Never Ignore Your Bank\'s Cost of Equity

A m ba s s a d o r F inancia l G ro u p, inc .

AMBASSADOR ALERT • 2011 • 2nd Quarter

Never Ignore Your Bank’s Cost of Equity Today’s bank managers face a very challenging environment given the sluggish economic recovery, very low interest rates and loan demand, and the need to increase regulatory capital. Increasing regulatory capital primarily means increasing the ratio of equity capital to risk-based assets. There are three ways to increase equity capital relative to assets: (1) boost the level of earnings retention by raising the retention rate or increasing income, (2) issue new shares, or (3) reduce assets. That makes the subject of this paper—the cost of equity—very relevant for all bankers who are committed to building value for their shareholders while maintaining or increasing their equity capital to satisfy regulatory requirements. The cost of equity becomes the benchmark to be considered if you want to issue new shares or increase your share price relative to its book value. Finance theory shows us that in order to achieve incremental increases in the firm’s stock price it must produce a return that exceeds the required or expected return based on its market risk. Given that $100 invested in January, 2006 in the NASDAQ bank index is still worth less than $70 with dividends reinvested, the challenge for bank management is readily apparent. Many community bank stocks still sell for half their share price in 2006. Many of these banks also added TARP preferred equity to shore up their capital at the end of 2008 and will want to replace that equity by 2013 when the dividend increases from 5% to 9%. To do that, they will need to increase profits to increase retained earnings or issue new shares of common stock at favorable multiples to its book value to replace TARP preferred equity. However, we have entered a decade with a very different economic environment than we have seen in the previous 30 years. The previous decades saw rapid economic growth, deregulation, innovation and a rapid rate of globalization, all of which led to above trend economic growth that was good for the growth of bank assets and profits. Now we are in a decade that is characterized by three big Ds—debt, deficits and demographics. The debt problem reflects that there is too much consumer debt and the crash of the housing bubble means that many borrowers owe more than their assets. Therefore, deleveraging will be slow and painful. Deficits and demographics are interconnected. The U.S. government is running deficits that are not sustainable. The elephant in the room is entitlements which are a major part of the deficit trend line because of the demographics of the aging baby-boomers. Next year the average baby boomer will receive $40,000 in Social Security and Medicare benefits and the numbers only get bigger. Even if the 2012 election results in a creditable solution to the deficits and demographics issue, it will be a long time before economic growth is above its current trend line of 2% to 2.5% versus the 3.5% to 4.5% we knew in most of the previous 30 years. The big Ds will shape the decade and in turn influence interest rate levels, investor expectations, unemployment, and growth in profits. It is likely that this decade will result in above average unemployment (7% versus 5%, which we generally consider full employment), lower interest rates and reduced investor expectations. For example, the average U.S. Treasury yield is 2.7% versus 5.7% in the previous 20 years. That means the risk free rate normally used in cost of equity models, such as the capital asset pricing model (CAPM), will be lower. Slow growth will also result in lower expectations for equity investors. The challenge ahead for bankers may even seem like pushing a boulder uphill like the mythical character Sisyphus. Nonetheless, it is still where good management must focus its efforts in order to get out of the hole in which we seem to find ourselves.

Never Ignore Your Bank’s Cost of Equity

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Ambassad or alert • 2011 • 2nd quarter

Traditional Cost of Equity Methods Among the models frequently used to determine the cost of equity, the CAPM and dividend discount model are very commonly used for community banks. Dividend Discount Model Value of Stock = Dividend per Share / (Cost of Equity less Dividend Growth Rate) The cost of equity is derived thus: Cost of Equity = (Dividend per Share / Price per Share) plus Growth Rate For example, assume the share price is $25, the dividend is $1 and the growth rate is 4%. The Cost of Equity = ($1/$25) + 4% = 4% + 4% = 8% If a bank pays little or no dividends, which is more common in a post TARP world, then the model is not useful. Also, if the growth rate is higher than the cost of equity, it has to be modified for multi-stage periods until there is a future period when the growth rate will be less than the cost of equity. For purposes of this discussion, that adds a level of complexity that does not help bankers to focus quickly on the job at hand.

The Capital Asset Pricing Model The cost of equity using the CAPM can be used whether the bank pays a dividend or not. The model formula is: Cost of Equity = Risk Free Rate + Beta (Market Risk Premium) In this paper, the risk free rate is assumed to be the 10-year treasury yield because it corresponds to the long-term time horizon of an equity investor. The model assumes that an investor can diversify the equity portfolio to eliminate company specific risk or non-systematic risk. If an investor only owns one stock, the investor has all the eggs in one basket. As the investor adds more stocks (between 20 to 30 individual stocks) to the portfolio, the portfolio begins to perform like the broad market such as the S&P 500 index. This broad market risk we call systematic risk and the measure of a stock’s price volatility to the broad market is called its beta. The market has a beta of one and individual stocks have betas which are usually more or less than one. In a diversified portfolio, the market risk premium is the extra return the investor expects to receive from a diversified equity portfolio for its greater risk versus the risk free rate. For example, let’s assume Stock A has a beta of 1.2 and Stock B has a beta of 0.80 and that the historical market risk premium is 5% and the risk free rate is 3%. Based on the CAPM, the cost of equity is as follows: Cost of Equity = Risk Free Rate + Beta (Market Risk Premium) Stock A = 3% + 1.2 (5%) = 3% + 6% = 9% Stock B = 3% + 0.8 (5%) = 3% + 4% = 7% Now let’s adjust this for the expected environment of this decade. If interest rates continue to remain low, the risk free rate will be 3% to 3.5%. That compares to the average treasury yield of 5.7% for the last 20 years. Likewise, let’s discuss the market risk premium for equity investors. In a well developed discussion of equity risk premiums, Aswath Damodaran of NYU’s Stern School of Business notes that there are three ways to measure equity risk premiums.¹ Equity risk premiums can be based on surveys of CFOs and portfolio managers, historical average premiums based on actual equity returns, and implied equity risk premiums based on current market indices.

¹ http://aswathdamodaran.blogspot.com/2011/02/equity-risk-premiums-2011-edition.html. Never Ignore Your Bank’s Cost of Equity

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Ambassad or alert • 2011 • 2nd quarter

The average equity risk premium can be determined in several ways depending upon the time period used, arithmetic versus geometric averages, and the maturity of the risk free rate used. Based on using the geometric average for the years between 1928 and 2010 and assuming a risk free rate based on long-term yields, the average risk premium is 4.31%. Historical averages are backward looking and not forward looking. The historical average also may not reflect investor expectations based on the current environment. They are valid if one believes that over time returns revert to a mean and also the risk premium by implication. However, that means the use of the historical geometric average will at various times produce valuations which are over or undervalued depending upon actual investor expectations for return versus historical returns. We often talk about 10% as the long-term rate of equity return and 6% for bonds, but both of those rates would make little sense in the current environment. Equity risk premiums based on surveys vary between 3% and 4% depending upon who is asked. CFOs are usually lower than portfolio managers. That may reflect the different perspective of each. A CFO is really thinking about returns of his own company while the portfolio manager is probably reflecting a market outlook which influences stocks selected and the allocation to asset sectors. If we average the range based on recent surveys, we would get 3.50%. The implied equity risk premium is derived from the current market index, such as the S&P 500 Index, based on growth in earnings, long-term bond yields, and dividend yields. It is currently 4.90% versus the average implied premium since 1960 of 3.95%. The implied equity risk premium is market neutral and more forward looking than the average historical risk premium. However, because it is market neutral it does not reflect a market outlook. In the next few years, it may be best to try to shape your expectation for the cost of equity based on the expectations of value investors who will be looking for stocks that will outperform the index in a sluggish economy. That means that the equity risk premium based on surveys will be around 3.50% versus the higher historical geometric average premium since 1928 of 4.31%. Based on CAPM, a risk free rate of 3% and a market risk premium of 3.5%, the expected return of the market would be 6.50% and the cost of equity for a stock with a beta of 1.0 would also be 6.50%. If the beta is 0.80, the cost of equity is the risk free rate of 3% plus 0.80 × 3.50% or 5.80%. That may seem like a low expectation, but the times are expected to be unusual for the next few years. In terms of value creation for investors, what does this mean? Expectations drive what investors assume they will make from a specific security or portfolio. In the case of equity, there is a level of return that must be exceeded for the share price to increase. If the return is achieved, then the share price should remain the same; and if the return is less than expectations, the share price will decline. For bankers wanting to improve their regulatory capital levels, this means that returns generated by the bank’s stock must exceed the required or expected return, based on the CAPM, in order to increase the share price or make it likely that new equity can be issued at prices higher than the book value of equity. This brings us to the excess returns model (ERM) which will help bankers understand what they must do to improve their share price relative to the traditional metric of return on equity (ROE). Again, Aswath Damodaran has written an analysis of ERM in his paper “Valuing Financial Service Firms.”² In short, the value of a bank can be written as the sum of the equity invested in the bank’s current capital plus the present value of expected excess returns to shareholders. Thus, excess returns will be earned if the bank’s ROE (assume 10%) is more than its cost of equity (k) based on the capital asset pricing model (assume 6.5%).³ This concept can be summarized as a formula: Value of Equity = Equity Capital Invested Currently + Present Value of Expected Excess Earnings

The ERM formula assumes that the bank will generate returns that are consistently above the shareholder expectations in the future. The next step is to add the value of future excess returns to the bank’s current invested equity capital (generally assumed to be the same as GAAP equity) to obtain the value of the bank’s equity capital.

² Professor Damodaran’s 44-page paper may be found at the Web site: http://pages.stern.nyu.edu/~adamodar/. Click the section titled Papers and scroll to “Valuing Financial Service Firms” to download the paper. ³ In simple terms, management creates value in excess of book equity if the bank’s ROE is more than its cost of equity capital (CAPM). Never Ignore Your Bank’s Cost of Equity

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Ambassad or alert • 2011 • 2nd quarter

Present value of expected excess earnings is defined as the difference between earnings earned on invested capital (assumed to approximate GAAP equity) based on CAPM as a proxy for the expected return and the ROE as the actual return on invested capital. The critical assumption is that ROE is more than the required return found from CAPM (ke ), and therefore the difference will always be positive or generate excess returns. If not positive, the bank may still be profitable but is not earning excess returns. To bring the concepts together, the value of equity is: Value of Equity = Invested Equity Capital + the Present Value of Expected Excess Returns to Shareholders

Now a word needs to be added about invested equity capital. Banks are unusual businesses to value for two reasons: 1. The value of their assets is usually close to the book value because, unlike manufacturing firms, few of the assets are depreciated over long periods. The assets frequently change as loans and securities generate cash flows from the payment of principal and interest or are sold. Also, many of the assets can be readily marked to market value and changes in their value reflected in the equity of the bank. 2. Also, most financial institutions utilize high amounts of leverage as part of their capital strategies. Consequently, including deposits or borrowed funds in the total capital is problematic because the leverage strategy is essentially one of the key elements of the bank’s operating strategy. If we assume a bank has a beta of 0.80, we noted above the cost of equity was 5.8%. Many community banks have earned an ROE below this cost of equity in recent years. It should come as no surprise that their share prices are also less than book values. This is consistent with the negative returns for investors holding bank stock portfolios that have performed like the NASDAQ Bank Index or similar indices since 2006. Many of these banks must improve performance or they will be unable to replace their TARP preferred in 2013 when the divided yield increases to 9%. If our example bank has 75% of its equity capital in common stock with a cost of 5.80% and 25% in TARP preferred at 5%, its current cost of equity is 5.60% (0.75 × 5.80 + 0.25 × 5%) but it increases to 6.60% (0.75 × 5.80% + 0.25 × 9%) in 2013. Realistically, in order for a bank to replace that TARP preferred by 2013, it must be making an ROE of 8% or more to earn profits that will sustain a higher share price, more retained earnings, or new equity capital. Yes, there are banks that do this. One community bank in our region has earned ROEs better than 10%, has no TARP preferred, has a dividend yield of 3.25% and sells for 140% of its book value. If a bank is making an ROE below or equal to its CAPM cost of equity, then it cannot improve its share price, increase retained earnings quickly, and will only be able to issue new equity that dilutes the value of ownership interests of existing shareholders. We have seen the banking industry consolidate significantly since 1990. That process will continue in the next decade for those banks that cannot justify a reason for investors to hold their shares based on proven performance. If Canada has more than 90% of its bank deposits with five banks, then we could easily do the same with 100 banks. In 1990 the six largest banks held 9% of all deposits. Today, the six largest banks hold 36% of all bank deposits. Of the top ten banks, one is a Canadian bank.

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Ambassad or alert • 2011 • 2nd quarter

Here are some summary points to remember: • The cost of equity in the foreseeable future will be less than it has been in the past 20 years. That reflects the low level of interest rates that are likely to continue for several years because of sluggish growth and lower investor expectations. • If your bank has TARP preferred, it faces an increased cost of equity in 2013 when the dividend increases substantially from 5% to 9%. • If your bank wants to increase its share price and grow its equity capital base, it will need to earn an ROE well above its cost of equity. Based on the prevailing current cost of equity, it means that the ROE must be more than 8% or more than 2% higher than the cost of equity. • Your strategy must quickly move to achieve these targets or seriously consider merger with another bank whose shares offer a better value proposition than yours. • Finally, as part of your strategy improvement, look for those low-yielding assets that offer potential to be redeployed in higher-yielding assets to improve net interest margins and in turn the ROE. – Joseph G. Blake, CFA Financial Consultant

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