Monday, December 2, 2013

An Inch by Any Other Name Is Still 25 Millimeters

Banks post the 2008 financial crisis, have been priced primarily upon a book or tangible book basis instead of the pre crisis earnings basis Metrics. This was largely due to a lack of earnings and uncertainty over asset quality. A common pricing metric used is P/B (price-to-book) =ROE-growth (g)/Ke (cost of equity)-g.

Asset quality and earnings issues have been largely resolved as banks have recovered. Thus, Price-Earnings (P/E) ratios have returned. Some mistakenly believe that using P/Es will lead to higher M&A  pricing than P/B ratios. Higher pricing may occur, but not because of a switch in pricing metrics. The higher pricing reflects improved fundamentals.

A bank is worth what someone will pay for it. What someone will pay for it is driven by the underlying fundamentals-how much cash is produced, for what period of time and how sure we are about our estimates. The different metrics-P/E and P/B must be equivalent just like an inch must be 25mm (rounding error excepted). Consider:

1)     P/B= ROE-g/Ke-g
2)     P/E=P/B divided by ROE

Thus, for a bank with a 12% ROE, 2% growth and 10% Ke the P/B is 1.25X and its P/E is 1.25/12% is 10.4X. An improving bank with a 15% ROE, 3% growth and 10Ke will generate a P/B of 1.7X and a P/E of 11.3X.Of course there can be divergences of opinion regarding future operating performance especially concerning expected synergies. Nonetheless, large differences need to be reconciled against more detailed discounted cash flow analysis.

For me, the biggest issues in bank M&A pricing is not P/B or P/E, but rather the premium over the pre-bid target trading price. Premiums less than 20% have a much greater chance of adding value for the buyer’s shareholders than those exceeding 40%. If you over pay relative to the cash flow acquired, regardless if expressed in P/E or P/B terms, your shareholders lose.

Ralph and I are on our way to Amsterdam to hold our annual acquisition financing class. Thus, posts next week may be suspended. I always learn something new from the interchange with the attendees, and will share those insights with you.

I hope everyone had a great Thanksgiving Day holiday. As usual, I over ate and watched too much football.


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