Managing the value of financial institutions

RMA Journal, The, March, 2005 by Beverly J. Foster

Winners and losers: What factors determine a bank's value? Representatives from some of the world's largest commercial and retail banks, corporate and investment banks and property and casualty insurers converged during a one-day program to get tips on managing the value of their institutions. Thomas C. Wilson managing director, Mercer Oliver Wyman, moderated three sets of penelists at a conference sponsored by RMA, Mercer Oliver Wyman, PRMIA (Professional Risk Managers International Association), CAS (Casualty Actuarial Society), and Microsoft. This first of three articles introduces the topic and then focuses on what the market looks at when valuing an institution. The second article will look at designing performance frameworks to align with what the market values. The third article will take this information and move from measurement to management.

CFOs and CROs of banks and insurance companies may focus on different types of risk--market, credit, or insurance--but they all have one objective, said Mercer Oliver Wyman's Tom Wilson as he introduced the first set of panelists who spent a snowy day in January addressing the topic "Managing the Value of Financial Institutions. That objective: to help their institutions create greater value for shareholders through disciplined finance and risk management.

Market dynamics, such as the state of the economy, competitors, customers, and regulators, all help to determine whether or not the market is attractive. Ultimately, though, it is the individual institution's strategic and tactical decisions that separate winners from also-rans in terms of shareholder value creation, he continued. Stock market data reveals a wide range of performance for banks in the same market, with the leader more than quadrupling its share price while the laggards barely doubling theirs over the same seven-year period.

Institutions increasingly are using some form of risk-adjusted performance as their information base to develop frameworks linking internal metrics and performance with shareholder value. "lb make these measures understandable and usable for senior management, management must see how the market sets the firm's valuation multiples. Wilson pointed out that shareholder value can be thought of as driven by the firm's market-to-book (M/B) multiple, return on equity (ROE), and its dividend rate.

"While simplistic, [Figure 1] suggests that if ROE is 12%, the dividend rate is 33%, and M/B is 1, share price will double in about 11 years," Wilson said. "This is because retained earnings, which are growing at 8% per annum net of dividends, receive a market lift (M/B) of only 1. On the other hand, if M/B is higher--for example 1.5, implying a higher lift on retained earnings--the institution will double its share price much more quickly. If ROE is 15% with more retained earnings being generated at the higher M/B of 1.5, the reinvestment of retained earnings result in doubling share price in only six years."

[FIGURE 1 OMITTED]

Most managers understand the drivers of ROE; but what drives the firm's market valuation multiple? A simple regression analysis (seen in Figure 2) suggests that the price-to-earnings (P/E) and M/B multiples are determined by the firm's fundamentals: excess returns (or ROE minus the cost of capital) and growth. Adding earnings volatility to the model produces a significant but spurious negative sign, which, corrected for line-of-business effects, disappears completely, said Wilson. "In other words, if you think about disaggregating the overall P/E and M/B into a weighted portfolio of line-of-business P/E and M/B, then earnings volatility no longer influences valuation," said Wilson. "It suggests that the market is actually looking through the corporation as a whole and valuing the institution as a sum of the parts. If growth, ROE, cost of capital, and everything else remain steady, you can think of the value of the firm as being equal to the paid-in capital, or the amount of equity that has been invested, plus some measure of excess profitability--ROE minus cost of capital, which often is called economic profit."

[FIGURE 2 OMITTED]

He summarized by saying that market valuation is determined by the following:

* Competitive positioning and corporate strategy--being in the right place at the right time with the right strategy--for example, enjoying and exploiting the mortgage refinancing boom in an otherwise lackluster economy.

* Operating performance and business model--how well the firm executes its strategy, whether it's focused on the customer, product, or cost efficiency.

* Earnings (not revenue) growth. Today, CFOs and CEOs frequently talk about the growth prospects of their companies in terms of driving their value.

* Capital management, which involves both the denominator for ROE as well as minimizing the cost of capital.

* Market perception and disclosure, versus opacity, to ensure that the market understands the firm's strategy, business model, and execution.

That said, good measurement alone is simply not enough: the most important consideration is management. "Someone once said that they would prefer a C-rated model and A-rated management to an A-rated model and C-rated management," Wilson said. "I have seen institutions with very elaborate, extensive, and 'accurate' measurement frameworks that nonetheless failed to get the ball over the goal because they lacked the necessary business insights and ability to make the necessary tough decisions. Equally as important, the firm's key decision-making process and organization--such as strategic planning and capital management--must be aligned to support effective decision clearing."