PP: The Art of Investing in Banks
Good banks are not necessarily good investments and bad banks are not necessarily bad investments. - Aswath Damodaran
Welcome to the 72nd Pari Passu Newsletter.
Today, we are learning about the practice and methodology behind investing in banks, whether that is breaking down the unique valuation philosophy, decoding the most important metrics, discussing the fundamentals of the business, and understanding the dividend discount model (plus Professor Damodaran’s unique model). It has been a wild ride in the banking sector recently, and it has moderately recovered since the collapse of Silicon Valley Bank on March 10, 2023. Today’s essay will be dense and long, but I truly believe that gaining a basic understanding of this sector can make us better investors overall.
This essay is divided into three main sections:
Fundamental Analysis
Technical Understanding
Valuation.
Let’s dive in.
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Part 1: Fundamental Analysis
Banks 101
At the most basic level, a bank makes money by borrowing money from depositors (and other creditors) and using the money to make loans and buy securities (and at times engage in higher-risk investments). If the investments end up being worth more than the deposits, the shareholders keep what’s left. As simple as that.
We now understand that banks and operating companies use debt in a completely different way. Banks, at their core, leverage debt not merely as a liability but as a foundational element to operate. This distinctive approach to debt transforms this sector into an asset class of its own, albeit one with complex implications for valuation and risk assessment.
If you might be wondering why banks have to use leverage while operating companies do not, you are on the right path to understanding the model. Technically, banks do not have to use leverage, but without it, the model would not be profitable enough to attract capital. Let’s assume a bank that does not take deposits (or any other type of liability), and finances all its business with $100 of equity. On average, it lends money at 4% interest generating $4 of profits and a ROE of 4%. Not cool.
On the other hand, let’s assume that the bank borrows $90 (in the form of deposits) paying 2% interest on these deposits, and now investors commit just $10 of equity. On average, the bank still lends money at 4% interest generating the same $4 of profits. In this case, the bank incurs an interest expense of $1.8 (the interest it has to pay to people who deposited the money) leading to $2.2 of profits. The equity is now $10, therefore the ROE is 22%. Much more cool.
Now that we understand the model at the most simple level, let’s get into the details.
Background Knowledge
In analyzing the financial sector, certain positive factors emerge that can significantly impact its performance. A moderate rise in interest rates, for instance, augments the profitability of banks by increasing the spread between what they pay on deposits and what they earn on loans. Similarly, a reduction in regulatory constraints can enhance operational efficiency and profitability by alleviating compliance costs and fostering a more conducive business environment. Moreover, lower consumer debt levels reduce the risk of default, potentially leading to increased lending activities and profitability due to a healthier consumer base willing to take on new debt. Conversely, the sector faces challenges that investors must carefully consider. Rapid increases in interest rates could dampen the demand for credit, affecting banks' core lending activities. A flattening yield curve (where the spread between long- and short-term interest rates narrows), can squeeze banks' interest margins, impacting their profitability. Furthermore, increased regulation, while aiming to protect consumers and ensure financial stability, can introduce operational complexities and costs, potentially limiting agility and growth [3] [6].
The financial structure of banks is underpinned by the concept of bank capital (equity), which serves as a vital cushion against losses. This capital, representing shareholders' investment, is not a liability in the traditional sense but an essential buffer that ensures a bank's resilience against insolvency. Regulatory bodies globally mandate banks to maintain a minimum capital ratio to safeguard against systemic risks, ensuring that banks operate with a prudent balance between pursuing profit and maintaining stability. However, the cost of capital is higher for banks than other forms of financing, such as deposits or loans, making it a critical factor in their financial strategy. Banks aim to optimize their capital levels to satisfy regulatory requirements and stakeholder expectations while minimizing costs to enhance profitability. In general, the more capital a bank requires, the lower its profitability [11]. This is what a typical balance sheet structure may look like:
Regulation-wise, the Basel Committee on Banking Supervision plays a pivotal role in shaping the global regulatory framework for banks. Established in the aftermath of the GFC, the committee's Basel III measures aim to fortify banks against future crises by enforcing stricter capital, risk management, and supervisory standards [11].
These measures emphasize the need for banks to hold sufficient capital against various risks, including credit, operational, and market risks. The operational risk component, in particular, highlights the need for robust internal controls and processes to mitigate losses from internal failures or external events, affecting banks with significant non-lending activities the most. Typically, there will be more regulatory impact on the capital requirements of banks that have more business outside of lending like wealth management and other fee-generating businesses.
Banking Landscape
At the apex of the hierarchy are the "too big to fail" money center banks, such as Chase, Bank of America, Citigroup, and Wells Fargo. These institutions are colossal in terms of assets and influence, serving as financial linchpins both domestically and globally. Their sheer size and systemic importance ensure that they are closely monitored and supported by regulatory mechanisms to prevent their failure, given the potentially catastrophic impact on the global economy. The next tier comprises large regional banks, which occupy a middle ground. These include significant players like US Bank, Regions Bank, Fifth Third, Zion Bank, and KeyBank. While these banks are substantial, commanding extensive networks and holding considerable assets, there's an ongoing debate about their status in the "too big to fail" spectrum. They are integral to the economy, particularly at the regional level, but their fallibility in times of financial distress is less certain compared to their larger counterparts.
Community banks, though smaller in asset size, play a crucial role in serving local communities, offering more personalized banking services, and fostering local economic development. They differ from regional and money center banks not just in size but in their community-focused operational approach. This stratification however has led to a two-tiered banking system, with the top tier enjoying perceived governmental support in times of crisis, thereby attracting more customer and investor confidence. In contrast, community and regional banks face challenges in such periods, as the flow of money tends to favor the perceived safety of the largest banks. The systemic imbalance, which, while not pronounced in stable times, becomes critically apparent during financial stress [1].
Background of 2023
The banking sector witnessed a tumultuous phase in 2023, marked by the failure of four significant banks, an event that starkly contrasted the financial crisis of 2008 and 2009. Unlike the earlier crisis, where 165 smaller banks failed over two years, the 2023 failures involved larger institutions whose combined scale surpassed those earlier casualties. A critical factor in these failures was the banks' mismanagement of their asset and liability structures, especially their handling of interest rate risk. Banks like Signature, Silicon Valley, and First Republic succumbed due to a dramatic exodus of deposits, a scenario for which their already thin net interest margins (NIMs) left them ill-prepared (we will cover NIMs in the next section). Typically, a healthy NIM is around 4%, but pressures on deposits have already reduced the norm to closer to 3%. These banks, however, were operating with margins below 2%, making their situation precarious even before the crisis hit.
Their inability to secure wholesale or brokered deposits affordably during the crunch was a death knell, given their upside-down balance sheets from poor interest rate risk management.
These failures also highlighted a broader systemic issue triggered by the Federal Reserve's policies. In response to the pandemic, the Fed injected unprecedented liquidity into the system, maintaining low-interest rates and creating an environment where banks were lulled into a false sense of security regarding deposit stability. This led to the acquisition of long-dated, low-yield bonds under the assumption that the conditions of liquidity and low-interest rates would persist. However, the Fed's rapid shift in monetary policy, aimed at combating inflation through aggressive rate hikes, caught these banks off-guard, exacerbating their vulnerabilities. The banking industry's challenges are further compounded by its slow process to innovate and adapt. The sector is dominated by veterans of previous financial crises, leading to a cautious approach towards credit and investment strategies that prioritize perceived risk-free securities. This conservatism, while aimed at prudence, backfired in the face of the Fed's sudden and aggressive policy shifts.
The aftermath of the bank failures in 2023 has starkly highlighted the disparities within the banking sector, particularly between the "too big to fail" institutions and their smaller counterparts. This scenario has exacerbated an already uneven playing field, where, in moments of crisis, public sentiment and financial flows overwhelmingly favor the largest banks. The migration of deposits to behemoths like Bank of America underlines a growing centralization of financial power and resources, which could have long-term implications for economic diversity and stability. The community and regional banking sectors have traditionally been pivotal in supporting small businesses and local economies, offering services and credit that larger banks may deem too minor to engage with. However, the trend of deposit consolidation poses a significant threat to these smaller entities, potentially diminishing their numbers and, by extension, their critical role in economic growth.
This consolidation raises concerns about the future of banking diversity, especially considering hypothetical scenarios where large banks could dictate terms on controversial sectors like firearms or oil, based on social or political pressures. The need for a diversified banking system, therefore, is not just about financial health but also about maintaining a balance of power and ensuring that various sectors of the economy have access to credit. The challenge of maintaining this diversity is compounded by regulatory realities, such as the FDIC insurance limit of $250,000, which hasn't kept pace with inflation or the needs of modern businesses. This limitation hampers smaller banks' ability to attract the larger deposits necessary for scaling and sustainability [1].
Banks and the Market
The cost-effectiveness of preemptive measures by regulatory bodies like the FDIC to avert bank failures, rather than addressing them post-factum, highlights a strategic approach to maintaining financial stability. This proactive stance can reduce market panic, preserving consumer confidence and preventing the detrimental outflows that precipitate bank failures. Market volatility, fueled by uncertainty, poses a unique risk to banks, given their reliance on consumer confidence and deposit stability. Unlike consumer goods companies, where product demand may remain steady regardless of stock performance, banks face a more immediate and reflexive impact from their stock prices. A significant drop in a bank's stock can trigger a withdrawal frenzy, as depositors rush to safeguard their assets amidst fears of insolvency. This phenomenon shows the critical interplay between bank performance, market perception, and consumer behavior, where the latter can precipitate a destabilizing feedback loop for financial institutions.
Addressing concerns surrounding the commercial real estate (CRE) sector reveals a landscape where doom and gloom predictions may not fully account for the resilience built into the system. Despite the challenges facing the office space segment, the banking sector's exposure to potential CRE downturns is mitigated by improved underwriting standards post-2008 financial crisis. The emphasis on equity upfront in loan agreements provides a buffer against downturns, suggesting that even significant market corrections may not directly translate into bank losses. Most of the exposure is rather a lot in REITs, insurance companies, pension plans, private equity, and private credit funds. This perspective offers a more nuanced view of the CRE sector's risks, recognizing the systemic safeguards in place.
The fintech revolution's impact on banking presents a narrative of evolution rather than obsolescence. Early predictions of internet banks displacing traditional banking have given way to a more integrated model, where technological advancements are leveraged to enhance, rather than replace, the services provided by community and regional banks. The accessibility of advanced banking technologies, facilitated by core system providers, enables even small banks to offer competitive services like mobile banking, democratizing technological adoption across the sector. Furthermore, the potential integration of artificial intelligence in processes such as credit underwriting and loan pricing represents a frontier for efficiency and profitability improvements. AI's ability to harness data for more precise decision-making could refine the pricing models, ensuring that banks do not leave margin on the table during negotiations. This technological pivot could streamline operations, reduce reliance on manual processes, and unlock significant value, illustrating the ongoing transformation and resilience of the banking industry in the face of technological and market challenges [1].
Summary
To summarize this section on Fundamental Analysis, here are several critical aspects that shape the banking sector's dynamics and its appeal to investors:
Unlike other industries, banks use debt as a foundational element, leveraging it to create profitable financial products. This unique approach, along with minimal capital expenditures and a focus on financial acumen rather than physical assets, defines their operational structure.
The banking sector's performance is significantly influenced by interest rates, regulatory changes, and consumer debt levels; moderate interest rate rises and reduced regulation can boost profitability, and rapid rate increases and enhanced regulation pose challenges.
The importance of bank capital as a buffer against losses and a requirement for regulatory compliance underscores banks' need to balance profitability with stability. The Basel Committee's standards, including Basel III, play a crucial role in shaping this regulatory framework.
The banking sector is stratified into "too big to fail" money center banks, large regional banks, and community banks, each playing distinct roles in the economy that has led to a two-tiered system where larger banks benefit from perceived governmental support during crises, overshadowing smaller institutions.
The integration of technology and fintech has transformed banking operations, offering opportunities for efficiency gains through advanced technologies like AI and mobile banking applications, while also challenging banks to innovate and adapt to a rapidly changing landscape.
Part 2: Technical Understanding
Key Metrics
In general, the most important valuation metrics to track for banks are the P/E and P/B ratios. Here, we will focus on the P/B ratio. To put it simply, the P/B ratio is the price to book value, where book value is derived by subtracting total liabilities from total assets. While P/E ratios are indicative of a bank's expected growth, payout potential, and risk profile, it is the P/B ratio that often garners more attention for its specific relevance and insight into a bank's valuation. This emphasis stems from the unique operational and regulatory landscape in which banks operate, making the P/B ratio a more critical measure for investors.
Unlike other sectors where the book value of equity might not hold significant meaning—indeed, it's not uncommon for companies outside the banking sector to have negative book values without raising major concerns—the banking industry stands apart. In banking, the book value of equity is not just a numerical figure; it represents the foundation of a bank's regulatory capital requirements. A bank cannot function with a negative book value of equity, as this would undermine its regulatory standing and operational viability. This connection between book value and regulatory capital underscores the operational consequences of the book value of equity in banking, distinguishing it from other sectors.
Moreover, the banking sector's intrinsic connection to market valuation practices, such as mark-to-market accounting, means that a bank's book value is often a closer reflection of its fair value than in other industries. Despite recent controversies, like those surrounding Silicon Valley Bank, which highlighted discrepancies in asset valuation, it remains true that banks mark more of their assets to market than any other sector. This practice lends the book value—and by extension, the P/B ratio—a degree of relevance and significance unparalleled in other fields. Understanding what drives the P/B ratio requires a dive into intrinsic valuation models, particularly the stable growth dividend discount model, famously known as the Gordon growth model. This model posits that the value of a bank's equity can be determined by its expected dividends, adjusted for the cost of equity and growth. By relating this model to the book value of equity, we uncover that the P/B ratio is fundamentally influenced by two critical factors: the bank's return on equity (ROE) and its cost of equity.
The P/B ratio for a mature bank is a direct reflection of its operational efficiency and financial health, as measured by its ROE relative to the cost of equity. A bank earning just about its cost of equity is likely to trade at around its book value. Conversely, a bank that consistently generates returns above its cost of equity commands a P/B ratio greater than one, indicating a premium valuation. On the flip side, a bank underperforming relative to its cost of equity will see its P/B ratio dip below one, signaling a discount in its market valuation [2].
Operational
The cost of funds is a critical metric for any banking institution, reflecting the interest rate that banks pay to borrow money, typically from Federal Reserve banks. This cost directly influences the interest rates charged to borrowers, thereby shaping the bank's profitability. The spread between the cost of funds and the lending rate to customers is a primary profit source for banks. In essence, a lower cost of funds can enhance a bank's returns on both short-term and long-term loans, which tells the importance of this metric in operational strategy. Calculating the cost of funds involves multiplying the borrowed amount by the interest rate over a specified period, providing a clear view of the financial burden on the bank for acquiring capital to lend.
Another pivotal measure is the efficiency ratio, which assesses a bank's operational effectiveness by comparing its non-interest expenses to its total revenue. This ratio offers insights into how adeptly a bank leverages its assets to generate income. An ideal efficiency ratio is 50% or lower, indicating that a bank is operating efficiently, with its expenses well-balanced against its revenues. A rising efficiency ratio signals growing expenses relative to revenues, prompting a reassessment of operational strategies to maintain profitability.
The net interest margin (NIM) highlights the difference between the interest income a bank earns on its lending activities and the interest it pays out to lenders. This ratio is particularly sensitive to changes in market interest rates. In environments of low interest rates, banks often experience a boost in net interest margins as their funding costs decrease more rapidly than the interest income from loans. Conversely, high interest rates can compress net interest margins as funding costs escalate, affecting the bank's net interest income and overall profitability [12].
The ROA ratio is a key profitability metric, especially pertinent to banks due to the challenge of conducting detailed cash flow analysis. It measures the efficiency with which a bank utilizes its assets to generate profit, reflecting the net income produced per dollar of assets. Given the high leverage typical of banks, a seemingly modest ROA of 1 to 2% can translate into significant profits, making it an essential indicator of effective bank management.
Health
The Loan-to-Deposit Ratio (LDR) serves as a crucial liquidity measure, indicating the balance a bank maintains between its loan obligations and the deposits it holds. An excessively high LDR may signal potential liquidity issues, suggesting that the bank might not have sufficient funds to meet its immediate obligations in the event of rapid deposit withdrawals. Conversely, a low LDR could imply that the bank is not leveraging its deposit base effectively to generate income through loans, thus not maximizing its earning potential. This ratio is calculated by dividing the total loans by total deposits, offering a snapshot of the bank's liquidity and operational efficiency.
The introduction of the Dodd-Frank reform has placed increased emphasis on capital ratios, especially for large and systemically important financial institutions subject to regular stress tests. These ratios, which include Tier 1 and Tier 2 capital ratios, are vital for evaluating a bank's capacity to absorb unexpected losses. Tier 1 capital is the core capital, including equity and disclosed reserves, that banks must hold to cushion against losses, while Tier 2 capital refers to a bank's supplementary funds, such as undisclosed reserves and subordinated debt. Calculated against risk-weighted assets, these ratios are benchmarks for assessing a bank's financial stability and its ability to withstand financial distress.
The capital adequacy ratio (CAR), or the Capital-to-Risk Weighted Assets Ratio (CRAR), is another critical measure that regulators use to assess a bank's financial health. It compares a bank's available capital to its risk-weighted assets to gauge how well it can cover potential losses and meet obligations to depositors. The Basel Accords provide the regulatory framework for this ratio, with Basel II setting the minimum requirement at 8% and Basel III elevating it to 10.5%, including a conservation buffer. A high CAR indicates that a bank is well-positioned to absorb losses, thereby contributing to the overall stability and efficiency of the financial system [9].
Accumulated Other Comprehensive Income (AOCI) represents the unrealized gains or losses recorded in the equity section of a bank's balance sheet, reflecting the bank's financial instruments' market value fluctuations. These figures are crucial for understanding the true financial strength of a bank's balance sheet, as they encompass income and expenses not included in net income. For instance, unrealized gains or losses from bond investments are captured in AOCI until they are sold and thus realized. This account provides insight into the potential impact of market movements on the bank's financial position.
CAMELS
The CAMELS rating system is a comprehensive framework used by regulatory bodies to assess the health and stability of banks and financial institutions. It evaluates six critical dimensions of an institution's operations and financial condition: Capital adequacy, Asset quality, Management capability, Earnings, Liquidity, and Sensitivity to market risk. Each category is rated on a scale from 1 to 5, with 1 representing the strongest performance and risk management practices, and 5 indicating a high probability of failure requiring immediate corrective action. The composite rating reflects the institution's overall condition within this scale.
CAMELS ratings are determined through a combination of financial statement analysis and on-site examinations conducted by designated supervisory regulators, such as the Federal Reserve, the Office of the Comptroller of the Currency, the National Credit Union Administration, the Farm Credit Administration, and the FDIC. These ratings are confidential and shared only with the institution's top management to avoid triggering a bank run in case of a downgrade. The CAMELS system plays a pivotal role in regulatory oversight, aiming to ensure the stability and integrity of the banking system by identifying institutions that may pose risks to financial stability and requiring them to address identified weaknesses. However, these could still provide a solid and holistic process to evaluate the health of a bank [7] [8].
Part 3: Valuation
The banking sector, inherently sensitive to economic cycles, is particularly appealing to value investors due to its propensity for price and valuation extremes. Banks and financial institutions form the backbone of the economy, with their health and stability closely tied to economic vitality. This sector encompasses a broad range of financial services, including retail banks, insurance companies, and investment firms. A robust banking sector is indicative of a healthy economy, whereas its weakening can presage economic downturns, as history has shown. The dividend-paying nature of many banking stocks further attracts value investors, who see consistent dividends as a mark of a company's reliability and a means of sharing in its profits.
Investing in banks can be fruitful through multiple avenues: multiple expansion, organic value creation, and M&A. Multiple expansion, a hallmark of traditional value investing, involves buying undervalued stocks that are expected to appreciate as market perceptions align with intrinsic values. Organic value creation is derived from the bank's core operations—accepting deposits, issuing loans, and efficiently managing resources to yield a solid return on equity, thereby growing earnings, tangible book value, and dividends over time. Lastly, the banking sector has witnessed a long-term trend of consolidation, offering another pathway to value realization. Banks that merge with or are acquired by larger entities often unlock significant value, benefiting from the synergies and efficiencies of larger scale operations.
However, valuing banks requires a nuanced understanding that goes beyond conventional metrics like EV/EBITDA or EV/Sales, which may not accurately capture a bank's value. As mentioned at the beginning of the essay, debt plays a completely different role compared to a classic operating business, therefore looking at metrics that do not take into account interest payments (like EBITDA and Sales) simply does not make sense.
The industry standard leans towards earnings multiples and price-to-tangible book value ratios, offering a balanced view that prevents dilution of tangible book values. Historical data suggests that a bank's stock price correlates with trends in its earnings per share and tangible book value, underscoring the importance of these metrics in valuation. Each bank, while operating within the same business model, has unique characteristics—market presence, focus areas, or management quality—that can significantly impact its value-creation potential. Separate banks share similarities in their operational framework, yet it's their distinctive approaches to managing their assets, liabilities, and strategic direction that define their success or failure in creating value for investors [5].
Equity Valuation
The approach to equity valuation necessitates a departure from conventional methodologies applied across other sectors. This divergence is primarily due to the unique operational model of banks, where debt functions as a core component of their operational framework rather than a financial burden. Banks aim to borrow or receive deposits at lower rates only to lend or invest at higher rates, thereby generating profit. This operational peculiarity informs the approach to both intrinsic valuation and pricing of bank equities, focusing solely on cash flows to equity and employing equity-specific multiples such as P/E and P/B, given the irrelevance and potentially misleading nature of EV multiples in this context.
At the heart of equity valuation for banks lies the challenge of estimating free cash flows to equity. Traditionally, this process involves adjusting net income for non-cash charges, capital expenditures, changes in working capital, and net debt changes to ascertain the cash available to equity holders. However, the application of this framework becomes complex in banking due to the difficulty in defining or quantifying banks' capital expenditures, depreciation, and changes in working capital in the same manner as other industries. This complexity has led to a reliance on the Dividend Discount Model (DDM) as a more straightforward and feasible approach to valuing bank equities. The DDM posits that the intrinsic value of a bank's equity can be determined by the present value of all expected future dividends. This model simplifies the valuation process by focusing on dividends as the tangible cash flows to equity holders, bypassing the need to estimate reinvestment rates or capital expenditure. To apply the DDM, one starts with the expected dividends in the next year and projects future dividends based on net income and the payout ratio. The sum of the present value of these dividends, including a terminal value calculated at a perpetuity growth rate, discounted back at the cost of equity, yields the equity value of the bank [2] [10].
Embedded in the DDM are critical assumptions about the bank's management and regulatory environment. Firstly, it assumes that banks are managed by rational actors who will not distribute dividends beyond what the bank can afford, particularly in situations requiring capital retention. Secondly, it presupposes an effective regulatory framework that prevents banks from undertaking excessive risks that could jeopardize their stability. The 2008 financial crisis challenged these assumptions, revealing instances of imprudent dividend policies and regulatory oversights.
FCFE Model and Example
The Free Cash Flow to Equity (FCFE) model presents a unique approach to equity valuation, tailored to the sector's regulatory and operational nuances. Aswath Damodaran's adaptation of the FCFE model for banks stresses the role of regulatory capital in determining a bank's capacity for growth and sustainability. Unlike traditional companies where reinvestment may refer to capital expenditures and changes in working capital, for banks, reinvestment is primarily about maintaining or growing their regulatory capital to meet or exceed statutory requirements. This model begins with net income as the initial measure of earnings available to equity investors. From there, it deducts investments in regulatory capital to arrive at free cash flow to equity, effectively treating these calculated cash flows as potential dividends. This adjustment is crucial as it bypasses the limitations inherent in actual dividend payments, which cannot be negative, thus providing a more comprehensive view of a bank's financial health, especially in scenarios where a bank might need to raise additional equity.
Let’s look at Damodaran's approach to valuing Citibank in May 2023 as an example that demonstrates the application of this model in a real-world context. Citibank, perceived as a lower-growth, less profitable entity compared to its peers like JPMorgan Chase, showcased an ROE below its cost of equity but maintained a healthy Tier 1 capital ratio. The valuation assumed a modest recovery in ROE from 8.78% to 9.5%, reflecting Citibank's historical performance, against a backdrop of a conservative growth assumption aligned with the broader economic outlook. The cost of equity, a critical input in this valuation, was derived not through conventional risk-return models but by reverse engineering from the market pricing of the largest U.S. banks. This approach factored in the average return on equity and the sector's growth prospects, pegged to the risk-free rate, to infer a cost of equity reflective of the banking industry's dynamics. For Citibank, this analysis yielded a cost of equity of 11.67%, against which its projected ROE improvements were evaluated.
Despite the seemingly pessimistic assumptions, including a growth trajectory that never surpasses the cost of equity, the valuation process unveiled an intrinsic value for Citibank's equity significantly higher than its market price at the time. This discrepancy suggested an undervaluation of around 32%, offering a compelling case for investment under the principles of value investing. From here, the conventional metrics of capital expenditure and working capital adjustments give way to considerations of regulatory capital investments. By directly linking cash flows to the bank's capitalization and allowing for adjustments in the cost of equity based on capital adequacy, the model offers a flexible and adaptable framework for valuing banks. It accommodates the sector's regulatory complexities and the economic realities influencing bank performance, providing a robust tool for investors navigating the banking industry's unique valuation landscape [13].
Credit: Damodaran’s Good (Bad) Banks, Bad (Good) Investments: Investing In Banks 2023
Looking Forward
As we navigate through 2024, the banking industry presents a nuanced picture of valuation and operational dynamics. While not as undervalued as in previous periods, banks are trading at roughly 14 times earnings, a figure that sits comfortably below the S&P 500's historical average of 19 times earnings (and current 21 times earnings). The big feat for the banking sector has been the rapid escalation in the cost of funds, essentially the interest rates that banks pay to their depositors. This metric saw a significant jump from 66 basis points in the third quarter of 2022 to 244 basis points in the same period of 2023, marking a fourfold increase within a mere year. Such a swift rise strains the industry's ability to adapt, given that the sector's cost of funds typically aligns with approximately 70% of the Federal Reserve's funds rate over time. This spike reflects a correction from unusually low levels in 2022, contrary to perceptions that pressures on deposits were a direct consequence of high-profile bank failures.
Interestingly, the landscape began to shift towards the end of 2023 and into 2024, with reports of some banks starting to reduce deposit rates. This adjustment indicates a potential easing of the cost of funds pressure, setting the stage for a stabilization and possible expansion of net interest margins. With banks having issued loans at higher rates in the preceding months, the maturation of older, lower-yielding assets coupled with the recalibration of deposit costs point to a notable margin outlook to keep track of. This environment could suggest, per bullish bank investors, that EPS can uptrend, buoyed by “better-aligned” loan pricing and deposit costs. Another factor poised to influence the banking sector's valuation is the treatment of AOCI, which relates to unrealized mark-to-market losses on banks' bond portfolios. These losses have historically depressed tangible book values, with some banks' tangible book values potentially understated by 20 to 30% due to these accounting treatments. However, with interest rates declining recently, the anticipated reduction in AOCI losses could lead to a significant reassessment of banks' tangible book values in the coming future, which could surprise the market with stronger-than-expected balance sheets if fulfilled.
As 2024 unfolds, the banking sector is primed for several pivotal shifts. The anticipated expansion of net interest margins, coupled with the recalibration of tangible book values following the contraction of AOCI losses, presents an interesting outlook for confident investors in the community. These developments, combined with the sector's relative undervaluation, position banks as potential candidates especially for value-oriented investors [1].
Sources: [1], [2], [3], [4], [5], [6], [7], [8], [9], [10], [11], [12], [13]
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