Update as of December 13, 2021
In the last five years, banking financials have improved dramatically based on IDC Financial Publishing‘s (IDC’s) NOPAT ROE rising from 12.0% in the fourth quarter of 2016 to a peak of 20.3% in the first quarter of 2021. During the same period, reported stockholders ROE increased from 12.5% to 23.2%. NOPAT ROE is expected to maintain the trend, with a forecast of 20.2% by the September quarter of 2022.
What fundamentals are driving this secular improvement in profitability?
IDC’s non-traditional approach to financial ratios, modeling, forecasting, and valuation offers a unique perspective to bank stock selection. The following information demonstrates how we are different and offers an explanation as to why and how the secular improvement is occurring in banking, driving higher price-to-tangible book valuations. By using the following unique ratios developed by IDC to forecast a bank’s appreciation potential, we demonstrate how our approach is superior to the standards of most bank analysis.
The Traditional ROE Equation and the Problem with the Bank Stock Analysis
The traditional ROE equation simply divides net income by the average of common stockholder’s tangible equity capital. The stockholder ROE, as a bottom-line measure of profitability, fails to reflect the true nature of asset value. Additionally, the traditional components of the ROE percentage – net interest margin, net income return on assets (ROA), and resulting stockholder ROE – confuse the source of net income by subtracting cost of funding too early in the analysis. Bank common stock evaluation is unable to separately compare operating and financial returns. Finally, accounting for the loan loss provision with its credit analysis risk deductions (CECL), or addition to net income from releases of reserves, and not adjusting net income for the increase on the loan loss reserve, fails to reflect the true cash flow to earnings used to value a bank stock.
The NOPAT ROE Equation and ROEA, a Measure of Operating Returns
In contrast IDC uses the NOPAT ROE equation to express ROE as a sum of two components, operating return (ROEA) and financial return (ROFL). ROEA equals the return that the bank earns on loans, securities, cash equivalents and other earning assets, after operating expenses and taxes, before the loan loss provision and interest expenses on the deposit and debt funds, but adds back the increase in the loan loss reserve. ROEA focuses on the operating strategy, which identifies returns from investments, loans, and non-interest income sources net of expenses and taxes, plus the cash flow from increases in the loan loss reserve, all as a percent of earning assets. Return on financial leverage (ROFL) measures financial returns or the level of deposits and debt required to finance earning assets not funded by tangible equity and the loan loss reserve and its after-tax cost. See our example below (Table I) that details the components of NOPAT ROE for all banks analyzed by IDC.
The key components required by IDC to value a bank are growth in tangible book value per share (TBVPS), NOPAT ROE, and cost of equity capital (COE).
Forecast growth in TBVPS is based on the recent growth rates for TBVPS, which is enhanced by increased share buy-backs. The annualized growth in average TBVPS for all 203 banks followed by IDC in the third quarter of 2021 was 4.8% and expected to increase by 10.1% over the next 12 months.
The components of NOPAT ROE are the operating returns (ROEA) plus the financial returns (ROFL). ROEA measures the operating profits after tax, excluding the loan loss provisions and funding costs, but includes the increase in the loan loss reserve to capture the true cash flow from operations. In the last five years, ROEA has improved from 1.49% from year-end 2016 to 1.68% in 2021Q3. Banks are expected to return to or exceed the favorable 2.20% earned in the last quarter of 2019, by 2023. IDC forecasts ROEA to recover to 1.97% by the third quarter of 2022.
To compute the financial return (ROFL), IDC forecasts 1) cost of adjusted debt after tax (COD), which are the funding costs divided by the earning assets, excluding tangible equity and the loan loss reserve. COD fell from 0.90% in 2019Q4 to 0.21% in 2021Q3 due to Covid and Federal Reserve policy to keep short term rates near zero. IDC forecasts banks will add 11 basis points to COD by September 2022, increasing after tax cost of debt to 0.32%.
Subtracting COD from ROEA provides 2) leverage spread, which increased from 1.11% at year-end 2016 to 1.46% in 2021, exceeding 1.30% realized in 2019Q4. The forecast for leverage spread improves again in 2022 to 1.65%, as strong operating returns exceed the increase in COD.
The most dramatic secular change in banking is 3) the leverage multiplier, which rose from
9.8-times in 2016Q4 to 12.2-times in 2021Q3. The leverage multiplier is the product of the earning assets excluding tangible equity and the loan loss reserve divided by the equity and loan loss reserve.
Return on financial leverage (ROFL) then equals the leverage spread times the leverage multiplier. In September 2022, a forecast leverage spread of 1.65% times a record high leverage multiplier of 12.20 provides a favorable forecast ROFL of 18.23%. Adding the forecast ROEA of 1.97% to the forecast ROFL of 18.23% provides a forecast NOPAT ROE 20.20%.
Bank Financial Ratios from 2012Q4
What other industry realizes a 52.2% secular increase in ROE in 5 years like banking?
An increase of double-digit growth in TBVPS coupled with a dramatic improvement in ROE to 20.2% creates accelerating EPS growth with a normal terminal p/e of 13.7-times, which offers a 53% appreciation potential for the average bank stock. The estimated target price to forecast TBVPS of 2.77 in September 2022 is a function of the forecast NOPAT ROE less the cost of equity capital (COE, estimated at 6% for September 2022) with the COE based on the forecast of 3% in long term U.S. Bond yields in 2022, plus one-half the bond yield adjusted for the specific risk of a bank. The current price to forecast TBVPS is 2.24.
Normal Valuation Line Reached Full Valuation in February 2018 and December 2019
The history of bank stock valuation, provided by appreciation potential of bank stocks from 2012 to 2021 demonstrates its accuracy. The major bull market in bank stocks began on December 12, 2012, and lasted to February 15, 2018, with the KBW Large Bank Index appreciating 130.5% over that 5-year, 2-month period, or 17.4% a year.
For the average bank stock, numbering 159 in 2012 to 190 in 2018, the average capitalization weighted 12-month appreciation potential, based on IDC’s valuation, began at 33.3%, rose to a peak of 95.52% in 2015, and ended in 2017Q4 with only a 11.1% appreciation potential, an indication of full valuation. A second valuation measure, current price to forecast TBVPS versus forecast price to forecast TBVPS (columns 11 & 12 in Table IV), provided a favorable spread from 2012 to 2017, but by year-end 2017 current price to TBVPS exceeded forecast price to TBVPS, indicating full valuation.
The current bank stock bull market began on October 29, 2020, with a 75% appreciation potential for the average bank stock. Despite an 76% appreciation in the KBW Large Bank Index from October 29, 2020 to December 2, 2021, another 52% appreciation potential in the BKX is forecast over the next 12 months. The current bull market could well offer the same or greater opportunity seen in the last bank stock bull market from 2012 to 2018.
Accuracy of Valuation Line in History
The following charts published by IDCFP in late 2017 (Chart II) and late 2019 (Chart III) highlight valuation data from the previous quarters, during periods of peaks in bank bull markets. Market capitalization to equity represented the price to tangible book value. The valuation line in history demonstrates the accuracy of this method.
See other recent articles published by IDC discussing how The German 10-year forecasts bull markets in bank stocks.
John E Rickmeier, CFA