To close our series on community bank valuation, we focus on concepts that arise when evaluating a controlling interest in another bank, such as arises in an acquisition scenario. While the methodologies we described with respect to the valuation of minority interests in banks have some applicability, the M&A marketplace has developed a host of other techniques to evaluate the price to be paid, or received, in a bank acquisition.
In the Valuing Minority Interests segment of this series, we discussed that valuation is a function of three variables: a financial metric, risk, and growth. From a buyer’s standpoint, the ultimate goal of a transaction, of course, is to enhance shareholder value, which would occur if the target entity can, on balance, enhance (or at least not detract from) the buyer’s financial metrics, risk, and growth. This can be achieved in several ways:
- The direct earnings contribution of the target, or the accretion to the buyer’s earnings per share if the consideration consists of the buyer’s stock. In a bank M&A scenario, this accretion often derives from cost savings resulting from eliminating duplicative branches, back office functions, and the like.
- An acquisition can provide diversification benefits, such as different types of loans, additional geographic markets, or new funding sources. If these characteristics of the target reduce any concentrations held by the buyer, the acquirer’s overall risk may lessen. However, numerous buyers have regretted entering lines of business or new markets via acquisition with which the buyer’s management team lacked the requisite familiarity.
- Accessing new markets or lines or business lines through acquisition gives the buyer more “looks” at new customers and transactions. For many banks, moving the needle on asset size or growth means looking outwardly beyond its existing markets or products, and the needle moves faster with an acquisition strategy versus a de novo market expansion strategy.
- Credit surprises. One or two unexpected losses usually do not affect the underlying rationale for a transaction, although it may create some uncomfortable conversations with investors regarding the buyer’s due diligence process. A more significant risk is that the buyer’s risk tolerance differs from the seller’s approach, leading to a potentially significant disruption to future revenues as risk appetites are synchronized. However, credit surprises often cannot be detached from the prevailing economic environment. In a post mortem, many transactions closed in the 2006 time frame look ill-advised given the subsequent financial crisis. Ultimately, factors outside the buyer’s control may have the most impact on post-transaction credit surprises.
- Cultural incompatibility. While sometimes difficult to detect from the outside, differences small and large between the cultures of the buyer and target can jeopardize the anticipated post-merger benefits. More often than not, this is manifest in personnel issues. Mergers are like chum in the water to competitors; buyers can expect competitors to look for any opening to attract personnel from the target bank.
Similarities to Valuations of Minority Interests
The previous installment of this series introduced the comparable company and discounted cash flow methods to bank valuations. Both of these methods remain relevant in assessing a controlling interest in a bank, meaning an interest of sufficient size to dictate the direction of the bank. Most often, controlling interest valuations arise in the context of an acquisition.
Comparable Transactions Method
In a controlling interest valuation, the comparable company method can be used. However, the resulting values often would be adjusted by a “control premium”, which is measured by reference to the value of historical M&A transactions relative to a publicly-traded seller’s pre-deal announcement stock price. This approach has the advantage of synchronizing the controlling interest valuation to current market conditions, which can be a drawback of the comparable transactions approach.
More often, though, the comparable company method morphs into the comparable transactions method in an M&A setting. Comparable M&A transactions can be identified by reference to geography, asset size, performance, time period, and the like. Ideally, the transactions would be announced close in proximity to the date of the analysis; however, narrowly defining the financial or geographic criteria may mean accepting transactions announced over a longer time period. The computation of pricing multiples, such as price/earnings or price/tangible book value, is facilitated by the widespread data availability regarding targets and the straightforward deal structures that usually allow analysts to identify the consideration paid to the sellers. That is, contingent consideration, like earn-outs, is rare. However, deal values are not always publicly reported for transactions involving privately-held institutions.
While the comparable transactions approach is intuitive – by measuring what another buyer paid for another entity in an industry with thousands of relatively homogeneous participants – the most significant limitation of the comparable transactions method is created by market volatility. Buyers’ ability to pay is correlated with their stock prices, and most bank M&A transactions include a stock component. Deals struck at a certain price when bank stocks traded at 16x earnings would not occur at that same price if bank stocks trade at 12x earnings without crushing dilution to the buyer. Thus, prices observed in bank M&A transactions need to be viewed in light of the market environment existing at the time of the transaction announcement data relative to the valuation date.
Discounted Cash Flow Method
We introduced the discounted cash flow method as a forward-looking approach to valuation reliant upon a projection of future performance. In an M&A scenario, buyers usually start with the target’s stand-alone forecast, unaffected by the merger. Acquirers then add layers to the forecast reflecting the impact of the transaction, such as:
- Expense savings. In a mature industry, realization of cost savings typically is a significant contributor to the transaction economics, with buyers often announcing cost savings equal to 30% to 40% of the target’s operating expenses. These are derived primarily from eliminating duplicative branches, back office functions, and the like. As the expense savings estimates increase, there often is a rising risk of customer attrition, with cuts going beyond the back office into activities more noticeable to customers, like branch hours or staffing.
- Revenue enhancements. Buyers may expect some revenue enhancements to occur from the transaction, such as if the buyer has a more expansive product suite than the target or a higher legal lending limit. However, buyers often loathe to include these in transaction modeling, and revenue enhancements are seldom reported as a driver of the EPS accretion expected from a transaction.
- Accounting adjustments. While fair value marks on assets acquired and liabilities assumed should not drive the economics of a transaction, they can affect the near-term earnings generated by the pro forma entity. Therefore, buyers usually are keenly aware of the accounting implications of a transaction.
Additional Considerations
While the comparable transactions and discounted cash flow models crossover – no pun intended with another valuation approach we describe below – from a minority interest valuation environment, several valuation techniques are unique to M&A scenarios.
Tangible Book Value Earn-Back
After the financial crisis, investors became focused on the tangible book value per share earn-back period, sometimes to the point of seemingly ignoring other valuation metrics. There are several ways to compute this, but the most common is the “crossover” method. This requires two forecasts:
- The buyer’s tangible book value per share, absent the acquisition
- The buyer’s pro forma tangible book value per share with the target
- The price/earnings or price/tangible book value multiples of the buyer’s stock relative to the multiples implied by the transaction value
- The extent of the merger cost synergies
Earnings per Share Accretion
As for the tangible book value per share earn-back period analysis, an EPS accretion analysis requires that the buyer forecast its EPS with and without the acquired entity. EPS accretion simply is the change in EPS resulting from the transaction. The attraction of this analysis lies in the correlation between EPS and value. For a buyer trading at 12x earnings, a deal that is $0.10 accretive to EPS should enhance shareholder value by $1.20 per share, holding other factors constant.
But how much accretion is appropriate? Should a deal be 1% accretive to be a “good” deal, or 10% accretive? It is difficult to answer this question in isolation. This is especially true for a deal comprised largely of cash, where the buyer is forgoing the use of its capital for shareholder dividends or share repurchases in favor of an M&A transaction. Recent deal announcements often indicate EPS accretion in the mid to high single digits with fully phased-in expense savings.
Contribution Analysis
A contribution analysis is most useful in transactions involving primarily stock consideration. It compares the buyer and seller’s ownership of the pro forma company with their relative contribution of earnings, loans, deposits, tangible equity, etc. In a merger of equals transaction, where the two merger parties are roughly similar in size, this type of analysis is important in setting the final ownership percentages of the two banks.
Conclusion
A valuation of a controlling interest may take many forms; fortunately, the strengths of certain valuation methods described here offset the weaknesses of others (and vice versa). Value ultimately is a range concept, meaning that there seldom is a single value at which a deal fails to make economic sense. There are good deals, reasonable deals, and dumb deals. Evaluating a number of valuation indications puts a buyer in the best position to slot a transaction into one of these three categories and to negotiate a deal that accomplishes its objective of enhancing financial performance, controlling risk, and developing new growth opportunities. It is crucial to remember, though, that deals are tougher to execute in reality than in a spreadsheet.
This concludes our multi-part series examining the analysis and valuation of financial institutions. While approximately 5,000 banks exist, the industry is not monolithic. Instead, significant differences exist in financial performance, risk appetite, and growth trajectory. No valuation is complete without understanding the common issues faced by all banks – such as the interest rate environment or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.
