Three Drivers of Bank Enterprise Value: Cash Flow, Risk, and Growth

Kelly Coughlin: Good morning, everybody. I’m excited for our podcast today. This is Kelly Coughlin, CEO of BankBosun. This is the second in a series of five podcasts that cover bank valuation, and enterprise value creation. At the end of the day, as CEOs and CFOs of our community banks, our fiduciary duty, is to our owners, shareholders, and all stakeholders. The best way to demonstrate that duty, in my mind, is to create value for our enterprise.

Now, certainly, the obvious way to create value is to increase revenues, profits, and free cash flow. Having a discussion on that, in my mind, is kind of disingenuous. Of course that creates value. On another podcast series, we’ll talk about tactical ecosystem marketing, where we’ll discuss some new strategies to help you cost-effectively increase relationships and customers, and revenues and profits.

Today, we’re going to talk to a bank valuation expert, Jay Wilson. He’s a Chartered Financial Analyst, at Mercer Capital’s Depository Institutions practice. Jay is involved in the valuation of banks, thrifts, and credit unions for multi-purposes, so, without further ado, I’m going to let Jay talk about himself and give us a brief introduction. Jay, are you there?

Jay Wilson: Thanks for having me today.

Kelly Coughlin: Jay, welcome aboard. Thanks for taking your time out. Jay, let’s start with a brief summary of your business background, education, where you live, family, kids, hobbies, and then, and then a minute or two on Mercer Capital, your employer. Does that work for you?

Jay Wilson: Jumping right in, into my educational background, I have a Economics and International Studies degrees from Rhodes College, a smaller liberal-arts school here in Memphis, which is where Mercer Capital is headquartered and I’m located. Mercer Capital is a valuation and advisory consulting firm. We have offices in Dallas, Nashville, Memphis. We do work in a variety of industries. We tend to segment our practice by industry specialization. Our largest industry concentration is financial institutions. We would define that fairly broadly.

That would include banks, insurance companies, wealth managers, broker dealers, specialty lenders, some non-bank financial companies as well. In terms of my time here, I’m focused in the financial services industry, to do some work for banks, insurance, wealth managers, as well as financial technology companies. Technology’s become an increasing part of the financial services industry, so we’ve seen some opportunities there, as well.

Kelly Coughlin: That’s terrific. Let’s get into the meat of the matter here today, on bank valuation. Jay, I thought we’d start with valuation metrics. Give us some ideas on the, let’s just say, the top five baseline metrics that you might look at in defining a bank value. Is it asset-based, deposit-based, customer-based, revenues, that sort of thing. What are the things that you kind of look at to find that value?

Jay Wilson: In terms of valuation, the three kind of key elements tend to be cash flow, risk, and growth. You can drill in on those and go to great lengths to come up with assumptions and different elements around those, around those three elements, but at the end of the day, those kind of three broad things tend to define valuation.

By its own nature, it’s more forward-looking than backward-looking, so when you’re thinking about those three elements, cash flow, risk, and growth, you’re kind of thinking about those in the future. However, to get a good estimate of those, you tend to use historical performance and how those have performed over time, to give you some idea of how those might look going forward. Like anything else, any predictions of future inputs depends on, those future assumptions depends on the quality of the input.

Finally, I think valuation is a range concept, so oftentimes in our engagements, we’ll come up with a point estimate of this little particular value for the bank or the stock, on more of a range type concept.

Kelly Coughlin: Have you seen any changes in trends over the past couple years in these baseline metrics?

Jay Wilson: You can think about return on assets, in terms of measuring the productivity of the assets deployed at the bank, or return on equity, how productively the bank may invested its capital. I think those kind of top-line metrics have certainly turned it up the last few years, coming off the depths of the financial crisis, but we haven’t seen them get back to where they were, sort of, pre financial crisis.

If you look at the 90’s and the early 2000’s for the median baseline measures for the community banks, you will find that a significant proportion of them were in the ten to fifteen percent range on return on equity. Now, you’re more in the six to ten percent range, and a significant proportion of the community bank pool is operating in that zero to ten percent, kind of, return on equity range. Although we’ve seen things improve, relative to the depths of the financial crisis, we haven’t seen the profitability metrics kind of get back to where they were, and I think there’s a couple things kind of driving that.

Certainly the interest rate environment is difficult, difficult for net interest margins. Then you’ve also got a lot of compliant, regulatory sort of operating costs, trending up across the industry. Offsetting those two trends, you have credit costs have improved, but not enough to offset the larger trends there.

Kelly Coughlin: A lot of companies today derive significant value from digital assets, like contacts, relationships, email addresses. Email addresses alone seem to derive significant value. Facebook because they’ve got connectivity with nearly every human being on the planet, they’ve got a $350 billion market cap, some say it’s going to go to a trillion. I don’t know if that’s true.

Jay Wilson: Right.

Kelly Coughlin: In the community bank market segment, do you see any value accruing to this kind of asset?

Jay Wilson: I think that’s a great question. In some ways, for the community banks, there’s a good opportunity there. They still are one of those primary figures in terms of the financial relationship or provider to a lot of their customer base. Over time, if they can leverage that relationship and effectively compete as things sort of transition to the digital format, then they may have more opportunity to provide better services, more efficiently, at lower costs, and also, offer more services.

Think about your smaller community bank, for example, in a rural location. They may have banked a particular family in the community for a long time, and have a relationship with the younger people in the family. If that person goes off to college or work in a different city, they may not be able to continue to bank that customer. While it’s difficult for the smaller banks to compete with the physical footprint of a lot of the larger banks, there may be some opportunities to compete effectively through some of the digital platforms.

Kelly Coughlin: Great. Let’s switch gears here for a minute, and talk about Net Interest Income versus Other Non-Interest Income.

Jay Wilson: Certainly.

Kelly Coughlin: Do you have any thoughts on whether a bank can fetch a higher valuation multiple if they have an increase in Other Non-Interest Income? Do you think that affects it? Certainly, the income affects valuation, but in terms of a premium, is a higher value placed on a bank that, that isn’t reliant completely upon interest and net interest?

Jay Wilson: That’s a question a lot of our clients have tasked us with from time to time, as they look at different opportunities in the non-interest income area, whether it be in a trust company, or an insurance agency, or different things like that. I would say it does depend on what type service line, or what type non-interest income they’re looking to add.

Banks that tend to have higher levels of non-interest income as a proportion of their total revenues, they do tend to have higher valuation multiples. Especially those where the source of non-interest income is something that is a recurring or consistent potential revenue stream over time. That would be in the forms of dividends, or additional earnings, or something that could be transferred to a buyer in a sales type situation.

I definitely think you’ve honed in on a key issue, and an area where there is an opportunity for a lot of banks to increase their potential valuation, and their multiple. There does seem to be some evidence of that, the publicly traded banks, banks that you look at out there.

Kelly Coughlin: Do you use the term in valuations these days?do you use the term ‘quality of earnings’ at all, anymore?

Jay Wilson: I think there are certainly some areas where people really dig in on quality of earnings (particularly in an M&A type scenario, where the buyer may want to look at something like a quality of earnings type report).

Kelly Coughlin: I guess in the banking world, it’s kind of like the quality of earnings analysis would dive into the underlying credit.

Jay Wilson: Where a bank would differ from some other industries, the balance sheet, really is the driver of a lot of the income statement. Any quality of earnings type analysis would be focused on 1) the credit condition, and how comfortable the buyer or potential investor would be with the underwriting, 2) how proactively the management team has been in sort of dealing with problem credit, 3) your assessment of risk profile in that area.

Kelly Coughlin: Let’s switch to financial technology. Banking and technology kind of intersect more and more these days. Of course, that opens up the whole cyber security risk element as well. Do you see any trends going on in the FinTech world impacting the community bank industry in the next few years?

Jay Wilson: You’ve seen an increasing number of startups in tech, whether in payment, online lending, or different solutions and offerings that can help banks with clients. I definitely think that’s a growing area where you’re going to see a lot of activity.

I think it sort of remains to be seen how that will transpire over time, in terms of whether that’s more of a disruptive threat to a lot of the banking business models, or whether banks are able to leverage some of the solution, things that people come up with in that arena.

Kelly Coughlin: Is there anything that you wanted to add, or should we hit with some of the more easy, fun stuff, like the dumbest thing you’ve ever said in your career and your favorite quote? Anything you want to add?

Jay Wilson: My favorite quote is from Bill Gates. “We always overestimate the change that will occur in the next two years, and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.” I like that quote, because I think I’ve seen that play out in my career.

Kelly Coughlin: That’s a good quote. All right. Dumbest thing you’ve done in your career. Do you have anything that comes to mind? Done or said?

Jay Wilson: Early in my career, I was more hesitant to either reach out if I had a difficult question on a valuation, or something with a client.

Kelly Coughlin: Early in your career, you’re kind of hesitant to show a weakness, or a perceived weakness, by asking a dumb question, right?

Jay Wilson: Right.

Kelly Coughlin: Then, worried that they’ll think, “Oh, God, why’d we hire this guy?” Right?

Jay Wilson: Yeah, exactly. We have had a few new hires start, and I’m trying to let them know that I can be a resource for them, and there are no dumb questions, so that hopefully they can accelerate that learning process faster than I did.

Kelly Coughlin: Yeah. One of my favorite quote is, “He who asks a question is a fool for a second. He who never asks a question, is a fool all his life.”

Jay Wilson: Yeah, that’s a good one, and I’ll have to remember that.

Kelly Coughlin: We’ve all worked with people that think they have the answers to everything, and those guys, they are the fools, aren’t they?

Jay Wilson: That’s right.

Kelly Coughlin: That’s great. Jay, I appreciate your time. That’s terrific. How can bankers get ahold of you if they need to?

Jay Wilson: We have a lot of resources on our website, We actually put out quite a bit of content. We have a bank watch publication that covers trends in the banking sector, valuation trends for the public banks, as well as for the private banks in the form of M&A transaction announcements. If you want to get signed up for that, they can just email me, You can all find my contact information, or feel free to give me a call, 901-685-2120.

Kelly Coughlin: Jay, thanks for your time. We appreciate it, and we’ll be in touch, okay?

Jay Wilson: Thanks as well, Kelly. Enjoyed it. Have a good day.