by Joel Comer, Principal, Sandler O'Neill & Partners

I recently had the pleasure of making a presentation on bank valuation at the Seattle Banks’s 2005 Management Conference. Two points in particular seemed to resonate with the audience: (1) the importance of expected future earnings in determining current stock value, and (2) what constitutes an acceptable rate of return for shareholders. Because it’s important for bankers not only to have their eye on the ball, but also to have their eye on the right ball, I’d like to revisit these two points.

In our experience, the single most important determinant of current stock value is the future earnings investors expect of a company. Here we must take a detour into the dry science of statistics to briefly discuss the coefficient of determination, or R². Simply put, R² is a statistical term describing the fraction of variance in a dependent variable that can be explained by an independent variable. It is a pure number ranging from 0 to 1, with 1 representing perfect explanation and 0 representing no explanation.

Saying that expected future earnings are the single most important determinant of share price implies that the coefficient of determination between share price, the dependent variable, and expected future earnings, the independent or explanatory variable, is rather high. Indeed, it is. When we plotted and calculated the coefficient of determination, or R², between expected 2006 earnings per share (EPS) and the share price for commercial banks nationwide with assets greater than $1 billion, we found it to be a robust 0.86.

In other words, expected future earnings explain a solid 86% of the fluctuation of the share price of these commercial banks.

When we ran our analysis for expected 2005 and 2007 EPS for these same banks, we found similarly high coefficients of determination of 0.85 and 0.84. The importance the market places on expected future earnings comes into clearer focus when comparing the explanative power of trailing earnings.

The coefficient of determination for the last 12 months (LTM) EPS for these same commercial banks was a meaningful 0.78, but was considerably less robust than the median R² of 0.85 for expected future earnings. In short, the market believes that past may be prologue, but not necessarily so.

If expected future earnings are a ball worth watching in building shareholder value, what else might deserve the attention of bank managers and directors? Equity or capital certainly comes to mind, so we analyzed the coefficients of determination for book value and tangible book value per share on the one hand and share price on the other for the same cohort of commercial banks.

The single variable of book value per share explained 74% of share price fluctuation—slightly less than the 78% for trailing EPS—while tangible book value per share explained a much lower 64% of share price fluctuation.

Finally, we wanted to test the old shibboleth of the importance to the market of the retail bank (loans and deposits) compared to the wholesale bank (securities and borrowings). To do so, we analyzed the ability of securities and borrowings as a percentage of assets to explain the P/E ratios of the same cohort of commercial banks.

The coefficients of determination were 0.00 for securities and 0.06 for borrowings—both so low that they indicated no explanative relationship between the percentages of securities and borrowings on the balance sheet and the P/E valuation the market awards a stock.

Realizing that earnings are the single most important determinant of current share value, however, leaves unanswered the important question of how much earnings is enough. In other words, what is an acceptable minimum rate of return for the shareholders of a specific bank?

The hurdle rate of return for shareholders begins with the risk-free rate of return and adds to this risk-free rate an equity risk premium adjusted for the specific company. Taking the current yield on the 10-year Treasury of about 4.00% as our risk-free rate and 600 basis points as the equity risk factor, the hurdle rate of shareholder return for a company with the market beta of 1.0 would be 4% + (6%*1.0), or 10.0%. Receiving this annual rate of return would be required to justify foregoing the risk-free rate of return, and the more a shareholder’s rate of return exceeded this hurdle rate, the better off he would be. The hurdle rate of return and the magnitude and growth of earnings are important factors in determining the net present value of a bank stock and whether shareholder value is building or wasting over time.

In conclusion, expected future earnings per share are the strongest single-variable determinant of current stock price. Of less significance, in diminishing order of importance, are trailing earnings per share, book value per share, and tangible book value per share. The superior explanative power of book value per share over tangible book value per share may imply the interesting proposition that the market values goodwill more highly than is commonly assumed. However, the main point here is that both are much less important to the market than expected future earnings.

The complete inability of the single variables of securities and borrowings on the balance sheet to explain P/E valuations suggests that bank managements that are reluctant to supplement the earnings of the retail bank with those of the wholesale bank have their eye on the wrong ball. Their game may be limited to singles and doubles rather than triples and home runs because the magnitude of earnings and earnings growth are key to share valuation and growing value over time.

Joel A. Comer is principal of Sandler O'Neill & Partners, L.P. He is currently based in San Francisco and oversees the firm's West Coast operations for banking, fixed income and research, specializing in mortgage portfolio valuation and securitization, client-firm relations, transaction negotiations, audit reviews, and sales and trading.

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