General Notes on Valuing Banks

 Warren Buffett looks to a bank's return on assets. In an interview on CNBC back in March 2013,
he explained:
“Yes, well a bank that ... earns 1.3% or 1.4% on assets is going to end up selling above
tangible book value. If it's earning six-tenths of a percent, or five-tenths of a percent on
assets, it's not going to sell below. Book value is not key to evaluating banks. Earnings
are key to evaluating banks, and you earn on assets.
Now, it translates to book value, because it -- to some extent, because you're required
to hold a certain amount of tangible equity, compared to the assets you have. But
you've got banks like Wells Fargo and USB, that earn very high returns on assets, and
they sell at a good price to tangible book.”
 During another interview, he went on about Wells Fargo:
“They get their money cheaper than anybody else. We're the low-cost producer at Geico
in auto insurance among big companies. And when you're the low-cost producer --
whether it's copper, or in banking -- it's huge ... The key to the future of Wells is
continuing to get the money in at very low costs, selling all kinds of services to their
customer and having spreads like nobody else has.”
 “Banks are not going to earn as good a return on equity in the future as they did five years ago.
Their leverage is being restrained for good reason in many cases. So, banks earn on assets but
the ratio of assets to equity, the leverage they have determines what they earn on equity.”
 “You don't have to be a rocket scientist when your raw material cost is less than 1-1/2%.”
 Customer base – should grow QoQ
 Buffet was asked, So what is your metric for valuing a bank?
o It's earnings on assets, as long as they're being achieved in a conservative way. But you
can't say earnings on assets, because you'll get some guy who's taking all kinds of risks
and will look terrific for a while. And you can have off-balance sheet stuff that
contributes to earnings but doesn't show up in the assets denominator. So it has to be
an intelligent view of the quality of the earnings on assets as well as the quantity of the
earnings on assets. But if you're doing it in a sound way, that's what I look at.
 John Huber suggests looking at ROE from 2008-2013 and checking if it is above 10%. More notes
on “great banks” according to him:
o To paraphrase what Buffett once said, banking is a business with numerous commodity
like aspects (they all sell the same basic service), but yet it also is a business where
certain banks can develop a moat (a durable advantage over their competition).
o Excluding the culture, compare OZRK to WFC
o Earnings in consideration:
 Pre-tax, pre-provision earnings, or PTPP—as it sounds, these are earnings before
taxes and before accounting for the money that a bank sets aside (provisions)
for future credit losses. Many analysts will refer to PTPP earnings as “core
earnings” because they more closely resemble the cash earnings that a bank
produces in any given year before paying tax.
 I look at PTPP, but I prefer to use simply pretax earnings after accounting for the
provisions, assuming that the provisions represent a normal, or average amount
(if not, you can adjust using an average of the last 10 years or so). I think it’s a
 slightly more conservative way to arrive at a value, but this might be getting too
inside baseball…
o WFC’s valuation relative to earnings at $41/share in 2013
 10.8 times earnings
 6.2 times pretax, pre-provision earnings (PTPP)
 6.9 times pretax earnings
 Pretty reasonable, if not downright cheap considering the quality…
o WFC Profitability: And speaking of quality, let’s look at the actual earning power ratios.
Here I’ll look at the normal ROA and ROE numbers, and also look at a number Buffett
focused on in the early 1990’s when he first bought WFC, which is the return on tangible
equity, and the pretax return on tangible equity (ROTE):
 ROA: 1.43%
 ROE: 13.0%
 Return on Tangible Equity: 18.3%
 Pretax ROTE: 27.3%
o In addition to low cost deposits (the most important funding source of a bank), WFC also
has a superior efficiency ratio, which basically measures the level of operating costs that
a bank has (Efficiency Ratio = Non-interest expenses/revenue).
 Look at average cost of deposits vs. industry
o On buying a bank on P/Tang. BV vs ROTE
 “Of course, the initial attraction is the fact that the tiny bank trades at .8 times
tangible book, and WFC trades at 2.0 times tangible book… but in the end, my
guess is more wealth will be created by the company that produces 18% returns
than the company that only produces 8% returns, and although the better
company’s assets are more expensive, you can buy both of them at the same
price relative to earnings!”
o Why does Buffett get so enthusiastic about paying 2-3 times tangible book for banks?
 “You don’t make money on tangible common equity. You make money on the
funds that people give you and the difference between the cost of those funds
and what you lend them out on.”
o none of these banks appear to be cheap if you look at the price to tangible book values
 often between 2-3 times tangible book
  the company with the lowest cost wins
 A low-cost structure is a huge advantage, and a significant margin of safety for
banks
o “It’s also interesting to compare the strategy of buying a cheap stock and waiting for
multiple expansion (i.e. buying a bank at 0.7 times book when it’s worth 1.0 times book
and waiting for the market to assign the correct multiple)vs. the strategy of buying the
best businesses that (thanks to their durable advantages) will continue to create above
average returns on equity over time which translate into passive above average long
term investment results without the need for multiple expansion (i.e. you could have
paid 2x book for WFC 20 years ago and it would have worked out very well, even though
WFC only trades at about 1.5x book now).
 Some view the former as more of a trading approach, and the latter as more of a long
term investment approach. I don’t differentiate between the two. To me, a business
owner can buy and sell businesses over time opportunistically, or he can hold the same
business for years, or some combination of both.
 Bank of America is an example of how significant the gaps between price and value can be even
when it comes to large cap stocks. BAC ended 2015 around $17. It traded for around $11 just
over a month later in early February 2016. It now trades around $22.In other words, the value
that the stock market placed on Bank of America dropped by about $60 billion in just 6 weeks at
the beginning of the year. Even more incredibly, the market now values this same company
around $110 billion more than it did just 10 months ago. This roller coaster ride in market
capitalization is much more pronounced than the change in intrinsic value (the value a private
buyer would have paid for BAC at any given point during 2016).
o How does a company as widely followed as BAC experience such a change in valuation?
 Investors sold it off earlier this year because of fears about a negative impact to
earnings that low oil prices would have on the bank’s energy portfolio, as well as
fears related to an overall economic slowdown and a possible recession. These
were factors that would have quite possibly impacted the near-term earnings
outlook at Bank of America, but would be very unlikely to impact the long-term
earning power of the franchise.
 Those willing to look out 3-5 years and possibly deal with negative short-term
results were able to buy stock in a profitable bank with a good balance sheet at
really cheap prices.
o Some quick, back-of-the-envelope math on the company earlier this year when the
stock traded around $12 per share:
 The bank has $190 billion of tangible equity
 The company was doing 10% returns on that equity, which I thought was a
reasonable proxy for normal earning power
 This equals around $19 billion in profits
 BAC has around 11 billion shares outstanding
 This is $1.70 in per-share profits
 So the stock traded around 7 times my estimate of earning power at a $12 stock
price
 BAC’s book value is growing at around 6-8% annually, which means the bank will
have somewhere around $20 of tangible book value in 3 years. At a modest
return on tangible equity of 10% (which is what the company was already doing
at all-time low profit margins), the company will have around $2 of earning
power in 3 years. I think this would probably be worth 10-12 times earnings or
so, meaning the stock would be worth somewhere between $20 and $24 in
three years, and you could buy as much as you wanted for $12.