Financial institutions, including banks, are highly regulated, extremely leveraged, and susceptible to interest rate fluctuations. Due to this unique exposure, calculating intrinsic value for bank stocks requires modification of the most popular valuation models. There are about five widely accepted intrinsic valuation models used with determining the core price for stock of most companies. Novice or lazy investors rely heavily on these so-called textbook models to calculate intrinsic value as the baseline for buying stock. Sophisticated investors will modify popular models to create a customized formula for each respective industry. It requires some rational thinking and reasonable assumptions to design and implement a model for any industry. This article goes into detail about designing and executing an intrinsic valuation model for banks.<\/span><\/p>\n To cover the thought process of creating this banking model, it is first explained how banks are in their own corner of the business world. Certain business attributes of banking are unusual and therefore demand modification to the intrinsic calculation model. Secondly, compliance regulation further complicates calculating value. In some situations, the government penalizes banks by restricting their ability to conduct business which then impacts earnings. Since most valuation models are oriented around earnings, compliance in banking demands changes to the intrinsic formula. A third dynamic with banks is the leverage issue. Most stock price valuation models assume the respective company is at least mildly leveraged. Banks are not not mildly leveraged in comparison to other industries; they are extremely leveraged. Therefore, the respective intrinsic value formulas must take this into consideration. Finally, banks and other financial institutions are susceptible to interest rate changes. If they have too much money loaned for extended periods of time (long-term notes) at low interest rates and the market rates for loans increase, earnings tied to interest will lag until these lower interest rate loans mature. Thus, the formula for intrinsic value must adapt to this interest spread between what is earned and what is paid out for use of money.<\/span><\/p>\n The last section of this article ties all of this together and explains how the model is fully modified and then applied against a popular bank stock. But first, it is important for the investor to understand the unique business environment with which banks exist.<\/span><\/p>\n The historical model for banking is as a depository institution that would loan out money from the deposits of patrons. The use of actuarial science is how a bank primarily earns its income. There are literally tens of thousands of patrons each depositing varying amounts of money. In turn, the bank makes loans to well qualified individuals and earns interest on behalf of the patrons. The bank then in-turn pays patrons a portion of the total interest earned from loans. The difference between what is earned and paid out is used to pay for operations of the bank; any balance left over is profit. In order for this to work, economy of scale is essential; deposits from patrons must be in excess of tens of millions of dollars. A simple example illustrates how this works.<\/span><\/p>\n Main Street Bank has 30,000 patrons among six branches. Each patron carries $3,000 on average on deposit with Main Street Bank. Therefore, Main Street Bank has $90 Million in deposits. Main Street issues 9,000 loans, each with a face value of $10,000. Main Street loans out $90 Million. Each loan has a simple interest rate of 7% per year. Therefore, each year, Main Street bank earns $6,300,000 in interest. Main Street agreed to pay interest to its patrons of 2% per year. Main Street pays out $1.8 Million of interest. The difference is $4.5 Million of net interest. Net interest is the primary source of revenue generated by banks and the common term used to define revenue for a bank.<\/span><\/p>\n Main Street’s operating costs are $600,000 per location including payroll, facilities, technology and all other operating expenses. Total costs to run the bank equals $3.6 Million. The bank generates a $900,000 annual profit.<\/span><\/p>\n This is the primary business model for banks. However, over the last 100 years, this model has developed into a much more multi-dimensional model. Today, banks have several streams of revenue. Here are several examples of other sources of revenue (referred to as non-interest income in banking terminology):<\/span><\/p>\n This is a simple bank. The really big banks are involved in several revenue venues. A typical big bank refers to these revenue venues as ‘Segments’. All of them have the traditional bank format as above and they commonly called this ‘Traditional Banking’. In general, the traditional segment is the powerhouse of the entire organization. Other segments include:<\/span><\/p>\n It is important to note the two obvious risk factors involved with banking. First is the interest spread or net interest income for the loans made and the amounts paid out to borrow the money. If this spread decreases, the end result is much less net interest income to the bank. The bank must be flexible enough to absorb or adjust to any change in this interest income. Typically these changes occur quickly in the market and the bank’s ability to adapt takes a lot more time. This is further evaluated in the net interest section below.<\/span><\/p>\n Secondly, banks make a lot of loans. If a borrower defaults on their loan, not only is the bank out of earning interest, it also must take a loss associated with the open balance of principal on that note. Thus, loan management, what banks refer to as risk management is extremely important to eliminate or significantly reduce loan losses. All banks have a single line item on their income statement identifying provision for loan losses. For the big banks, this line item is in the hundreds of millions of dollars per year. Wells Fargo’s<\/strong><\/a> <\/span>provision for loan losses in 2019 was $2.7 Billion, yes, you read that correctly, $2,700,000,000 was written off the books. Wells Fargo’s total revenue in 2019 was $85 Billion. This means Wells Fargo’s lost 3.1% of every dollar it earned because of bad loans. This is not unusual; JP Morgan Chase<\/strong><\/a><\/span> set aside $5.6 Billion for loan losses against $115.6 of revenue. This is 4.8% of every dollar earned.<\/span><\/p>\n Finally, before explaining the broad intrinsic value determinants, the balance sheet for a bank must be explained. In general, they do not display the traditional current, fixed and other assets format. A bank’s format is basically presented as follows:<\/span><\/p>\n Assets<\/span><\/strong><\/span> Thus, the earning assets portfolio is the primary asset to be concerned with when calculating intrinsic value. Remember, intrinsic value includes both elements of income and assets. Since loan assets are shorter term than traditional fixed assets, they are more susceptible to changes in value tied to money in the market. In effect, inflation and the market’s accepted interest rate drives the value of these loans. Given this, intrinsic value for a loan pool is rarely significantly greater than the face value of the respective loans. This is almost the exact opposite of real estate based operations; there, the intrinsic value is lifted higher due to the fair market value of the underlying real estate.<\/span><\/p>\n With this in mind, it can be easily deduced that intrinsic value will rarely exceed 125% of book value. Why? The underlying assets’ fair market value will rarely exceed the respective face value of the loans. Thus, a value investor’s first step with determining intrinsic value for a bank is to focus on book value<\/span><\/strong><\/a>. Then, immediately set a maximum value point of 125% of book value. This is the absolute BEST CASE for intrinsic value for a bank stock. Rarely will the loans have much greater value than the face amounts of these loans. The most common cause for this unusual greater value situation is when loans have high interest rates and the market interest rate is much lower.\u00a0<\/span><\/p>\n On the opposite aspect of this is the quality of those loans. Since the loans are reported at face value LESS a provision for bad loans, it is possible that in a dramatic or extended economic downturn with the economy or with certain types of loans such as auto, consumer or mortgage, the economic impact can impair the face value of this loan portfolio. Thus, a low point or adjustment should be considered to include a ‘what if’ the default rate is much higher than the current set aside. How much can this affect the intrinsic value related to book value?\u00a0<\/span><\/p>\n The answer is simple, to set an impairment adjustment tied to quality of loans, simply assume that whatever the existing loan portfolio is, reduce it another 5% and adjust the book value accordingly. Thus, in the example above, instead of the loans being 88% of total assets, it is reduced to 84% ((.88 X (1-.05) = .836)) of all assets. This must be adjusted to the equity element in the bottom half of the balance sheet. This means that instead of the equity position at 11%, it is now 7% as the liabilities cannot change. This is then reflected with an adjustment to book value as a percentage of this equation. Since 7% equity position equals 64% of the original equity, then the bottom or floor value for intrinsic value must approximate two-thirds of book value.\u00a0<\/span><\/p>\n Now the range for intrinsic value is set. In general, intrinsic value will approximate somewhere between 66% and 125% of book value.\u00a0<\/span><\/p>\n Before finishing, there is one last important point about bank stock book values. Banks actually report two book values. They place a lot of importance on this with their reports. The first is the traditional book value as defined in textbooks. The second one is much more conservative. It is called ‘Tangible Book Value’ and it reflects the existing traditional book value adjusted lower related to intangible assets. Many banks grow by not opening new branches but by merging with other small bank organizations. This method of expansion is common as it brings into play a business principle known as economy of scale<\/strong>. The larger the bank, the better its chances of borrowing money at lower interest rates and demanding better terms with loans issued. This merging often requires the recording of goodwill<\/span><\/strong><\/a> as an asset in the other assets section of the balance sheet. In addition, there are other intangible assets including ‘rights to certain contracts’ and derivatives.<\/span><\/p>\n For the purpose of determining intrinsic value, always use traditional book value as the beginning basis in the formula. It is not uncommon for the difference between traditional book value and tangible book value to have a 25% lower differential of traditional book value. However, use the traditional book value to determine floor and ceiling for intrinsic value.\u00a0<\/span><\/p>\n Therefore, rule number one with calculating intrinsic value of a bank stock. Intrinsic value of bank stocks will NEVER exceed 125% of traditional book value and will most likely (assuming a good operation) end up around the traditional book value as reported with the financial statements.<\/span><\/p>\n For example, Wells Fargo recently released their 4th quarter 2020 financial supplement. On page 23 of their supplement, they indicate book value at $40 per share and tangible book value at $33 per share. Thus, 66% of traditional book value is the floor value for intrinsic calculation. The ceiling is 125% of traditional. This means that the extreme floor and ceiling for intrinsic value for Wells Fargo are $25 for the floor and $50 for the ceiling. This sets the price barriers. Always think that intrinsic value will end up around the traditional book value as reported with the bank’s financial results.<\/span><\/p>\n Here is a summary of the first two rules of intrinsic value calculation for bank stocks:<\/span><\/p>\n For now, this section is designed to explain how to determine the general ceiling and floor intrinsic value points for bank stocks. From here forward, the tangible book value is used to determine the true intrinsic value; the limits let us know where this final result will end up.<\/span><\/p>\n The first adjustment for a bank stock’s intrinsic value calculation relates to compliance. Compliance refers to the regulations and reporting requirements the government imposes on banks.<\/span><\/p>\n Banks are one of the most regulated industries in the United States. There are at least four levels of regulation for big banks. Value investors are only interested in the larger banks. Smaller banks have at least three levels of regulation.<\/span><\/p>\n The upper level of regulation starts with the Federal Reserve<\/span><\/strong><\/a>. All national banks, i.e. they serve more than one state, must become a member of the Federal Reserve<\/span><\/strong><\/a>. In addition to the traditional membership requirements of the Federal Reserve, the Graham-Leach-Bliley Act of 1999 grants the Federal Reserve more authority over large financial institutions which most banks fall under. From the Federal Reserve’s website: “The Federal Reserve is responsible for supervising–monitoring, inspecting, and examining–certain financial institutions to ensure that they comply with rules and regulations, and that they operate in a safe and sound manner. Supervision of financial institutions is tailored based on the size and complexity of the institution”.<\/em><\/span><\/span><\/p>\n![\"Intrinsic](\"https:\/\/businessecon.org\/wp-content\/uploads\/Bank-Vault.jpg\")
<\/a><\/p>\nIntrinsic Value – Banking Business Model<\/strong><\/span><\/h2>\n
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\n\u00a0 Cash\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5% of all assets<\/span>
\n\u00a0 Earning Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 88% of all assets<\/span>
\n\u00a0 Other Assets Including Fixed\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a07% of all assets<\/span>
\nLiabilities and Equity<\/span><\/strong><\/span>
\n\u00a0 \u00a0Non-Interest Bearing Deposits\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 17%\u00a0<\/span>
\n\u00a0 \u00a0Interest Bearing Deposits\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 51%<\/span>
\n\u00a0 \u00a0Borrowings\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 21%<\/span>
\n\u00a0 \u00a0Equity\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 11%\u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span><\/p>\n\n
Intrinsic Value – Compliance<\/span><\/strong><\/span><\/h2>\n