Publications & Resources

October/November 2007
Focus: Directors Issues

What Do Bank Investors and Buyers Look For During A Down Market?

By Monte Giese and Tom Hayes

Historical Bank Stock Performance

Bank stocks saw an unprecedented increase from the second quarter of 2000 until the end of 2006. The NASDAQ Bank Index was up 128% over the time frame, versus an increase of 19.3% for the Dow Jones Industrial Average and a decrease of 2.5% for the S&P 500. What is even more impressive is NASDAQ and NYSE publicly-traded banks in the Western U.S. (Alaska, Arizona, California, Hawaii, Idaho, Nevada, New Mexico, Oregon, Utah and Washington – “Western U.S.”) outperformed the NASDAQ Bank Index, increasing by 180% on average from the second quarter of 2000 until the end of 2006.

This period of relative prosperity for banks was preceded by a significant underperformance of banks with the NASDAQ Bank Index down 28.1% from the beginning of 1998 until the second quarter of 2000. The late 1990’s downturn compares to the recent downturn in bank stocks in which the NASDAQ Bank Index was down 11.8% from the beginning of 2007, while the S&P 500 and NASDAQ Composite Index were up 4.0% and 7.5%, respectively.

While it is tough for bank stocks to buck the trend of the entire industry (only 24% of bank stocks increased in value from 1998 to 2000), it is possible for banks to outperform their peers in this most recent downturn. It is important to look back at the characteristics of the banks who delivered the best relative performance during the last market downturn. We will examine the performance of publicly-traded banks in the Western U.S. during the bank stock downturn to see if we can isolate what measures investors looked for in high performing banks.

Publicly-Traded Banks in the Last Downturn

In our analysis, we attempted to identify what measures resulted in premium valuations for certain banks during the last downturn. We looked at an eleven year period: a few years before the last downturn (1996-1997), the downturn (1998-1999), and the period between the last downturn and the most recent downturn (2000-2006).

The most important factor that drives stock price performance is a bank’s earnings performance. The data in the above tables shows that investors, all things being equal, are willing to pay premium multiples for banks with higher return’s on assets and return’s on equity.

While the above metrics are clearly important to investors, it is evident that they did not have a major influence on bank valuation multiples during the last market downturn.

Bank Merger and Acquisitions in the Last Downturn

We also examined bank merger and acquisition multiples paid during the last downturn. We looked at an eleven year period: a few years before the last downturn (1996-1998), the downturn (1999-2001), and the period between the last downturn and the most recent downturn (2002-2006). The bank M&A multiple downturn lags the downturn in the trading multiples by approximately 12 months and the downward trend lasts approximately 24 months longer than the trading multiple decline.

We again ranked the banks into quartiles based on average price-to-book multiples paid over the time frames. Table 4 summarizes the quartile rankings of the banks over the three time periods.

One point about the data above is 48% of the transactions in the 1996-1998 time frame were done using pooling accounting, which went away after June 30, 2001, while only 36% of the deals in the 1999-2001 time period were done using the pooling method. The pooling method of accounting allowed for higher purchase prices to be paid without the addition of goodwill to the buyer’s balance sheet.

Again, the most important factor that drives acquisition multiples is a bank’s earnings performance. Buyers are willing to pay more for higher performing institutions. While the above metrics are clearly important to bank buyers, it is evident that they did not have a major influence on multiples paid during the last downturn in bank M&A multiples.

Conclusion

It appears that both bank investors and banks themselves look for the same attributes in high performance banks. We will not know how long this current bank stock downturn will last, but there are several things bank directors can focus on to maximize value whether it is in the value of the stock in trading minority positions or in selling the entire institution, including:

Earnings are the single most important factor in determining value
Net interest margin and efficiency are very important in driving strong earnings
Growing the balance sheet by itself does not create value if it does not lead to growth in earnings
Core, low-cost deposits are more important than ever in adding to a bank’s franchise value
Asset quality, which has been at historically high levels, will become more important as we return to historical averages
The longer the downturn in bank stocks last, banks need to have a plan for the excess equity that accumulates which can include:
Cash dividends
Stock buybacks
Acquisitions

Monte Giese is a managing director and Tom Hayes is a vice president in D.A. Davidson & Co.'s Financial Institutions Group investment banking practice located in Great Falls, Montana. They can be reached at 406-791-7421, or via email at mgiese@dadco.com or thayes@dadco.com.