Valuation Methods and Banks’ Takeover Premium: an Empirical Investigation across the Financial Crisisof 2007
Daniele Previtali
Luiss Guido Carli University,
Abstract
No empirical investigation about valuation methods of banks has been provided by literature. Using and outside analyst perspective, the aim of this paper is to provide a first empirical investigation on how valuation methods are able to explain banks’ deal values in mergers and acquisitions. The paper places in the acquisition premiums determinants literature adopting a value relevance research design and providing a comparison of methods’ statistical significance prior and after the financial crisis of 2007. Findings show that prior the financial crisis analytical methods are strongly related to premiums while, after the financial crisis, banks’ takeover pricing seems to be more related to market benchmarks rather than business’ fundamentals. In addition, risk variables are tested. Results support the literature of leverage pro-cyclicality (Tobias and Song Shin., 2010).
Jel Codes: M41, G21, G34
1. Introduction
How can we capture the intrinsic value of a bank looking both at its value creation capability and its risk management quality? Before answering to this question, it has to be asked whether current valuation methods of banks allow investors and managers to capture the complexity of banks’ value generation which does not stem only from their ability to make profits. Although the corporate finance theory provides some methodologies to be applied in financial firms valuation, however the metrics currently used are just a simplification of the ones employed for industrial firms. Therefore, those methods can only be considered as “proxy models” as they are not bank-specific. Such divergences between banks' business model and their valuation models need to be discussed even through the way in which risk is considered in many different valuation approaches (Damodaran, 2005). Basically, as risk is for banks the main sources of revenues, greater attention should be paid to the way banks manage their risk appetite and risk tolerance. Those information are much more reliable and significant to discriminate those banks which perform better than others in the long run (BCE, 2010). At the moment none of the banks valuation methods incorporate those information.
Notwithstanding the relevance of the topic, not so many contributions have been proposed by scholars in academic journals probably owing to the difficulties linked to modeling valuation methods and testing their variables. However a new stream of literature is starting to think to a new valuation model of banks such as Dermine (2010) and Calomiris and Nissim (2007). Those two contributions are quite a step forward into a new model of valuation based on fundamentals of banks’ business.
This paper places in the literature of valuation metrics of banks,neither proposing a new valuation model, nor making adjustments on the most used metrics. Differently, it provides empirical evidences on the value relevance of valuation methods (Damodaran, 2009) and on the importance of capturing risk in the intrinsic value of banks. Since no empirical literature exists on the topic of banks valuation methods, the research design employed is the one of the banks takeover premiums literature. In these terms, no attempts have been made in linking premiums paid in mergers and acquisition neither to valuation methods nor to risk factors (Hagendorff et al., 2012).
The sample is composed by 225 U.S. bank mergers and acquisitions from 2003 to 2011 including listed and non-listed banks. Findings show that premiums were positively related to fundamental valuation methods in the pre-crisis period while to market models in the post-crisis period. The empirical results support studies which found that practitioners’ market orientation has driven valuations toward an overweighed role of the relative (or multiples) approach, while, generally, cash-flow expectations and earnings growth became thorough to be valued during the aftermath of the financialcrisis (Goedhart et al., 2010).In addition further evidences highlight the absolute importance of leverage as a risk indicator and even on how its pro-cyclicality (Tobias and Song Shin, 2010) is priced by managers.
The paper is organized as follows. After a literature review of banks’ valuation methods and bank takeover pricing in section 2, the methodology and sample description are presented in section 3. Results are discussed in section 4. Finally, in section 5, the conclusions draw additional considerations and further implications of the presented results, discussing limitations and future research.
2. Literature Review
2.1 Main issues invaluation of banks
In the recent years, the topic of banks valuation has been raising a lot of interest among academics and practitioners. The financial crisis of 2007, which has struck the global banking sector, highlighted that not only the value of a bank has to be measured and interpreted in terms of returns, but even in light of risks. However, the metrics commonly used to value banks are not able to fairly weight return and risk. In facts, the standard valuation metrics can hardly be adjusted to the business of banks since they work by a different business model which doesn’t allow to consider banks as industrial firms. In this perspective, a very large part of the literature underlined that the valuation methods usually applied to financial firms are not the best way to accurately explain their fundamental value. In these terms, the relevant issues discussed by literature[1] in banks’ valuation are briefly recalled in the following paragraphs.
First of all, there is no question that the supervisory Authorities and their regulation generally have a relevant impact on banks’ future growth. Such a condition undoubtedly affect reinvestment rates and growth assumptions[2]. In addition, banks’ regulation generally becomes more pervasive during periods of financial turmoil. In facts, the financial crisis of 2007 represent an unequivocal example of the tightening of baking law[3] as a result of a shock in the financial system.
Another relevant issue is represented by the different role of debt in the banking industry. As a matter of fact, the debt represents the “raw material” of financial intermediation as it is the primary source of banks’ incomes. In these terms, the interest bearing liabilities should be considered as operative costs instead of interest expenses since they are part of banks’ core business. In this perspective, there are some problems in considering what is real debt and what is not, especially in terms of deposits which, usually, represent the greatest amount of banks’ funding. As a consequence, the “real” banks’ capital ought to be considered only in terms of the regulatory capital fixed by Authorities. Besides in a valuation perspective, banks generally report a high ratio of debt over equity. The outbalanced relation between debt and capital underestimates the cost of capital since the cost of debt will have a higher weight than the cost of equity. In other words, the only way to measure the cost of capital of banks is by the equity side approach.
A further issue to take into account is the net working capital and fixed investments estimation. Basically, their assessment is unrealistic[4] for banks. Essentially banks invest in human capital, processes and procedures enhancement, brand and other intangibles assets which are normally accounted like operative costs. Moreover if we define the net working capital of banks as the difference of current assets and liabilities, it clearly would undergo a swift pace of changing even in the short-term. In facts, neither free cash flows to operations nor standard free cash flow to equity can fairly be assessed in banks valuation. Such problems make the residual perspective of dividends the best proxy of banks’ cash flows.
The fourth issue that need to be mentioned is linked to the loan loss provision accounting. Banks usually make provisions to smooth earnings over the time shrinking the level of actual earnings. The uncertainty of the expected banks’ provisions compared to their real needs may lead to wrong estimations of both net earnings and retention ratios. Thus the value of a bank is even related to the amount of provisions set aside over the years since the fundamental future growth depends on both earnings and retention ratio estimation. Therefore it has to be assessed the potential misalignment among provisions and real losses when adjustments on dividends are to be made.
The last element which deserves to be mentioned is the mark-to-market approach. Since a large part of banks’ asset and liabilities (especially in investment banks) are traded the book value of equity represent more an updated value of equity than of the value originally invested. Such setting raise doubt on the ability of the market to price assets and liabilities and on the meaningless role of banks’ equity in time and cross industries analysis.
On the whole, there is no universal agreement on how these issues can totally be overcome. Many attempts have been proposed by analysts and manuals, however none of them seem to be broadly accepted by theory and practice.
The next sections briefly introduce the literature review on the topic of banks valuation.
2.2 Valuation methods of banks: main contributions
Scholars have investigated many topics related to the valuation methods of financial firms. Most of them have tried to formalize the “right” methods to use. However only few papers found place into journals since the topic has been frequently faced by practical analysis instead of empirical investigations. As a result, those works have been rather accepted in manuals than in academic journals.
One of the most relevant work on banks valuation has been proposed by Damodaran (2009, 2010) who clustered the valuation metrics of banks in five main categories: (a) dividend discount model (excess capital)[5]; (b) cash flow to equity models; (c) excess returns models; (d) asset-based model; (e) relative valuation (price-earnings and price to book value). Damodaran concerns to explain the theoretical and the practical issues of each model providing also short case studies. In his work, Damodaran has underlined that among the models potentially applicable, the dividend discount model, the excess returns metric and the multiple of price to book value and price-earnings are the methods more consistent with banks’ business model.
In the value creation analysis, Copeland et al. (2000), Dermine (2009) and Koller et a. (2012) explore the banks valuation by a different perspective. In particular, they suggest the economic-spread analysis as a fair model in order to assess whether banks are creating or destroying value[6].
The only published or working papers which I am aware of do not contain any empirical evidence. Most of them present applications of different valuation metrics which substantially replicate manuals’ theoretical background without offering new empirical evidences (i.e. Yao Yao, 2005). However , Dermine (2010) and Calomiris and Nissim (2007) have recently proposed two different papers which both focused on a bank-specific model construction. The new relevant perspective is that those methods specifically look at banks’ business fundamentals. As a matter of facts, Calomiris and Nissim (2007) presented a valuation method for Bank Holding Companies (BHC) based on banks’ assets and liabilities structure[7]. Diversely, Dermine (2010) proposed an evaluation metric (the Fundamental Valuation Formula) where the equity value of a bank would be equal to the sum of liquidation value (that is the difference between current assets and liabilities) plus the franchise value (that is the present value of future profits made from credit intermediation) on deposits and loans, less the present value of operating expenses and taxes effect.
Notwithstanding those new attempts still have not received a strong support by academics, actually they represent the evidence that current valuation methods are not the best way to catch the value of banks.
Another interesting paper has been proposed by Franceschi (2008), who has made an attempt of linking valuation methods to mergers and acquisitions literature. In facts, Franceschi gathered data from a few Italian mergers and acquisitions fairness opinions from 2002 to 2007 clustering the metrics which have been more used by advisors in valuing targets. Franceschi found that the dividend discount model, market price method, market multiples and value map method were the methods more applied by practitioners. However no empirical investigation was given.
On the whole, no empirical contributions seem to be provided by literature on how valuation methods work.
2.3 Valuations methods of banks and M&A research design
The lack of an empirical literature in valuation methods of banks is the main gap that this research project tries to cover. As a matter of fact, since all the previous contributions (especially manuals) have presented the main issues and metrics, this is the first contribution to be concerned of the statistical significance of banks’ valuation methods variables. In particular, the research project tests the importance of valuation metrics (Damodaran, 2009) on mergers and acquisitions prices in order to assess whether they are significantly related to banks’ pricing. The choice of M&A prices instead of stock market prices is due to the higher degree of theoretical reliability of the former than the one of the latter. As a matter of fact, stock market prices are often driven by investors’ behavior which is characterized by problems of timing (Bernard and Thomas, 1990) and overreaction (De Bondt and Thaler, 1985) which make market prices temporary deviating from their fundamental value.
For those reason, the financial determinants on premiums paid in mergers and acquisitions among banks is the main stream of literature this work refers to. In the next sections, the literature review of bank takeover premium is presented.
2.4 Relevant literature of bank takeover determinants
The topic of mergers and acquisitions among banks has been deeply investigated by scholars. Wide overviews spanning over 30 years of literature have been presented by De Young et al. (2009), Amel et al. (2004) and Berger et al. (1999). Those contributions provide a broad description of many topics regarding banks takeovers.
Narrowing the field of investigation, my contribution places into the literature of financial determinants of bank takeover premium. Over the years, many empirical evidences have been found by scholars, although their findings have been sometimes equivocal due to their research design, sample composition, and, especially, period of observation.
Table 1 summarizes the relevant studies on banks takeovers premiums which represent the main contributions which the project refers to.
Looking at table 1, it can be claimed that the only three studies which are focused on Europe are those of Hagendorff et al. (2012), Molyneux et al. (2010) and Diaz and Azofra (2009). On the opposite, scholars have paid a lot of attention to the U.S. market. However, by the studies I am aware of, none of them takes into consideration neither the theoretical framework of valuation methods nor the effect of the financial crisis on premiums. In the next paragraphs I discuss the relevant existing literature of banks takeovers pricing.
Almost all of those studies investigate banks mergers pricing focusing on the targets features. In facts, there is no doubt that the first level of analysis should concern the targets’ performance since bidders managers are strongly focused on the combined performance of the “in-house” business and the acquired one. Firstly, all these studies have been focused on a profitability measure which usually proxy target’s expected cash flow (Hagendorff et al., 2012). However, the explanatory variables used have been the return on asset and return on equity which do not explain the future growth in earnings and cash flows but a backward looking performance. In addition recent studies demonstrated inefficiency of such performance indicators since they do not consider banks’ risk profile and revenues sustainability over time (BCE, 2010). However literature found managers particularly focused on return on equity ratio.
Another relevant variable in mergers is relative size. As a matter of fact, size has frequently been used as a proxy of operating synergies (Jackson and Gart, 1999, Akhavein et al., 1997, Hannan and Rhoades, 1987) among merging entities. In particular, relative size explains the potential synergies pursued by acquirers in order to reduce the operating costs of the combined businesses (DeLong, 2001; Benston et al., 1995). With regards to size, scholars showed contradictory results. A large and significant evidence that acquirers pay less for greater targets has been found by Hakes et al. (1997), Benston et al. (1995), Palia (1993), Cheng et al.(1989). On the opposite, Brewer and Jagtiani (2007), Brewer et al. (2000) and Rogoski and Simonson (1987) found positive coefficients, whilst recent European studies such as Diaz and Azofra (2009) and Hagendorff et al. (2012) have reported insignificant betas.
Specifically to small banks, Fraser and Kolari (1987) analyzed 132 mergers and acquisitions prior and after the 1985 finding that smaller sized banks showed higher premiums due to their better economic and financial structure than the one of large sized banks. Also De Young et al. (2004) investigated the small banks’ performance in mergers and acquisitions. They underlined that the higher was the amount of deposits, which, according to them, was strictly related to their relationship lending approach, the greater was the availability of acquirers to pay for.