The quality of a bank’s earnings has an overlooked and potentially underappreciated impact on that bank’s valuation, according to an analysis of publicly traded bank stocks by Invictus Group.

Trading multiples of public banks are driven by variables such as asset size and quantity of earnings, but factors like strong core deposits, optimal loan-to-deposit ratios and loan concentrations in categories such as commercial real estate can also affect stock prices.

Here’s the proof.

Asset size and quantity of earnings, as measured by return on assets, are two important and obvious drivers of valuation. Banks with strong earnings trade at a premium to banks with lower earnings; on average, bigger banks trade at a premium to smaller banks with similar profitability.

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Size matters for a variety of reasons. Larger banks have market and operational benefits, such as liquidity of the stock, the level of institutional ownership and research coverage. Increasing asset size is the first step necessary for a bank to truly move the needle with respect to valuation.

Size isn’t enough, however: earnings also matter. For banks, executives should aim for their stock to trade on a multiple of its earnings, as opposed to a multiple of its book value. But without a critical mass of earnings, investors have no choice but to value the stock based on a multiple of book value. Usually the result are not pretty – especially in a market where bank stock valuations are increasingly depressed across the board.

When a bank is valued by its earnings, as opposed to book value, its resulting price to book multiples will naturally expand.

For banks with $1 billion to $10 billion in assets that had higher price to earnings multiples and strong earnings, defined as a return on assets of at least 0.8%, price to tangible book values are correspondingly high.

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Quality of Earnings – the Holy Grail
What characteristics separate the banks in the highest quartile from the rest of the institutions that “qualify” to be valued on their earnings? Investors correctly assert that the quality of a bank’s earnings matter, especially in this late-cycle environment.

Banks with lower loan-to-deposit ratios, strong core deposit funding, and reduced CRE concentrations are less vulnerable to changes in interest rates and economic conditions. They also have better growth prospects, relative to other banks, because they have excess capacity on their balance sheets, giving investors the growth potential they crave.

In contrast, banks with high loan-to-deposit ratios risk a greater dependency on non-core funding. Firms with high CRE concentrations have little to no capacity left on their balance sheet for growth.

There is a clear correlation between a bank’s capacity for growth and its stock trading multiples, when analyzing metrics among banks with $1 billion to $10 billion in assets.

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Maximizing Shareholder Value
How can a bank move into the top quartile in this environment? The simplest and most-efficient way to overcome balance sheet constraints is an acquisition. Many banks balk at the low valuation of their currency and the multiple it trades at, which can increase the tangible book value dilution and amount of time it would take to earn it back.

But the right acquisition can allow a bank to reconfigure its balance sheet virtually overnight. Deposit-rich targets with lower growth and earnings can significantly improve a buyer’s profitability by lowering its reliance on high-cost funding and increasing the net interest margin.

A deal also increases the resulting institution’s asset size, improves profitability and increases its capacity for future growth. Acquirers can position themselves to realize a significant expansion in its trading multiples.

It is important that bank executives see the forest for the trees. A certain segment of a bank’s investor base that is more focused on short-term results may object to a deal that appears to have a higher tangible book value dilution earn-back period.

However, the right acquisition will have an outsized impact on a bank’s size, quantity of earnings – and perhaps most importantly – the quality of earnings. The right acquisition can change a bank’s balance sheets and growth prospects. The right acquisition will push a bank’s valuation – your bank’s valuation – to trade at a premium to peers, from both a multiple-to-earnings and multiple-to-book perspective.

Andrew O’Keefe