Investors and analysts measure the performance of bank holding companies by comparing return on equity (ROE) against the cost of equity capital (COE). If ROE is higher than COE, management is creating value. If ROE is less than COE, management is destroying value. Bank value is determined by comparing its stock price to its book value, and then, compared to the spread between ROE and COE.
The wider the spread between ROE and COE, the higher the valuation of price compared to book value. For example, the value of increasing a positive spread (ROE less COE) by 100 basis points adds an estimated 12.5 basis points to the market capitalization to equity ratio.
Some argue this method is flawed because of the various ways ROE and COE can be calculated. As an example, banks generally believe returns should be measured on tangible equity, excluding goodwill, and other intangible assets. This exclusion generates a higher tangible ROE, but lower tangible book value. It also distorts the spread between ROE and IDCFP's COE.
Our Approach to Measuring Cost of Equity
Some analysts use a standard of 10 percent COE when measuring the cost of capital. IDC Financial Publishing, however, uses the long-term U.S. Treasury yield plus one-half of that yield, adjusted for bank specific risk.
The high correlation of market capitalization/book common equity compared to IDCFP's spread of ROE less COE for large bank holding companies demonstrates how price-to-book value can be calculated accurately both at a static point in time and how changes in the ROE-to-COE spread creates dynamic changes in bank valuations over time.
Latest Bank Valuations
Valuations for select large bank holding companies as of Nov. 18, 2019:
On Sept. 30, 2019, the long bond U.S. Treasury yield was 2.1 percent and the average COE for all large bank holding companies was 4.44 percent, with COE ranging from 3.51 percent for PNC Financial Services (PNC) to 6.15 percent for Bank of America Corp (BAC). As seen in the chart above, there is a high correlation between market capitalization/tangible book common equity compared to IDCFP's spread of ROE less COE for large bank holding companies. This correlation demonstrates how COE, when defined by long-term U.S. Treasury yields and bank-specific risk, best determines cost of equity capital, and therefore the value correlation or valuation line.
The inverted yield curve in 2019 caused bank stocks to sell at a discount to normal valuation. As illustrated in the chart below, most large banks on Aug. 16, 2019 sold at a discount to the normal valuation line. The Federal Reserve corrected its 2018 rate hike errors, which peaked at 2.50 percent at year-end, with a series of rate reductions to the range of 1.75 percent to 1.50 percent. This provided a 1.51 percent T-Bill yield versus a 1.76 percent T-Note 10-year yield. The return to a positive yield curve created the recovery in bank stocks to normal valuations.
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John E. Rickmeier, CFA, President, email@example.com
Robin Rickmeier, Marketing Director