Key Topics

Ch. 6
Measuring and Evaluating the Performance of Banks and Their Principal Competitors
1

Stock values Profitability ratios The Du Pont Identity Measuring credit, liquidity, and other risks

Stakeholders of bank performance

Stockholders Bank management Regulators Depositors Business community
3

External performance
Market value
Is the bank maximizing shareholder wealth? Meeting its business goals relative to competitors in the region? Assets, deposits, loans, financial services?

Regulatory compliance
Is the bank complying with federal and state regulations dealing with capital adequacy, riskiness of assets, security laws, etc?

Public confidence
Does the public perceive the bank to be safe?
4

Shareholders Wealth: Value of stock

Present value of future cash flows Determinants of stock price: Size of cash flows Timing of cash flows Riskiness of cash flows
Vo = CF1
(1 + r)1

Value of stock

E(Dt) P0 = t t =1 (1 + r)
(1 + r)n
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+ CF2
(1 + r)2

+ CF3
(1 + r)3

+ + CFn

Value of stock
V
0

Value of Banks Stock if Earnings Growth is Constant

D1 P1 + (1 + r ) 1 (1 + r ) 1

P1 =

D2 P2 + (1 + r ) 2 (1 + r ) 2

P0 =

P2 =

D3 P3 + (1 + r ) 3 (1 + r )3

D1 r -g
8

V0 =

D1 D2 D3 D4 Pn + + + + ... + (1 + r )1 (1 + r ) 2 (1 + r )3 (1 + r ) 4 (1 + r ) n
7

Value of stock
Vo = $20 (1.12)1 + $20 + $20 + $20 + $20 + $100 = $128.7 (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5

Value of stock
Changes in value due to
Changes dividends Changes in discount rate -- bank risk and market interest rate changes

V0 =

D1 $20 = = $166.67 r g .12 0

V0 =

D1 $18 = = $150.00 r g .12 0

V0 =

D1 $20 = = $200.00 r g .12 .02

V0 =

D1 $20 = = $142.86 r g .14 0

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Valuation using P/E ratio

P/E = price per share earnings per share

Valuation using P/E ratio

Expected P/E: 20, 22, 24 Earnings per share: $4.50

Forward looking price per share, based on future expected growth and earnings. Backward looking earnings based on historical data.
11

Estimated price:
$4.50 x 20 = $90 $4.50 x 22 = $99 $4.50 x 24 = $108

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Key Profitability Ratios in Banking

Return on Equity Capital (ROE) = Net Income Total Equity Capital

Key Profitability Ratios in Banking (cont.)

Total Operating Revenues Total Operating Expenses Net Bank Operating Margin = Total Assets
Earnings Per Share (EPS) = Net Income After Taxes Common Equity Shares Outstandin g
__ Total Interest Expense Total Interest Bearing Liability

Return on Assets (ROA) =

Net Income Total Assets

Net Interest Income Net Interest Margin = Total Assets Net Noninterest Income Net Noninterest Margin = Total Assets
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Total Interest Income Earnings Spread = Total Earning Assets

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Profitability ratios: ROE

Net Income $2,520 ROE 2007 = = = .178 = 17.8% Total Equity Capital $14,128

Profitability ratios: ROA

ROA2007 = Net Income $2,520 = = .0122 = 1.22% Total Assets $205,973

Net Income $2,492 ROE 2006 = = = .186 = 18.6% Total Equity Capital $13,408

ROA2006 =

Net Income $2,492 = = .0136 = 1.36% Total Assets $183,767

Compare to peer of 0.84%

Compare to peer of 12.4%

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margin

Profitability ratios: Net interest

Total Interest Income Total Interest Expense Average Earning Assets

Profitability ratios: Net noninterest margin

Net NoninterestM argin2007 = NoninterestIncome NoninterestExpense Average Earning Assets $571 $3,624 = $187472 , = 1.63%

Net Interest M arg in2007 =

Total Interest Income Total Interest Expense = Total Securities + Net Loans and Leases $17,915 $10,021 $97,371 + $90,101 $7,894 = $187,472 = 4.21% =

Net Interest M arg in 2006 =

Peer comparison: 3.90%

$ 18 , 001 $ 10 , 200 $ 81 ,964 + $ 81 ,857 $ 7 ,801 = $ 163 ,821 = 4 . 76 %

Net Non int erest M arg in 2006 =

$ 577 $ 3,876 $ 163 ,821 = 2 . 01 %

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Profitability analysis
Return on equity (ROE) can be decomposed as follows:
ROE = Net income Total Assets Total Assets Total Equity Capital

Profitability analysis
ROE2007 =

Net income Total Assets Total Assets Total Equity Capital $2,520 $205,973 = $205,973 $14,128 = 1.22346% 14.5791 = 17.84%
ROE $ 2 , 492 $ 183 , 767 $ 183 , 767 $ 13 , 408 = 1 . 3561 % 13 . 7058 = 18 . 59 % =
20

= ROA Equity Multiplier

Profitability (or the lack thereof!) thus has two parts: Managerial efficiency Financial leverage
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2006

Peer comparison: ROE= 12.4%= .84% x 14.8

Profitability analysis
The lower a banks ROA, the higher it must push its leverage to achieve a target ROE. Higher risk; higher return. Leverage: Equity Multiplier 10:1 15:1 20:1 ROA 0.5% 5.0% 7.5% 10.0% 1.0% 10.0% 15.0% 20.0% 1.5% 15.0% 22.5% 30.0%
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Breaking Down ROE Summary

ROE = Net Income/ Total Equity Capital

x
ROA = Net Income/Total Assets Equity Multiplier = Total Assets/Equity Capital

x
Net Profit Margin = Asset Utilization = Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
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ROE Depends On:

Equity Multiplier
Leverage or Financing Policies

Components of ROE for All Insured U.S. Banks (1996-2005)

Year 2005 2004 2003 2002 2000 1998 ROE 12.68 13.27 15.04 14.11 13.53 13.51 = = = = = = = NPM 18.89 19.81 19.86 17.10 12.02 12.73 X X X X X X X AU 6.93 6.51 6.95 7.60 9.48 9.11 X X X X X X X EM 9.63 9.72 10.93 10.87 11.78 11.74

Net Profit Margin

Effectiveness of Expense Management

Asset Utilization
Portfolio Management Policies
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Profitability analysis: The Du Pont Identity

Return on equity (ROE) can be decomposed as follows:
ROE = Net income / Total equity = Profit margin x Total asset turnover x Equity multiplier
ROE = Net income Operating Re venue Total Assets Operating Re venue Total Assets Total Equity Capital

Profitability Analysis: The Du Pont Identity

ROE2007 = Net income Operating Re venue Total Assets Operating Re venue Total Assets Total Equity $2,520 $18,486 $205,973 = $17,915 + $571 $205,973 $14,128 = 13.63% 8.97% 14.58 = 17.84%

Profitability (or the lack thereof!) thus has three parts: Operating efficiency (keep expenses under control) Asset use efficiency (portfolio mgt policies, mix & yield) Financial leverage (sources chosen to fund bank)
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ROE 2006 =

Peer comparison: ROE= 12.4%= 8.4% x 10.0% x 14.8

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$ 2, 492 $ 18 ,578 $ 183 ,767 $ 18 ,001 + $ 577 $ 183 ,767 $ 13, 408 = 13 .41 % 10 .11 % 13 .71 = 18 .59 %

Profitability Analysis

Trends in ROE
14.5% 14.0% 13.5%

Leverage
Usually largest contributor to ROE 15x for smaller banks 20x for larger banks Under managements control
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13.0% 12.5% 12.0% 11.5% 11.0% 1992 1994 1996 1998 2000 2002 2004
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All FDIC-insured institutions

Trends in Components of ROE

ROE =
20 18 16 14 12 10 8 6 4 2 0 1992 1994 1996 1998 2000 2002 Leverage
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A Variation on ROE
Net Income Pre-Tax Net Operating Income Pre-Tax Net Operating Income Total Operating Revenue

Total Operating Revenue Total Assets Total Assets Total Equity Capital

2004

Profit margin

Asset usage

ROE = Tax Management Efficiency Expense Control Efficiency Asset Management Efficiency Funds Management Efficiency
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All FDIC-insured institutions

Profitability Analysis Variation ROE

Pr etax Net Operating Re venue Total Operating Re venue Total Assets Net income ROE = Pr etax Net Operating Re venue Total Operating Re venue Total Assets Total Equity = tax mgt efficiency exp ense control efficiency asset mgt efficiency leverage

Breakdown of ROA
ROA = Net Interest Income Net Noninterest Income + Total Assets Total Assets PLL-Security Gain(Losses)+Taxes-Extraordinary Gains Total Assets

ROE

2007

$ 2 , 520 $ 4 , 748 $ 18 , 486 $ 205 , 973 $ 4 , 748 $ 18 , 486 $ 205 , 973 $ 14 ,128 = 53 . 08 % 25 . 68 % 8 . 97 % 14 . 58 = 17 . 84 % =

ROE

2006

$ 2 , 492 $ 4 , 625 $ 18 , 578 $ 183 , 767 = $ 4 , 625 $ 18 , 578 $ 183 , 767 $ 13 , 408 = 53 . 88 % 24 . 90 % 10 . 11 % 13 . 71 = 18 . 59 %
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ROA = Net Interest Margin + Net Noninterest Margin + Special Transactions Affecting Net Income
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Operating efficiency ratios

Measure of expense control Wages and salaries are largest non-interest expense

Profitability Analysis
Superior profitability is due to
Careful use of financial leverage Careful use of operating leverage Careful control of operating expenses Careful management of asset portfolio to meet liquidity and return needs Careful control of exposure to risk to maintain profitability and equity capital.
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wage ratio =

wages and salaries total expenses

Fixed operating expenses

fixed cost ratio =

fixed occupancy costs total expenses

Which bank earnings matter?

Earnings before securities gains and losses -fundamental deposit taking and lending activities of banks. Securities gains and losses -- More transitory and volatile than other components of earnings. Barth, Beaver, and Wolfson
Stock prices positively related to operating earnings and negatively related to securities gains/losses. Market views securities gains/losses as attempt by management to smooth earnings
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Bank Risks
Credit Risk Liquidity Risk Market Risk Interest Rate Risk Operational Risk Legal and Compliance Risk Reputation Risk Strategic Risk Capital Risk
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Credit risk
Probability that an asset will decline in value
nonperforming assets Total loans and leases Nonperforming ratio =

Credit Risk

Nonperform ing ratio =

nonperform ing assets Equity capital

Non-performing assets include nonaccrual loans, restructured loans, and other real-estate owned They are a leading indicator of poor bank performance
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The Probability that Some of the Financial Firms Assets Will Decline in Value and Perhaps Become Worthless
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Credit Risk Measures

Nonperforming Loans/Total Loans Net Charge-Offs/Total Loans Provision for Loan Losses/Total Loans Provision for Loan Losses/Equity Capital Allowance for Loan Losses/Total Loans Allowance for Loan Losses/Equity Capital Nonperforming Loans/Equity Capital
39

Credit risk
Loss ratio = Net chargeoffs on loans Total loans and leases Gross chargeoffs recoveries = Total loans and leases

Charge-offs are a lagging indicator of bank performance

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Credit Risk
Provision for loan loss ratio 2007 = Provision for loan loss Gross loans and leases $1,294 = $93,196 = 1.388%

Credit Risk
Provision for loan loss ratio 2007 = Provision for loan loss Equity capital $1,294 = $14,128 = 9.16%

Provision for loan loss ratio 2006 =

Provision for loan loss Gross loans and leases $3,208 = $84,675 = 3.789%

Provision for loan loss ratio 2006 =

Provision for loan loss Equity capital $3,208 = $13,408 = 23.9%

Peer comparison: 1.18%

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Credit risk
Reserve ratio 2007 Reserves for loan losses = Total loans and leases $3,006 $93,196 = 3.23% =

Credit Risk
Loan and lease ratio 2007 = = Net loans and leases Total assets $90,101 $205,973 = 43.74%

Reserve ratio

2006

$ 2 ,356 $ 81 ,857 = 2 . 88 % =
43

Loan and lease ratio 2006 =

Net loans and leases Total assets $81,857 = $167,258 Peer comparison: 48.70% = 48.94%

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Liquidity Risk
Probability the Financial Firm Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs

Liquidity Risk Measures

Purchased Funds/Total Assets Net Loans/Total Assets Cash and Due from Banks/Total Assets Cash and Government Securities/Total Assets
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Liquidity ratios
temporary investments ratio = = liquid assets total assets Fed funds sold + short term securities * +due from bank total assets $10,500 + $11,871 + $9,039 = $205,973 $31,410 = $205,973 = 15.25%

Liquidity risk
Trend toward less liquidity Liability mgt replacing asset mgt resulting in:
Higher rates of return because more assets have greater maturity Lower holdings of U.S. Treasury securities Higher credit risk
48

Volatile liability dependency ratio = =

* Not broken out in financial statements total volatile liabilities - temporary investments
net loans and leases & long term leases $83,009 $31,410 $142,101 = 36.31%

Peer comparison: 43.50%

47

Market Risk
Probability of the Market Value of the Financial Firms Investment Portfolio Declining in Value Due to a Change in Interest Rates

Market risk
Uncertainty associated with changing market prices or rates
Price risk
Value of bond portfolios and equity capital most at risk with fast changes in market values of bonds

Interest rate risk

Impact on profit due to changes in interest rates
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Market Risk Measures

Price risk
Book to Market = Book value of assets Market value of assets

Book-Value of Assets/ Market Value of Assets Book-Value of Equity/ Market Value of Equity Book-Value of Bonds/Market Value of Bonds Market Value of Preferred Stock and Common Stock
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Book to Market =

Book value of equity Market value of equity

Market to book =

Market value of bonds Book value of bonds

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Interest Rate Risk

Interest Rate Risk Measures

The Danger that Shifting Interest Rates May Adversely Affect a Banks Net Income, the Value of its Assets or Equity
53

Interest Sensitive Assets/Interest Sensitive Liabilities Uninsured Deposits/Total Deposits

54

Interest rate risk

Dollar gap ratio = Interest rate sensitive assets - Interest rate sensitive liabilities Total assets

Operational Risk
Uncertainty Regarding a Financial Firms Earnings Due to Failures in Computer Systems, Errors, Misconduct by Employees, Floods, Lightening Strikes and Similar Events or Risk of Loss Due to Unexpected Operating Expenses
56

Interest rate-sensitive means short-term with maturities of less than one year (or repriced in less than one year). Liabilities > assets, then bank at higher risk with rising rates Assets > liabilities, then bank at higher risk with falling rates 55

Operational risk
Risk due to failing computer systems, errors, misconduct by employees, floods, tornadoes, lightning strikes

Legal and compliance risk

Legal risk legal system creates adverse outcomes, e.g., unenforceable contracts, adverse lawsuit judgments Compliance risk violations to the rules and regulations, e.g., insufficient capital
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Legal and Compliance Risk

Risk of Earnings Resulting from Actions Taken by the Legal System. This can Include Unenforceable Contracts, Lawsuits or Adverse Judgments. Compliance Risk Includes Violations of Rules and Regulations
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Reputation risk
Uncertainty due to public opinion as it pertains to confidence of customers and creditors

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Reputation Risk

Strategic risk
Variation in earnings due to poor business decisions, improper implementation of decisions, lack of responsiveness to industry changes or public expectations.

This is Risk Due to Negative Publicity that can Dissuade Customers from Using the Services of the Financial Firm. It is the Risk Associated with Public Opinion.

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Capital risk
Impact of all the previous risks affects capital and the banks survival chances

Capital Risk
Probability of the Value of the Banks Assets Declining Below the Level of its Total Liabilities. The Probability of the Banks Long Run Survival
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Capital risk
Spread between market yields on debt and on government securities of same maturity P/E ratio Equity to total assets Purchases funds to total liabilities Equity capital to risk assets
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Capital Risk Measures

Stock Price/Earnings Per Share Equity Capital/Total Assets Purchased Funds/Total Liabilities Equity Capital/Risk Assets
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Other Goals in Banking

Operating Efficiency Ratio = Total Operating Expenses Total Operating Revenues

UBPR
The Uniform Bank Performance Report Provided by U.S. Federal Regulators so that Analysts Can Compare the Performance of One Bank Against Another
68

Employee Productivity Ratio =

Net Operating Income Number of Full Time-Equivalent Employees

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