made sense strategically, even if not immediately.
There have been other shifts in how the valuation game has played out in recent years. In the early or mid-1990s, having a higher capital ratio meant a bank wasn’t using capital properly, said Glossman. Now investors favor higher capital ratios because they want to make sure enough has been set aside for unexpected crises. At the same time, investors are not yet keyed in to the notion of the adequacy of returns in different parts of the economic cycle, she said. Nor do they understand market-based risk well enough.
What’s in a Name?
Public valuations have become more skittish in the post-tech-bubble era, with small news items gyrating stocks. In the wake of accounting scandals, settlements resulting from fraudulent investment bank research, tainted IPO allocation processes and other bad news, banks need to face reputational risk head-on, stressed H. Rodgin Cohen, chairman of law firm Sullivan & Cromwell. He defined reputational risk as the “risk that the reaction of external bodies … to a legal or compliance failure [will cause] significant harm to the financial institution.” The external bodies include regulators, the media, police, law enforcement agencies and so on.
When a bank’s reputation suffers a major hit, he said, the result could “send an institution’s stock into a tailspin” and serve as a “straightjacket for future acquisitions.” The perception of this risk impacts external valuations of banks.
Financial institutions have high exposures to reputational risk because of the complex regulations and laws they must obey and because some laws are uncertain or ambiguous, making 100% compliance impossible. Adding to the complexity is the presence of numerous regulators: the Office of the Comptroller of the Currency, the National Association of Securities Dealers, The Securities and Exchange Commission, the Commodities and Futures Trading Commission, state regulatory agencies and others. In addition, regulators have become less tolerant of perceived violations, more willing to separate out errors and malfeasance and more willing to impose higher penalties for mistakes, Cohen noted.
Cohen and Glossman both addressed vulnerabilities confronting financial institutions. Asked whether valuations in the financial industry are exposed to further investigations and civil suits with big banks, Cohen said he expects to see “large settlements but nothing that approaches breaking the bank.” Banks can protect themselves best by developing a compliance program and by working with regulators. “I believe if there is a flaw discovered anywhere on the spectrum, the regulatory reaction will be less severe if there is a compliance, best-of-class regimen in effect,” he said. The reason: There tends to be “regulatory recognition” of these programs.
Glossman agreed, adding that all international banks were negatively impacted by last year’s rumors about the potential size of asbestos litigation settlements, but that regulators wouldn’t put the largest financial institutions at risk of failure. Short-term valuations haven’t bounced back because the nominal GDP growth rate has remained sluggish, extending the impact, she said.
Similar, but Different
So why are banks discounted relative to the market? “They take risk for a living. Period. The end,” said Glossman. It’s the market’s assessment of how a bank takes risk, and how well, that determines the company’s valuation relative to its peers. “You only know after the fact if they’ve done a good job,” she added.
“Financial institutions are complex, they’re opaque, and people don’t trust them because they’re opaque,” summed up Dan Borge, a former managing director at Bankers Trust (which was bought by Deutsche Bank in 1999) and architect of BT’s risk-adjusted return on capital (RAROC) methodology.
The typical answer to the lack of transparency is disclosure. Glossman noted that there have been moves in this direction but that most investors are “only interested when something bad happens, such as when Argentina shows up on the front page of USA Today.” Every “bubble of new information” comes on the heels of a bad news event, she pointed out.
On the other hand, 10Ks, written for more sophisticated investors, have for years included discussions of risk management. The problem, however, is that even sophisticated investors often have trouble ferreting out a bank’s true exposures. The numbers are complex, market risk data is by definition point-in-time data, and banks hold a lot of illiquid positions that aren’t marked to market. All of this results in a persistent valuation discount relative to the market. Borge highlighted the problem rhetorically, asking: “Are financial institutions just inefficient mutual funds?”
If applied consistently, a good mark-to-market methodology would benefit the industry by exposing weaknesses, Borge said. At the same time, disclosing risk positions increases the complexity of a firm’s story – and the main thing a bank must do is to convince people it has a strong management.
Borge stressed the importance of risk-based capital allocation in making management decisions. Bankers Trust rolled out the first enterprise risk management system in the financial industry in 1978 and had it fully operational by the mid-1980s.
BT’s RAROC, a radical innovation, was intended to change the behavior of the entire institution – and not just some of the time, but all the time. “We believed if we changed the behavior of the institution to be more alert to risk, to be paid for risk … over time we’d be better off doing so,” Borge noted.
He added that BT would never have gotten into the derivatives business if the firm weren’t confident it could quantify the risks. Now, he worries analytics have outpaced management. “Analytics, when disconnected from management, become useless,” he warned. Just as actuaries have become an “isolated priesthood” within companies, so, too, could the discipline of risk analysis. He argued that financial institutions must make explicit the connection between risk analysis and what the bank’s chairman or board of directors wants to do.
Inside the Castle
The conference also included a number of speakers on the internal metrics that financial institutions use to allocate capital. Michel Crouhy, senior vice president for business analytic solutions in the treasury balance sheet and risk management division at Canadian bank CIBC, focused on estimating risk-adjusted return and economic capital. He noted that RAROC can be used profitably for capital allocation, which is calculated ex ante, but not as easily for performance evaluation, an ex post concept.
Andre F. Perold, a finance and banking professor at Harvard Business School, pointed out that financial firms get haircuts relative to the market because they bear significant deadweight costs of capital, some of which arise from guarantors facing moral hazard and adverse-selection issues. Since deadweight costs eat away at profit and increase risks on the downside – and are borne by shareholders – more attention must be focused on calculating them effectively.
Yet another effort to redress a valuation shortcoming came from Thomas C. Wilson, managing director and global head of the finance and risk practice at Mercer Oliver Wyman. He argued that financial institutions significantly overvalue their investment banking and other high-risk businesses and undervalue retail banking and other low-risk businesses. By using a common hurdle rate or cost of capital across all business lines, banks frequently wind up following strategies that don’t make sense and that hurt shareholder value. To correct this mistake banks should use a differentiated cost of capital across different businesses and projects.
For all the emphasis on variables, hurdle rates and performance measurement throughout the conference, however, there was little sense that banks would succeed in closing the gap between internal and external valuations. Financial institutions, it was generally agreed, trade at a discount to the market for legitimate reasons.
(Acronym crib sheet: P/E: Price-to-Earnings; P/B: Price-to-Book; EPS: Earnings Per Share; EVA: Economic Value Added; WACC: Weighted Average Cost of Capital; CAPM: Capital Asset Pricing Model; ROE: Return on Equity; RAROC: Risk-Adjusted Return on Capital; ROIC: Return on Invested Capital; NPV: Net Present Value; DCF: Discounted Cash Flow)
