By C. Matthew Allen

It’s been a long time since earnings models have taken a back seat to balance sheet models when valuing a banking company – but that is exactly the dynamic that is becoming prevalent. As asset quality continues to deteriorate across the broader bank spectrum, the two main questions that need to be answered to begin the process of valuing a bank are “What is true book value?” and “How strong is the core deposit franchise?”

To be certain, core deposits have always been highly sought after in an M&A context and are a good barometer of profitability in the banking sector (and thus a good measure of how banks trade relative to one another). It has generally been the earnings question, though, that gets asked first in either valuation scenario. The question of what price a particular bank trades for or was sold for was generally answered with a price-earnings multiple. The bank that sold for 25x earnings “killed it,” while the bank that traded for 10x earnings was a solid investment.

Not anymore. With the wide-spread and arguably most massive real estate re-pricing process this country has ever seen well underway, the first questions are “Are there holes in the loan portfolio?” and “How strong is the liquidity (securities portfolio) position?” and “How strong is the reserve methodology and what level of loan loss reserve is appropriate?” All of these questions drive to the point of establishing a base equity level – the true book value of the bank. Only after such balance sheet questions are asked and answered will the discussion of future earnings potential and core franchise value proceed.

Asset quality and deposit metrics are the new (perhaps “re-found” is a more apt term) kings of bank valuation, and either has much more power to drive the decision-making process in a recapitalization or acquisition process today than either has had over the past 15 years or more. Part of the reason is subjective and psychological – the word “failure” was substantially removed from the bank lexicon over this time, but it is back now. The other part of the reason is quite real – with the depths of the current cycle as yet unplumbed, the wrong investment can go to zero and the wrong acquisition can sink two banks instead of just one. And while asset quality can in today’s environment determine the overall viability of a bank, deposit strength will certainly determine the profitability of the bank as we come out of this downturn.

With M&A volumes down more than 52% year-over-year and almost 40% of publicly traded banks trading below stated book value at the time of this writing, it is clear that bank acquirers and bank investors alike are struggling with the calculus of the current environment. Which losses are real, how far down does the macroeconomic undercurrents take us, and how long before we see any stability are all valid questions that do not have solid, perfect answers now. Over the foreseeable future, however, establishing a solid valuation for the balance sheet will be the first (and sometimes the only) decision factor when making bank investment, recapitalization and acquisition choices.

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