A VALUATION OF A U.S. REGIONAL BANK’S COMMOM STOCK
Sheau-wen Jou
B.S., National Taiwan University, Taiwan, 1995
M.S., National Taiwan University, Taiwan, 1997
PROJECT
Submitted in partial satisfaction of
the requirement for the degree of
MASTER OF BUSINESS ADMINISTRATION
(Finance)
at
CALIFORNIA STATE UNIVERSITY, SACRAMENTO
FALL
2009
A VALUATION OF A U.S. REGIONAL BANK’S COMMOM STOCK
A Project
by
Sheau-wen Jou
Approved by:
_____________________________, Committee Chair
Hao Lin, Ph.D., CFA
__________________________
Date
ii
Student: Sheau-wen Jou
I certify that this student has met the requirements for format contained in the University
format manual, and that this Project is suitable for shelving in the Library and credit is to
be awarded for the Project.
_____________________________________________
Monica Lam, Ph.D.
Associate Dean for Graduate and External Programs
College of Business Administration
iii
_____________________
Date
Abstract
of
A VALUATION OF A U.S. REGIONAL BANK’S COMMOM STOCK
by
Sheau-wen Jou
Statement of the Problem
This report analyzes a mid-west regional bank in the U.S. that provides various banking
and financial services to individuals and businesses. We call the bank ABC Bank for the
purposes of confidentiality. To determine the appropriate investment recommendation for
this company, I have applied discounted cash flow valuation and relative valuation
approaches to determine whether its stock is undervalued, overvalued, or fair valued. In
addition, in order to evaluate ABC Bank’s financial strength against unexpected losses, I
have utilized its tier 1 capital and tangible common equity (TCE) ratios to judge its future
viability.
Source of Data
I have analyzed the five-year historical data of ABC Bank’s 10Ks to determine the range
and performance of the major items, such as loan balance, deposit balance, net interest
margin, and efficiency ratios. Then, based on different assumptions of the economy, we
iv
have developed four scenarios to forecast financial performance over six years to
determine the company’s earning capability and financial position.
In addition, from ABC Bank’s proxy statements, we select other five mid-west regional
banks to estimate ABC Bank stock’s fair value by the price-earnings and the price-tobook values ratios. The companies’ current stock prices, past year earnings, forecasted
earnings, and book values of their common equities were required for the relative
valuation approach.
Conclusions
Based on the residual income valuation for different scenarios, I estimate ABC Bank’s
weighted average intrinsic value to be $15.87 per share and its target stock price to be
$14.77 per share based on the review of PE multiples. As the economy showed signs of
stabilization as of August 2009, ABC Bank is expected to improve its profitability in
2010. Accordingly, I would suggest that investors buy and hold at the current price of
$10.29 per share and sell when it reaches the target price of $14.77 to $15.87 per share.
Moreover, by forecasting ABC Bank’s tangible common equity ratio under different
scenarios, I determine that the bank has enough financial strength to confront the
unexpected loan losses.
_____________________________, Committee Chair
Hao Lin, Ph.D., CFA
__________________________
Date
v
ACKNOWLEDGEMENTS
I would like to express my appreciation to all those who helped me to complete this
project. I would like to thank Jonathan E. Lederer, President of Lederer Private Wealth
Management, LLC for giving me the opportunity to initiate this analysis. He also gave
me a very thorough instruction about the nature of the banking sector and helped me
develop the scenarios for different economic assumptions.
I deeply appreciate my supervisor Prof. Hao Lin at the College of Business
Administration of California State University, Sacramento. He taught the asset valuation
class which stimulated my interests and enhanced my knowledge in this area. He always
gave me very useful suggestions and encouraged me throughout this project.
My English writing tutor, Ann Shadden, and my classmate, Jesse Dias, supported me in
my research work for English style and grammar, correcting both and offering
suggestions for improvement. My best classmate, Rula Shaban, supported me in the
formatting of the document and encouraged me when I was stressed. I would like to
thank them for all their help, support, interest and valuable suggestions.
Finally, I would like to give my special gratitude to my husband David who sponsored
me for the MBA education. Especially, his patience and love helped me to complete this
work.
vi
TABLE OF CONTENTS
Page
Acknowledgements ............................................................................................................ vi
List of Tables ................................................................................................................... viii
List of Figures .................................................................................................................... ix
Chapter
1. INTRODUCTION ........................................................................................................ 1
Purpose of the Study ............................................................................................... 1
Background of ABC Bank ...................................................................................... 1
2. METHODOLOGY ....................................................................................................... 3
Fundamental Valuation Approach .......................................................................... 3
Relative Valuation Approach .................................................................................. 5
3. ASSUMPTIONS ........................................................................................................... 7
Key Items ................................................................................................................ 7
Scenarios ............................................................................................................... 11
4. FUNDAMENTAL VALUATION.............................................................................. 16
Pro forma Financial Statements ............................................................................ 16
Intrinsic Value Estimation .................................................................................... 17
The Tangible Common Equity Ratio .................................................................... 19
5. RELATIVE VALUATION ........................................................................................ 21
Price-earnings (PE) ratio ....................................................................................... 21
Price-to-book value (PBV) ratio ........................................................................... 21
6. FINDINGS AND INTERPRETATIONS ................................................................... 23
Bibliography ..................................................................................................................... 41
vii
LIST OF TABLES
Page
1. Table 1 Assumptions for loan growth rate and interest rate for each of the four
scenarios ....................................................................................................... 24
2. Table 2 Assumptions for deposit growth rate and interest rate for each of the four
scenarios ....................................................................................................... 25
3. Table 3 Assumptions to estimate provision for loan losses ........................................ 26
4. Table 4 Predicted earnings summary and selected financial data for scenario 1 ........ 27
5. Table 5 Predicted earnings summary and selected financial data for scenario 2 ........ 28
6. Table 6 Predicted earnings summary and selected financial data for scenario 3 ........ 29
7. Table 7 Predicted earnings summary and selected financial data for scenario 4 ........ 30
8. Table 8 Predicted intrinsic value of scenario 1 ........................................................... 31
9. Table 9 Predicted intrinsic value of scenario 2 ........................................................... 32
10. Table 10 Predicted intrinsic value of scenario 3 ....................................................... 33
11. Table 11 Estimated intrinsic values and assigned weight of average for different
required rate of return and scenarios ............................................................ 34
12. Table 12 Tier 1 capital ratios and TCE ratios from 2004~2008 ............................... 35
13. Table 13 Predicted TCE Ratios for each of the four scenarios ................................. 36
14. Table 14 ABC Bank’s PE ratio compared to its peer companies ............................. 37
15. Table 15 ABC Bank’s PBV and price-to-tangible-book value ratios compared to its
peer companies............................................................................................. 38
viii
LIST OF FIGURES
Page
1. Figure 1 Relationship between ABC Bank’s provision for loan losses and Milwaukee
ISM rolled forward one quarter (Inverse scale) from 2003 Q1 to 2009 Q2.
...................................................................................................................... 39
2. Figure 2 Stock performance comparison of ABC Bank, S&P 500 index and regional
bank index from 5/1/2009 to 9/1/2009 ........................................................ 40
ix
1
Chapter 1
INTRODUCTION
Purpose of the Study
Due to the financial crisis and economic recession in 2008, U.S. bank failures have
increased dramatically in 2009 as financial institutions continue to work through
nonperforming loans that were made during the credit boom. In order to stabilize the
financial sector after the 2008 subprime mortgage crisis, the U.S. government proposed
the Troubled Asset Relief Program (TARP). This report analyzed a midcap, mid-west
regional bank that received bailout funds from the TARP program, which will be referred
to by the pseudonym, ABC Bank.
I have applied a discounted cash flow valuation approach to determine ABC Bank’s
intrinsic value so that recommendations can be made to buy, hold, or sell its stock. In
addition, I compared its price-earnings ratio and price-to-book value ratio to those of
other banks of its peer group and have analyzed its historical data to determine whether
its stock is undervalued, overvalued, or fair valued. Finally, in order to evaluate the
ability of ABC Bank to pay its debts of all types, I have analyzed its tier 1 capital and
tangible common equity (TCE) ratio to judge its future viability.
Background of ABC Bank
ABC Bank is a mid-west regional bank in the U.S. providing various banking and
financial services to individuals and businesses primarily in Wisconsin, Illinois, and
Minnesota. Banking and wealth management are its two major segments. Banking
includes lending and deposits services to consumers, businesses, and governments and
wealth management includes investment management and advisory services. Its net
2
income is the result of net interest income plus noninterest income, and then subtracts
provisions for loan losses, noninterest expenses, and income taxes. In November 2008, it
sold 525,000 shares of preferred stock to the Capital Purchase Program (CPP) under the
Troubled Asset Relief Program (TARP). ABC Bank is listed on NASDAQ and its
market capitalization is $1.32 billion on September 09, 2009.
3
Chapter 2
METHODOLOGY
In order to assess an appropriate range of ABC Bank’s equity value, I have conducted a
fundamental valuation approach and a relative valuation approach to determine whether
the ABC Bank’s stock is overvalued, undervalued, or fair valued. The fundamental
valuation approach, also referred to as the discounted cash flow valuation, estimates the
intrinsic value of an asset by evaluating the present value of its expected future cash
flows. In contrast, the relative valuation approach evaluates the value of an asset by
examining the pricing of comparable assets relative to common variables such as
earnings and book value.
Fundamental Valuation Approach
In a fundamental valuation, the intrinsic value of an asset is expressed by the present
value of its future cash flows at an appropriate discount rate. The future cash flows of
equity can be defined as expected dividends paid to shareholders, expected free cash
flows to equity, or projected excess returns by different situations. The appropriate
discount rate is the required rate of return of shareholders or the cost of equity.
For a financial institution, expected dividends and expected residual income are more
appropriate than expected free cash flow to estimate the intrinsic value because it is
difficult to estimate the reinvestment of capital expenditures and working capitals.
However, because of the financial crisis in 2008, ABC bank has faced a significant
decrease of its profit, which caused its management to change its dividend policy.
Therefore, I have employed the residual income model to evaluate ABC Bank’s intrinsic
value.
4
Residual income, also referred to as excess returns, is calculated by subtracting the
company’s equity costs from its net income. Using the residual income model, I first
estimated ABC Bank’s earnings and equity book value from 2009 to 2014 based upon
different economic conditions. The equity costs is the equity book value times the
required rate of return. After subtracting the equity costs from the net income, we can
calculate the residual income for each year from 2009 to 2014. Then, ABC Bank’s
intrinsic value was determined by adding the beginning equity book value to the sum of
the present value of residual income for the forecasted time horizon.
The expected future residual income was estimated according to the following steps:
1. Analyzed the five-year historical data of ABC Bank’s 10Ks from U.S. Securities and
Exchange Commission (SEC) filings to determine the range and performance of the
major items, such as loan balance, deposit balance, net interest margin, and efficiency
ratios. The financial statements were downloaded from SEC website
<http://www.sec.gov/>.
2. Set four scenarios to project financial performance over six years to determine the
company’s earning capability under different economic conditions. Assumptions
have been made for interest rates, loan growth, deposit growth, and the provision for
loan losses.
3. Completed interlinked income statements, balance sheet statements, and the
statements of cash flows to estimate the earnings and to make sure the predicted
financial earnings and financial positions are consistent.
4. Subtracted the capital charge from the estimated net income to get the residual
income for each year.
5. According to Dechow, Hutton, and Sloan (1999), residual income fades over time, so
5
to determine the value after the forecasted time horizon, a persistence factor was used
to estimate the continuing residual income.
Dechow et al. (1999) suggests the following equation to estimate the intrinsic value by
the residual income model:
5
Vo  B0  
t 1
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
(Equation 2.1)
Where B0 is the book value of equity at the beginning time of the analysis, NIt is the net
income earned during the time period t, Bt-1 is the book value of equity at the beginning
period of time t, r is the required rate of return for the equity, and ω is the persistence
factor which is between 0 and 1. Because over time the firm’s net income regresses
toward its equity cost, the persistence factor implies an annual decaying rate of residual
income. Dechow et al. (1999) suggested that the persistence factor equaled 0.62 based on
their research in a large sample of company data from 1976 to 1995.
Relative Valuation Approach
The relative valuation approach is an alternative to evaluate whether an asset is fairly
valued, undervalued, or overvalued when compared to its benchmark or its historical
average. Since operating income and sales or revenues are not easily measurable for a
financial institution, the price-earnings (PE) ratio and the price-to-book value (PBV) ratio
are more appropriate for valuing a financial service firm. These two ratios can be
expressed as below:
PE ratio = Price per share / Earnings per share
(Equation 2.2)
PBV ratio = Price per share / Equity book value per share
(Equation 2.3)
6
In the PE ratio analysis, I used both trailing and forward PE ratios to estimate ABC
Bank’s price range. The earnings per share (EPS) of trailing PE ratio is the accumulated
EPS for the past twelve months while the EPS of forward PE ratio is the estimated future
earning performance. By referring ABC Bank’s proxy statements, I have selected five
regional, mid-west banks to estimate ABC Bank’s fair value by the PE and the PBV
ratios.
7
Chapter 3
ASSUMPTIONS
Key Items
Net Interest Income
Net interest income is the major source of ABC Bank’s revenue. It is the difference
between interest income on interest-earning assets and the interest expense on interestbearing deposits and other borrowings used to fund the company’s capital. Banks usually
borrow short term funds and lend long term loans. When the shape of the yield curve is
steep, the net interest margin would be higher which would be favorable to the net
interest income. However, if the shape of the yield curve is flat or inverse, the net
interest margin would be lower, which would be unfavorable to the net interest income.
The categories to be analyzed in net interest income are interest income and interest
expenses. Interest income is the sum of interest on loans and interest on investments.
Commercial loan interest, residential mortgage interest and retail loan interest are the
major components of interest on loans. Interest expenses are divided into interest on
deposits and interest on short term borrowing. The interest on loans or deposits in
forecasted time horizon is calculated by the annually average loan balance or deposits
balance times the forecasted interest rates. The average loan/deposit balance can be
simplified as the beginning loan/deposit balances plus the ending loan/deposit balances,
and then divided by two. To project the net interest income, the loan balances and
deposit balances from 10-K in 2008 have been utilized as the base data and the assumed
interest rate and loan/deposit growth rate have been employed for the next six years for
each of the four scenarios. Table 1 presents the assumptions of loan growth rate and
interest rate on loans for each of the four scenarios from 2009 to 2014. When the
8
economy is expanding, we assume that the commercial loans, residential mortgages, and
retail loans would grow and the interest rates would gradually increase. In contrast, when
the economy is contracting, we expect that the loans would decrease and the interest rates
would stay low or increase slowly. Table 2 demonstrates the assumptions of deposit
growth rate and interest rate on deposits for each of the four scenarios. In a recovered
and health economy, we assume that the deposits would grow and the interest rates would
gradually increase. On the opposite side, in a contracted economy, we expect the
deposits would stay at the same level of 2008 and the interest rate on deposits would
decrease or stay low.
Provision for Loan Losses
The provision for loan losses is a non-cash charge to earnings which represents the credit
risks for loan portfolios. It is the sum of the change in the allowance for loan losses and
net charge offs. It can be expressed by equation 3.1.
Provision for loan losses(t) = Allowance for loan losses(t) - Allowance for loan losses at
the beginning of the period(t-1) + Net charged off(t)
(Equation 3.1)
The allowance for loan losses is the management’s estimate of an amount sufficient to
cover possible credit losses in the loan portfolio on the balance sheet date. It can be
represented as a function of a number of factors, including changes in the loan portfolio,
net charge offs, and nonperforming loans. Net charge offs are the gross amount of loans
charged off as bad debt, less recoveries collected from earlier charge-offs which means
that poor credit quality loans that are not worth keeping on the books are eliminated from
the loan portfolio.
9
Because of the financial crisis in 2008, ABC Bank’s provision for loan losses increased
significantly compared to previous years which notably impacted the earnings for 2008
and 2009 first and second quarters. Thus, it is essential to determine the provision for
loan losses to forecast earnings.
Before estimating the provision for loan losses, the allowances for loan losses at the
beginning of the period and the ending of the period and the net charge offs during the
period must be determined. The allowance for loan losses and the net charge offs can be
represented as equations below:
Allowance for loan losses = Allowance for loan losses to total loans * total loans
(Equation 3.2)
Net charge offs = Net charge offs as a percentage of nonperforming loans *
Nonperforming loans
(Equation 3.3)
As a result, the ratio of the expected nonperforming loans to total loans, net charge offs as
a percentage of nonperforming loans, and the allowance for loan losses to total loans are
utilized to predict the provision for loan losses. Table 3 presents the expected allowance
for loan losses to total loans, nonperforming loans to total loans, and net charge offs to
nonperforming loans for each of the four scenarios.
Noninterest Income and Noninterest Expenses
The major components of ABC Bank’s noninterest income are trust service fees, service
charges on deposit accounts, card-based and other non-deposit fees, retail commissions,
mortgage banking, bank owned life insurance income, and other income. By observing
ABC Bank’s 10-K, the noninterest income is approximately 40% to 50% of the net
10
interest income from 2004 to 2008. Therefore, we assumed that the predicted noninterest
income would be in between 40% to 50% from 2009 to 2014.
ABC Bank’s noninterest expenses include personnel, occupancy, equipment, data
processing, business development and advertising, stationery and supplies, other
intangible asset amortization, courier, legal and professional, foreclosure/OREO, and
other expenses. The efficiency ratio, which is noninterest expense divided by the sum of
taxable equivalent net interest income and noninterest income, is used to evaluate the
operating competence of a bank. By studying ABC Bank’s 10-K, the efficiency ratio is
approximately 48% to 54% from 2004 to 2008. Therefore, we expected that the
noninterest expense from 2009 to 2014 would fluctuate between of 50% to 60% for each
of the four scenarios.
Preferred Stock
In November 2008, ABC Bank sold $525 million of Senior Preferred Stock to the Capital
Purchase Program under the Troubled Asset Relief Program. The investment will have a
dividend rate of 5% per year for the first five years and 9% annually thereafter. While
any Senior Preferred Stock is outstanding, all of its dividends have to be fully paid before
paying out the dividends on the common stock. Therefore, $26,250,000 must be paid
annually from 2009 to 2013 and $47,250,000 must be paid annually from 2014 and
thereafter before any dividends on common stock being distributed.
11
Scenarios
To determine the excess returns of ABC Bank, the following four scenarios have been
established to predict the operation performance and equity cost from 2009 to 2014.
Scenario 1
Scenario 1 is the most optimistic case based on the assumption that the economy would
begin to recover starting in the fourth quarter of 2009. In a recovered and healthy
economy businesses would be encouraged to start to borrow for investments, so
commercial loans could be assumed to start growing in 2010. We expected that
residential loan would decrease in 2009 because of refinancing, and then grow at 5%
annually from 2010 to 2014. Retail loans were expected to decrease 5% in 2009 and then
it should grow at 5% annually from 2010 to 2014. Because people have more money to
save, we assumed that deposits would grow gradually and the growth rate of total
deposits would remain from 2% to 3% until 2014.
The yield curve would be steep, which means the spread between long term and short
term Treasuries is more than three percent. Therefore, we predicted that interest rates on
both loans and deposits would gradually increase.
Because we expected solvency of borrowers would be better starting from the fourth
quarter of 2009, the provision for loan losses would gradually drop. We assumed the
allowance for loan losses as a percentage of total loans would increase to 3.00% in 2009,
decrease 0.5% annually for 2010 and 2011, and then stay at the level of 1.5% for the
following year. Nonperforming loans as a percentage of total loans were predicted to
decrease over the forecasted time horizon. Net charge offs to nonperforming loans were
12
expected to be 40% in 2009, start to drop annually, and then reach to the level of 20% in
2014.
Scenario 2
Scenario 2 is the moderate case based on the assumption that the economy would begin
to recover starting in 2010. Businesses would start to borrow for investments, so loans
would be assumed to start to grow in 2011. It is assumed that deposits would grow
slowly over the next six years. We expected that residential loan growth rates would
decrease 6% in 2009 because of refinancing, and then gradually grow from 2010 to 2014.
Retail loans were expected to decreases 7% in 2009 and then it should grow at 3%
annually from 2010 to 2014. Because people have more money to save, we assumed that
deposits would grow gradually and that the growth rate of total deposits would remain at
2% to 3% until 2014. However, because people are more conservative during the
recession year, deposits grow 9.00% in 2009. As the economic prediction gets more
optimistic, deposits are assumed to grow slowly at 0.75% for the following years.
The yield curve would be steep, but both short term and long term interest rates would
increase more slowly than scenario one. We assumed the commercial loan interest rates
would be 6.00% in 2009, and then step up a quarter of percentage to 6.25% in 2010, and
then stay at 6.50% until 2014. Residual loan interest rates are assumed to be 5.5% in
2009, and then increase a quarter of percentage to 5.75% in 2010, and keep at 6.00% until
2014. We expected retail loan interest rate would be 6.20% in 2009, 6.50% in 2010, and
keep at 6.75% for the following years. We assumed that the interest rates on deposits
would be approximately 1.50% in 2009, 1.75% in the 2010, and then stay at the 2.00%
level from 2011 to 2014.
13
Because the solvency of borrowers was expected to be better in 2010 or later, the
provision for loan losses would stay similar for the next two years then start to decrease.
We assumed that the allowance for loan losses as a percentage of total loans would
increase to 3.50% in 2009, then gradually decrease from 2010 to 2014. Nonperforming
loans as a percentage of total loans were predicted to be 5.00%, 4.50%, 4.00%, 3.00%,
3.00%, and 2.00% from 2009 to 2014. We expected that net charge offs to
nonperforming loans would be in the range of 40% to 45% in this scenario.
Scenario 3
Scenario 3 is the slow recovery case based on the assumption that the economy begin to
recover in 2011. Businesses would be still conservative about borrowing for investment
so the loan growth would be negative then start to grow in 2011. We assumed that
commercial loans would decrease 7% in 2009, 5% in 2010, and then grow at 2% annually
from 2011 to 2014. We expected that residential loans and retail loans would decrease in
2009 and 2010, and then grow slowly from 2011 to 2014. Deposits were expected to stay
at the same level for three more years and then start to grow in 2012.
The yield curve was expected to be normal and both short term and long term interest
rates would continue to drop then slowly increase starting in 2011. We assumed that
interest rates on commercial loans and residual loans would drop in 2009 and 2010, and
then gradually increase from 2011 to 2014. Retail loans interest rates were assumed to
drop from 2009 to 2011, then gradually increase from 2012 to 2014. We expected that
interest rates on deposits would decrease from 2009 to 2011, and then reach 3% in 2014.
Because the solvency of borrowers would be still unfavorable in 2009 and 2010, the
provision for loan losses would stay at a higher level until 2011 then start to decline. We
14
assumed that the allowance for loan losses as a percentage of total loans would increase
to 4.00% in 2009 and 2010, decrease 0.5% annually from 2011 to 2013, and reach 1.75%
in 2014. Nonperforming loans as a percentage of total loans were predicted to plateau at
5.5% in 2009 and 2010, and then gradually decrease to 2.5% in 2014. We expected that
net charge offs to nonperforming loans would be 40% in 2009, jump to 60% in 2010,
decrease to 50% in 2011, and then stay at 40% for the following years.
Scenario 4
Scenario 4 is the most pessimistic case based on the assumption that the economy would
not recover for at least six years. This scenario was designed to examine under the worst
condition, how long the company could survive without raising extra funds.
We assumed that businesses would still be conservative concerning borrowing for
investments, so there would be no loan growth from 2009 to 2014. We assumed that
commercial loans would decrease 9% in 2009, 5% in 2010, and then continue to decrease
3% annually until 2014. Residential loans were expected to decline 10% in 2009, and
then continue to decrease 5% annually until 2014. We predicted that retail loans would
decreases 10% in 2009, and continue to decrease 5% annually for the following years.
Deposits were assumed to stay at the current level from 2009 to 2014.
We assumed that the yield curve would be flat and both short term and long term interest
rates would continue to drop and stay low. Therefore, we expected that interest rates on
commercial loans, residual loans, and retail loans would continue to drop through the
forecasted time horizon. Interest rates on deposit were expected to be 1.50% in 2009,
1.25% in 2010 and stay at the 1.00% level for the following years.
15
As we assumed that the solvency of borrowers would still be unfavorable through the
forecasted time horizon, the provision for loan losses would continually increase over the
next six years. We expected that the allowance for loan losses as a percentage of total
loans would jump to 5.00% in 2009, and increase 1% annually for the following years.
We also assumed that nonperforming loans as a percentage of total loans would continue
to increase from 2009 to 2014. Net charge offs to nonperforming loans were expected to
be 40% in 2009, jump to 60% and 70% in 2010 and 2011, and then remain at 75% for the
following years.
16
Chapter 4
FUNDAMENTAL VALUATION
Pro forma Financial Statements
To predict future financial earnings and the book value of equity, we have completed
interlinked income statements, balance sheet statements, and the statements of cash
flows. By observing the historical income statements, the effective tax rate was assumed
to be in the range of 25% to 30%. We also assumed that the investment securities as 35%
of loan balances, other assets as 3.5% of total assets, and accrued expenses and other
liabilities are as 2.00% of total liabilities. In addition, in order to eliminate the effect of
changing dividend policy, dividend payouts were assumed to be $0.20 per share for the
forecasted time horizon for each of the four scenarios.
Table 4 represents the selected forecasted earnings summary and financial data for
scenario 1. Even though the net interest income was predicted to increase in 2009,
because of the rising of provision for loan losses, the net income was predicted to
decrease. However, as the economy was expected to recover from the fourth quarter of
2009, the net income was forecasted to increase in 2010. The EPS was expected to be
$0.02, $2.18, $2.77, $2.95, $2.67, and $2.95, and the book value per share was predicted
to be $18.39, $20.38, $22.96, $25.71, $28.17, and $30.92 from 2009 to 2014.
Table 5 corresponds to the selected forecasted earnings summary and financial data for
scenario 2. Because the economic condition in 2009 was assumed to be weaker, the
increased provision for loan losses would impair the profitability and ABC Bank was
expected to face a net loss. As the economy is assumed to be recovering, the provision
for loan losses was expected to decrease and the net income is expected to be positive
17
from the 2010. The EPS was expected to be -$0.51, $1.14, $1.42, $2.24, $2.31, and
$2.35, and the book value per share was predicted to be $17.86, $18.80, $20.02, $22.07,
$24.17, and $26.32 from 2009 to 2014.
Table 6 describes the selected forecasted earnings summary and financial data for
scenario 3. The economy was assumed to be recovering starting from 2011, so ABC
Bank was expected to confront a net loss for 2009 and 2010. We expected that the
provision for loan losses would decrease and the net income would be positive from
2011. The EPS was expected to be-$1.79, -$0.68, $1.12, $1.69, $1.88, and $1.43, and the
book value per share was predicted to be $16.59, $15.71, $16.63, $18.12, $19.79, and
$21.02 from 2009 to 2014.
Table 7 represents the selected forecasted earnings summary and financial data for
scenario 4. The economy was assumed to deteriorate over the forecasted time horizon.
We expected that the provision for loan losses would destroy the profitability and equity
value of ABC Bank. In this scenario, it is predicted that ABC Bank would fail to meet
the minimum capital requirement of 8% in 2011 or 2012 during the forecasted time
horizon.
Intrinsic Value Estimation
The intrinsic value of residual income was calculated by Equation 2.1, which represents
the beginning book value plus the summation of the present value of net income less the
equity charge. This figure is then added to the present value of terminal value. The
beginning book value of equity is the value at the end of 2008. Net incomes for each
period of the forecasted time horizon for each of the scenarios were derived from the pro
forma income statements. Equity charges for each period were determined by
multiplying the estimated book value of equity at the beginning of the period by the cost
18
of equity or the required rate of return. The terminal value was calculated by subtracting
the equity charge from the net income of the last period. This figure was then divided by
one plus required rate of return less the persistence factor.
Because of the financial crisis in 2008, ABC Bank’s stock prices fluctuated from the
previous twelve months, so the market required rate of return has been utilized instead of
the company’s required rate of return. By referring to Damodaran’s analysis of historical
equity risk premium and the current ten year U.S. Treasury Bonds rate, the required rate
of return to analyze ABC Bank’s equity value was estimated to be in the range of 8% to
10%.
Table 8 demonstrates the calculation of the intrinsic values of ABC Bank at various
discount rates for scenario 1 and the suggested range of intrinsic value is $18.36 to
$20.94. Table 9 demonstrates the calculation of the intrinsic values of ABC Bank at
various discount rates for scenario 2 and the suggested range of intrinsic value is $15.63
to $17.80. Table 10 demonstrates the calculation of the intrinsic values of ABC Bank at
various discount rates for scenario 3 and the suggested range of intrinsic value is $12.30
to $14.00. In scenario 4, because the negative earnings were expected to continue over
the forecasted time horizon which was projected to erode the equity value, the intrinsic
value was estimated to be $0.
According to the Summary of Commentary on Current Economic Conditions of August
2009 by the Federal Reserve District, overall economic activity in the Minneapolis area
was transformed from contracted to flat. Therefore, the economy is expected to begin to
recover starting at the end of 2009 or the starting of 2010. In addition, the current shape
of the yield curve is steep sloped, which is favorable to ABC Bank’s net interest margin.
Moreover, Figure 1 demonstrates that ABC Bank’s provision for loan losses and the
19
ISM-Milwaukee index rolled forward one quarter are highly negative correlated with a
correlation coefficient of -0.81. The ISM-Milwaukee index is the manufacturing index
for Milwaukee which indicates the business activity in the Milwaukee, Wisconsin region.
As the ISM-Milwaukee index started to rally from the second quarter of 2009, I expected
the provision for loan losses of ABC Bank would gradually decrease from the end of
2009 or the beginning of 2010. Based on the observations above, the weight assigned to
scenario 2 is 50%. The weight for scenario 1 and scenario 3 are 25% and 20%. The
probability of the economy remaining contracted for more than six years is extremely
low, so the weight assigned to the scenario 4 is 5%. The assigned weight for each
scenario and discount rate were given in Table 11 and the weighted average of ABC
Bank’s intrinsic value is $15.87 per share.
The Tangible Common Equity Ratio
ABC Bank is subject to regulatory capital requirements administered by the federal
regulators. The regulation defines the tier 1 capital ratio as the measure of a bank’s
ability to provide protection against unexpected losses, which is represented as the ratio
of a banks equity capital to its total assets. Failure to meet minimum tier 1 capital
requirements could result in certain mandatory actions by regulators, which could have a
direct material effect on the rights of its common shareholders. ABC Bank’s minimum
requirement for the tier 1 risk-based capital ratio is 8%. In Table 12, the historical tier 1
risk-based capital ratios are 9.64%, 9.73%,9.42%, 9.06%, and 11.91% from 2004 to
2008, which suggests ABC Bank may have the enough financial strength to confront the
unexpected losses.
However, since common equity provides a cushion against credit losses, the tangible
common equity (TCE) ratio is a better measure of solvency than the tier 1 capital ratio.
20
The TCE ratio is tangible common equity divided by tangible assets. For a regional
bank, a ratio of the level at 5% is suggested to be adequate. In Table 12, ABC Bank’s
TCE ratio is in between 5.86% to 6.36% from 2004 to 2008. We also calculated the TCE
ratio for each of the four scenarios in order to predict ABC Bank’s future solvency. In
the most optimistic scenario, the TCE ratios are expected to maintain at a higher level for
the following six years. In the moderate recovery scenario, the TCE ratios are expected
to decrease in 2009 and then start to improve and maintain at a higher level from 2010.
In the slow recovery scenario, the TCE ratios are expected to fall below 5% in the first
three years and then start to improve after 2012. In the most pessimistic scenario, the
TCE ratios are expected to fall below 5% for every year of the forecasted time horizon
and the tangible common equity is expected to be negative, so ABC Bank is not expected
to be viable in this scenario. From the analysis of the four scenarios, it is suggested that
except the extremely unfavorable economic condition, ABC Bank would have enough
cushion against its credit losses.
21
Chapter 5
RELATIVE VALUATION
Price-earnings (PE) ratio
Table 14 lists ABC Bank and its peer companies’ price on September 09, 2009, the EPS
from third quarter of 2008 to second quarter of 2009, the estimated EPS for 2009 and
2010, and the corresponding price-earnings (PE) multiples. First, the average trailing PE
ratio of peer companies was 19.64x with a median of 17.78x while ABC Bank’s trailing
PE was 20.58x, which indicated that the price of $10.29 was overvalued based on the past
four quarter’s earnings. Based on its past EPS, ABC Bank’s price was suggested to be
$9.8 per share. However, since the stock price reflects the investors’ expectation of its
future profitability, the forward PE ratio is also an important indicator. According to the
estimation data on September 09, 2009 of analysts’ expected EPS at the end of 2010
<http://finance.yahoo.com>, the average forward PE ratio of peer companies was 16.41x
with a median of 15.93x. Based on the scenario analysis, ABC Bank’s weighted average
estimated EPS at the end of 2010 was expected to be $0.90, so its target price was
suggested to be $14.77 per share to reflect the potential of future earnings.
Price-to-book value (PBV) ratio
Table 15 lists ABC Bank and its peer companies’ price on September 09, 2009, the book
value per share, the tangible book value (the book value less goodwill and other
intangible assets) per share, and the corresponding price-to-book value (PBV) multiples.
The book values and tangible book value per share of the second quarter of 2009 were
acquired from company SEC 10-Q filings. The average PBV ratio of peer companies
was 1.14x with a median of 1.09x while ABC Bank’s PBV ratio was 0.55x. In addition,
22
the average price-to-tangible-book value ratio of peer companies was 1.96x with a
median of 1.62x while ABC Bank’s PBV ratio was 0.95x. Based on both the PBV and
price-to-tangible-book value ratios, ABC Bank was undervalued and the suggested price
was approximately $21.20. One reason for ABC Bank’s underestimated price may be its
low return on equity (ROE) because the PBV ratio of a firm in a stable growth stage can
be determined by the differential between its ROE and its required rate of return.
23
Chapter 6
FINDINGS AND CONCLUSIONS
Based on the residual income valuation, I estimate ABC Bank’s intrinsic value to be
$15.87 per share, and its target stock price to be $14.77 per share based on the review of
PE multiples. During the research period of this project (5/1/2009 to 9/9/2009), ABC
Bank’s stock price ranged from $8.92 to $19.09 per share and the current price was
$10.29 per share on 9/9/2009.
As Figure 2 demonstrates, ABC Bank’s stock price performance was relatively weaker
than the S&P 500 index and the KRE (regional bank index) during the period of this
project. The possible reasons could be the announcement of a net loss in the second
quarter and the high turnover rate of top management in August 2009. In addition,
according to the Summary of Commentary on Current Economic Conditions of August
2009 by the Federal Reserve District, the commercial real estate markets continued to
soften and investors may also have questioned whether the bank had allocated a sufficient
allowance or declared an adequate provision for loan losses.
However, as the economy showed signs of stabilization as of August 2009, it is
anticipated to rebound from the state of recession. As long as ABC Bank can fulfill its
capital requirements, it is expected to improve its profitability in 2010. And though
profitability should greatly improve from 2009 conditions, it is not expected to reach the
level of 2008 performance until 2011 or later. Accordingly, I would suggest that
investors buy and hold at the current price of $10.29 per share and sell when it reaches
the target price of $14.77 to $15.87 per share.
24
Table 1 Assumptions for loan growth rate and interest rate for each of the four scenarios
2009
2010
2011
2012
2013
2014
Scenario 1
-4.00%
5.00%
5.00%
5.00%
5.00%
5.00%
Scenario 2
-5.00%
3.00%
2.00%
2.00%
2.00%
2.00%
Scenario 3
-7.00%
-5.00%
2.00%
2.00%
2.00%
2.00%
Scenario 4
-9.00%
-5.00%
-3.00%
-3.00%
-3.00%
-3.00%
Scenario 1
6.00%
7.00%
8.00%
8.50%
9.00%
9.50%
Scenario 2
6.00%
6.25%
6.50%
6.50%
6.50%
6.50%
Scenario 3
5.50%
5.25%
6.00%
6.25%
6.50%
6.50%
Scenario 4
5.50%
5.25%
5.00%
4.75%
4.50%
4.25%
Scenario 1
-4.00%
3.00%
3.00%
3.00%
3.00%
3.00%
Scenario 2
-6.00%
1.00%
2.00%
3.00%
3.00%
3.00%
Scenario 3
-8.00%
-3.00%
2.00%
2.00%
3.00%
3.00%
Scenario 4
-10.00%
-5.00%
-5.00%
-5.00%
-5.00%
-5.00%
Scenario 1
5.50%
6.00%
6.50%
7.50%
8.50%
9.50%
Scenario 2
5.50%
5.75%
6.00%
6.00%
6.00%
6.00%
Scenario 3
5.00%
4.75%
5.00%
5.50%
6.00%
6.50%
Scenario 4
5.00%
4.75%
4.50%
4.25%
4.00%
3.75%
Scenario 1
-5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
Scenario 2
-7.00%
3.00%
3.00%
3.00%
3.00%
3.00%
Scenario 3
-8.00%
-3.00%
3.00%
3.00%
3.00%
3.00%
Scenario 4
-10.00%
-5.00%
-5.00%
-5.00%
-5.00%
-5.00%
Scenario 1
6.20%
7.00%
8.00%
8.50%
9.00%
9.50%
Scenario 2
6.20%
6.50%
6.75%
6.75%
6.75%
6.75%
Scenario 3
6.20%
6.00%
5.80%
6.50%
6.75%
6.75%
Scenario 4
6.20%
6.00%
5.80%
5.60%
5.40%
5.20%
Commercial Loans
Growth rate
Interest rate
Residential Mortgages
Growth rate
Interest rate
Retail Loans
Growth rate
Interest rate
25
Table 2 Assumptions for deposit growth rate and interest rate for each of the four
scenarios
2009
2010
2011
2012
2013
2014
Scenario 1
3.00%
3.00%
3.00%
3.00%
3.00%
3.00%
Scenario 2
8.00%
1.00%
1.00%
1.00%
1.00%
1.00%
Scenario 3
0.00%
0.00%
0.00%
3.00%
3.00%
3.00%
Scenario 4
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Scenario 1
1.50%
2.00%
3.00%
4.00%
5.00%
5.50%
Scenario 2
1.50%
1.75%
2.00%
2.00%
2.00%
2.00%
Scenario 3
1.50%
1.25%
1.00%
1.25%
2.00%
3.00%
Scenario 4
1.50%
1.25%
1.00%
1.00%
1.00%
1.00%
Scenario 1
0.00%
-10.00%
-10.00%
-5.00%
-5.00%
-5.00%
Scenario 2
50.00%
-3.00%
-3.00%
-3.00%
-3.00%
-3.00%
Scenario 3
0.00%
0.00%
0.00%
-5.00%
-5.00%
-5.00%
Scenario 4
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Scenario 1
2.50%
3.50%
4.50%
5.50%
6.50%
7.00%
Scenario 2
2.50%
2.75%
3.00%
3.00%
3.00%
3.00%
Scenario 3
2.00%
1.50%
2.00%
2.50%
3.50%
4.50%
Scenario 4
2.00%
1.50%
1.50%
1.50%
1.50%
1.50%
Interest-bearing
Deposits, exclude
brokered CDs
Growth rate
Interest rate
Brokered CDs
Growth rate
Interest rate
26
Table 3 Assumptions to estimate provision for loan losses
2009
2010
2011
2012
2013
2014
Allowance for loan losses to total loans
Scenario 1
3.00%
2.50%
2.00%
1.50%
1.50%
1.50%
Scenario 2
3.50%
3.25%
3.00%
2.50%
2.00%
1.75%
Scenario 3
4.00%
4.00%
3.00%
2.50%
2.00%
1.75%
Scenario 4
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
Nonperforming loans to total loans
Scenario 1
4.50%
3.50%
3.00%
2.50%
2.00%
1.50%
Scenario 2
5.00%
4.50%
4.00%
3.00%
3.00%
2.00%
Scenario 3
5.50%
5.50%
4.50%
3.50%
3.00%
2.50%
Scenario 4
6.00%
6.50%
7.00%
7.50%
8.00%
8.00%
Net charge offs to nonperforming loans
Scenario 1
40.00%
35.00%
30.00%
30.00%
25.00%
20.00%
Scenario 2
40.00%
45.00%
45.00%
40.00%
40.00%
40.00%
Scenario 3
40.00%
60.00%
50.00%
45.00%
40.00%
40.00%
Scenario 4
40.00%
60.00%
70.00%
75.00%
75.00%
75.00%
27
Table 4 Predicted earnings summary and selected financial data for scenario 1
2008
2009
2010
2011
2012
2013
2014
$1,776
$1,934
$2,105
Earnings summary
Interest income
$1,127
$1,144
$1,325
$1,576
-$431
-$355
-$475
-$641
$696
$789
$850
$935
$941
$915
$965
-$202
-$489
-$136
-$84
-$58
-$104
-$71
$494
$300
$714
$851
$883
$811
$894
$286
$316
$340
$374
$376
$366
$386
-$557
-$574
-$618
-$681
-$685
-$653
-$675
Pretax Income
$223
$42
$436
$544
$574
$523
$604
Income tax expense
-$54
-$12
-$130
-$163
-$172
-$157
-$181
Net income
$169
$30
$306
$381
$402
$366
$423
-3
-$26
-$26
-$26
-$26
-$26
-$47
$164
$4
$280
$355
$376
$340
$376
128
128
128
128
128
128
128
$1.30
$0.02
$2.18
$2.77
$2.95
$2.67
$2.95
Interest expenses
Net interest income
Provision for loan losses
Net interest income after
provision for loan losses
Noninterest income
Noninterest expenses
Preferred dividends
Net income to common equity
Shares outstanding
EPS
-$835 -$1,019 -$1,140
Selected financial data
Year end balance
Loans
Allowance for loan losses
$16,284 $15,595 $16,332 $17,105 $17,914 $18,763 $19,653
-$265
-$468
-$408
-$342
-$269
-$281
-$295
Loans, net
$16,019 $15,127 $15,924 $16,763 $17,646 $18,482 $19,358
Total Assets
$24,192 $24,711 $25,387 $26,166 $27,024 $27,868 $28,768
Deposits
$15,155 $15,586 $15,951 $16,337 $16,776 $17,230 $17,701
Total Liabilities
$21,316 $21,858 $22,281 $22,731 $23,239 $23,768 $24,318
Senior preferred stock
$508
$508
$508
$508
$508
$508
$508
Common shareholder’s equity
$2,368
$2,345
$2,598
$2,927
$3,277
$3,592
$3,942
Total shareholders’ equity
$2,876
$2,853
$3,106
$3,435
$3,785
$4,100
$4,450
Book Value per share
$18.53
$18.39
$20.38
$22.96
$25.71
$28.17
$30.92
$438
$555
$477
$502
$497
$508
$531
Cash flows data
Cash flow from operating
(In millions dollars, except per share data)
28
Table 5 Predicted earnings summary and selected financial data for scenario 2
2008
2009
2010
2011
2012
2013
2014
Earnings summary
Interest income
$1,127
$1,139
$1,195
$1,269
$1,288
$1,308
$1,330
-$431
-$361
-$419
-$470
-$472
-$475
-$478
$696
$778
$776
$799
$816
$833
$852
-$202
-$589
-$291
-$258
-$125
-$126
-$102
$494
$189
$485
$541
$691
$707
$750
$286
$286
$295
$312
$326
$333
$341
-$557
-$533
-$535
-$555
-$571
-$583
-$596
Pretax Income
$223
-$58
$245
$298
$446
$457
$495
Income tax expense
-$54
$17
-$73
-$89
-$134
-$137
-$148
Net income
$169
-$41
$172
$209
$312
$320
$347
-3
-$26
-$26
-$26
-$26
-$26
-$47
Net income equity
$166
-$67
$146
$183
$286
$294
$300
shares outstanding
128
128
128
128
128
128
128
$1.30
-$0.51
$1.14
$1.42
$2.24
$2.31
$2.35
Interest expenses
Net interest income
Provision for loan losses
Net interest income after
provision for loan losses
Noninterest income
Noninterest expenses
Preferred dividends
EPS
Selected financial data
Year end balance
Loans
Allowance for loan losses
$16,284 $15,373 $15,792 $16,144 $16,525 $16,915 $17,315
-265
-538
-513
-484
-413
-338
-303
Loans, net
$16,019 $14,835 $15,279 $15,660 $16,112 $16,577 $17,012
Total Assets
$24,192 $25,484 $25,767 $26,089 $26,518 $26,958 $27,405
Deposits
$15,155 $16,501 $16,627 $16,755 $16,885 $17,018 $17,153
Total Liabilities
$21,316 $22,699 $22,862 $23,028 $23,197 $23,368 $23,542
Senior preferred stock
$508
$508
$508
$508
$508
$508
$508
Common shareholder’s equity
$2,368
$2,277
$2,397
$2,553
$2,813
$3,082
$3,355
Total shareholders’ equity
$2,876
$2,785
$2,905
$3,061
$3,321
$3,590
$3,863
Book Value per share
$18.58
$17.86
$18.80
$20.02
$22.07
$24.17
$26.32
$438
$587
$498
$503
$474
$483
$485
Cash flows data
Cash flow from operating
(In millions dollars, except per share data)
29
Table 6 Predicted earnings summary and selected financial data for scenario 3
2008
2009
2010
2011
2012
2013
2014
Earnings summary
Interest income
$1,127
$1,064
$977
$1,058
$1,148
$1,248
$1,350
-$431
-$348
-$287
-$271
-$361
-$491
-$678
$696
$716
$690
$787
$787
$757
$672
-$202
-$683
-$461
-$193
-$143
-$115
-$124
$494
$33
$229
$594
$644
$642
$548
$286
$272
$248
$299
$299
$295
$269
-$557
-$593
-$563
-$652
-$597
-$557
-$489
Pretax Income
$223
-$288
-$86
$241
$346
$380
$328
Income tax expense
-$54
$86
$25
-$72
-$103
-$114
-$98
Net income
$169
-$202
-$60
$169
$243
$266
$230
-3
-$26
-$26
-$26
-$26
-$26
-$47
Net income equity
$164
-$228
-$86
$143
$217
$240
$183
shares outstanding
128
128
128
128
128
128
128
$1.30
-$1.79
-$0.68
$1.12
$1.69
$1.88
$1.43
Interest expenses
Net interest income
Provision for loan losses
Net interest income after
provision for loan losses
Noninterest income
Noninterest expenses
Preferred dividends
EPS
Selected financial data
Year end balance
Loans
Allowance for loan losses
$16,284 $15,085 $14,440 $14,762 $15,091 $15,449 $15,815
-$265
-603
-578
-443
-377
-309
-277
Loans, net
$16,019 $14,481 $13,862 $14,319 $14,714 $15,140 $15,538
Total Assets
$24,192 $24,050 $23,803 $23,920 $24,552 $25,229 $25,868
Deposits
$15,155 $15,155 $15,155 $15,155 $15,545 $15,953 $16,374
Total Liabilities
$21,316 $21,427 $21,292 $21,292 $21,734 $22,197 $22,680
Senior preferred stock
$508
$508
$508
$508
$508
$508
$508
Common shareholder’s equity
$2,368
$2,115
$2,003
$2,120
$2,310
$2,524
$2,680
Total shareholders’ equity
$2,877
$2,623
$2,511
$2,628
$2,818
$3,032
$3,188
Book Value per share
$18.53
$16.59
$15.71
$16.63
$18.12
$19.79
$21.02
$438
$518
$438
$399
$422
$418
$390
Cash flows data
Cash flow from operating
(In millions dollars, except per share data)
30
Table 7 Predicted earnings summary and selected financial data for scenario 4
2008
2009
2010
2011
2012
2013
2014
Earnings summary
Interest income
$1,127
$1,059
$967
$911
$863
$819
$779
-$431
-$348
-$288
-$231
-$221
-$221
-$221
$696
$711
$679
$678
$642
$598
$558
-$202
-$845
-$665
-$778
-$840
-$852
-$816
$494
-$134
$14
-$100
-$198
-$254
-$258
$286
$355
$340
$340
$321
$299
$279
-$557
-$608
-$612
-$612
-$578
-$538
-$502
Pretax Income
$223
-$387
-$258
-$372
-$455
-$493
-$481
Income tax expense
-$54
$115
$76
$111
$136
$148
$144
Net income
$169
-$272
-$182
-$261
-$319
-$345
-$337
-3
-$26
-$26
-$26
-$26
-$26
-$47
Net income equity
$164
-$298
-$208
-$287
-$345
-$371
-$384
shares outstanding
128
128
128
128
128
128
128
$1.30
-$2.33
-$1.61
-$2.24
-$2.70
-$2.91
-$3.01
Interest expenses
Net interest income
Provision for loan losses
Net interest income after
provision for loan losses
Noninterest income
Noninterest expenses
Preferred dividends
EPS
Selected financial data
Year end balance
Loans
Allowance for loan losses
$16,284 $14,759 $14,021 $13,499 $12,997 $12,515 $12,053
-$265
-738
-841
-945
-1,040
-1,126
-1,205
Loans, net
$16,019 $14,021 $13,180 $12,554 $11,957 $11,389 $10,848
Total Assets
$24,192 $23,981 $23,615 $23,180 $22,697 $22,198 $21,695
Deposits
$15,155 $15,155 $15,155 $15,155 $15,155 $15,155 $15,155
Total Liabilities
$21,316 $21,427 $21,297 $21,168 $21,055 $20,953 $20,860
Senior preferred stock
$508
$508
$508
$508
$508
$508
$508
Common shareholder’s equity
$2,368
$2,046
$1,810
$1,504
$1,134
$737
$327
Total shareholders’ equity
$2,877
$2,554
$2,318
$2,012
$1,642
$1,245
$835
Book Value per share
$18.53
$16.05
$14.23
$11.80
$8.89
$5.78
$2.57
$438
$612
$522
$556
$559
$544
$516
Cash flows data
Cash flow from operating
(In millions dollars, except per share data)
31
Table 8 Predicted intrinsic value of scenario 1
2009
2010
2011
2012
2013
2014
Required rate of return = 8%, Persistence factor = 0.62
Beginning book value
$18.53
$18.34
$20.31
$22.89
$25.63
$28.09
Net income
$0.02
$2.18
$2.77
$2.94
$2.66
$2.94
Cost of equity
$1.48
$1.47
$1.63
$1.83
$2.05
$2.25
Excess return
-$1.46
$0.71
$1.15
$1.11
$0.61
$0.69
PV of excess return
-$1.35
$0.61
$0.91
$0.81
$0.41
PV of terminal value
5
Vo  B0  
t 1
$1.02
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $20.94
Required rate of return = 9%, Persistence factor = 0.62
Beginning book value
$18.53
$18.34
$20.31
$22.89
$25.63
$28.09
Net income
$0.02
$2.18
$2.77
$2.94
$2.66
$2.94
Cost of equity
$1.67
$1.65
$1.83
$2.06
$2.31
$2.53
Excess return
-$1.65
$0.52
$0.95
$0.88
$0.35
$0.41
PV of excess return
-$1.51
$0.44
$0.73
$0.62
$0.23
PV of terminal value
5
Vo  B0  
t 1
$0.57
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $19.60
Required rate of return = 10%, Persistence factor = 0.62
Beginning book value
$18.53
$18.34
$20.31
$22.89
$25.63
$28.09
Net income
$0.02
$2.18
$2.77
$2.94
$2.66
$2.94
Cost of equity
$1.85
$1.83
$2.03
$2.29
$2.56
$2.81
Excess return
-$1.83
$0.34
$0.74
$0.65
$0.10
$0.13
PV of excess return
-$1.67
$0.28
$0.56
$0.44
$0.06
PV of terminal value
5
Vo  B0  
t 1
$0.17
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $18.36
(Per share data)
32
Table 9 Predicted intrinsic value of scenario 2
2009
2010
2011
2012
2013
2014
Required rate of return = 8%, Persistence factor = 0.62
Beginning book value
$18.53
$17.81
$18.74
$19.96
$22.00
$24.10
Net income
-$0.51
$1.13
$1.42
$2.24
$2.30
$2.34
Cost of equity
$1.48
$1.42
$1.50
$1.60
$1.76
$1.93
Excess return
-$1.99
-$0.29
-$0.08
$0.64
$0.54
$0.41
PV of excess return
-$1.85
-$0.25
-$0.06
$0.47
$0.37
PV of terminal value
5
Vo  B0  
t 1
$0.61
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $17.8
Required rate of return = 9%, Persistence factor = 0.62
Beginning book value
$18.53
$17.81
$18.74
$19.96
$22.00
$24.10
Net income
-$0.51
$1.13
$1.42
$2.24
$2.30
$2.34
Cost of equity
$1.67
$1.60
$1.69
$1.80
$1.98
$2.17
Excess return
-$2.18
-$0.47
-$0.27
$0.44
$0.32
$0.17
PV of excess return
-$2.00
-$0.40
-$0.21
$0.31
$0.21
PV of terminal value
5
Vo  B0  
t 1
$0.23
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $16.67
Required rate of return = 10%, Persistence factor = 0.62
Beginning book value
$18.53
$17.81
$18.74
$19.96
$22.00
$24.10
Net income
-$0.51
$1.13
$1.42
$2.24
$2.30
$2.34
Cost of equity
$1.85
$1.78
$1.87
$2.00
$2.20
$2.41
Excess return
-$2.36
-$0.65
-$0.45
$0.24
$0.10
-$0.07
PV of excess return
-$2.15
-$0.54
-$0.34
$0.16
$0.06
PV of terminal value
5
Vo  B0  
t 1
-$0.09
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $15.63
(Per share data)
33
Table 10 Predicted intrinsic value of scenario 3
2009
2010
2011
2012
2013
2014
Required rate of return = 8%, Persistence factor = 0.62
Beginning book value
$18.52
$16.54
$15.66
$16.58
$18.06
$19.73
Net income
-$1.78
-$0.68
$1.11
$1.68
$1.87
$1.42
Cost of equity
$1.48
$1.32
$1.25
$1.33
$1.44
$1.58
Excess return
-$3.26
-$2.00
-$0.14
$0.36
$0.43
-$0.16
PV of excess return
-$3.02
-$1.71
-$0.11
$0.26
$0.29
PV of terminal value
5
Vo  B0  
t 1
-$0.23
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $14.00
Required rate of return = 9%, Persistence factor = 0.62
Beginning book value
$18.52
$16.54
$15.66
$16.58
$18.06
$19.73
Net income
-$1.78
-$0.68
$1.11
$1.68
$1.87
$1.42
Cost of equity
$1.67
$1.49
$1.41
$1.49
$1.63
$1.78
Excess return
-$3.45
-$2.16
-$0.30
$0.19
$0.25
-$0.35
PV of excess return
-$3.16
-$1.82
-$0.23
$0.14
$0.16
PV of terminal value
5
Vo  B0  
t 1
-$0.49
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $13.11
Required rate of return = 10%, Persistence factor = 0.62
Beginning book value
$18.52
$16.54
$15.66
$16.58
$18.06
$19.73
Net income
-$1.78
-$0.68
$1.11
$1.68
$1.87
$1.42
Cost of equity
$1.85
$1.65
$1.57
$1.66
$1.81
$1.97
Excess return
-$3.63
-$2.33
-$0.45
$0.03
$0.07
-$0.55
PV of excess return
-$3.30
-$1.93
-$0.34
$0.02
$0.04
PV of terminal value
5
Vo  B0  
t 1
-$0.71
( NI t  rBt 1 )
NI 6  rB5

t
(1  r )
(1  r   )(1  r ) 5
= $12.30
(Per share data)
34
Table 11 Estimated intrinsic values and assigned weight of average for different required
rate of return and scenarios
Intrinsic value
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Assigned weight
Scenario 1 (25%)
Scenario 2 (50%)
Scenario 3 (20%)
Scenario 4 (5%)
R=8%
R=9%
R=10%
$20.94
$17.80
$14.00
N/A
$19.60
$16.67
$13.11
N/A
$18.36
$15.63
$12.30
N/A
5%
10%
4%
1%
15%
30%
12%
3%
5%
10%
4%
1%
35
Table 12 Tier 1 capital ratios and TCE ratios from 2004~2008
2004
Tier 1 risk-based capital
ratio
TCE Ratio
2005
2006
2007
2008
9.64%
9.73%
9.42%
9.06%
11.91%
6.18%
6.29%
6.36%
6.36%
5.86%
(In millions dollars, except ratio data)
36
Table 13 Predicted TCE Ratios for each of the four scenarios
2009
2010
2011
2012
2013
2014
Scenario 1
Tangible common
equity
Tangible assets
$1,343
$1,603
$1,939
$2,296
$2,618
$2,975
$23,709
$24,392
$25,178
$26,043
$26,893
$27,801
TCE Ratio
5.66%
6.57%
7.70%
8.82%
9.73%
10.70%
Scenario 2
Tangible common
equity
Tangible assets
$1,275
$1,401
$1,564
$1,832
$2,108
$2,388
$24,482
$24,771
$25,100
$25,536
$25,983
$26,438
TCE Ratio
5.21%
5.66%
6.23%
7.17%
8.11%
9.03%
Scenario 3
Tangible common
equity
Tangible assets
$1,113
$1,008
$1,132
$1,329
$1,549
$1,713
$23,048
$22,808
$22,931
$23,571
$24,254
$24,901
TCE Ratio
4.83%
4.42%
4.93%
5.64%
6.39%
6.88%
Scenario 4
Tangible common
equity
Tangible assets
$1,044
$819
$516
$153
-
-
$22,979
$22,619
$22,192
$21,716
-
-
4.54%
3.62%
2.32%
0.70%
-
-
TCE Ratio
(In millions dollars, except ratio data)
37
Table 14 ABC Bank’s PE ratio compared to its peer companies
EPS
Company
Price on
Name
09/09/09
P/E Multiple
Forward
Forward
P/E
P/E
(CY’09)
(CY’10)
20.58x
NA
9.44x
$1.44
26.2x
25.59x
15.10x
$0.43
$0.55
17.78x
25.44x
19.07x
$1.20
$1.00
$1.22
14.93x
17.92x
14.69x
$16.09
-$1.19
-$0.75
$0.96
NA
NA
16.76x
$10.55
-$4.02
$0.79
-$0.17
NA
13.35x
NA
Peer Group Mean of P/E Multiple
19.64x
20.58x
16.41x
Peer Group Median of P/E Multiple
17.78x
21.68x
15.93x
Q308 ~
Estimated
Estimated
Trailing
Q209
CY’09(1)
CY’10(1)
P/E
$10.29
$0.50
-$0.72(2)
$0.90(2)
U*B
$21.75
$0.83
$0.85
O*B
$10.49
$0.59
F**R
$17.92
M**I
F**B
ABC
Bank
(1) The estimated EPS is the analysts estimate data in Yahoo! Finance on 09/09/09.
http://finance.yahoo.com/
(2) The estimated EPS for ABC Bank is the weighted average EPS by the four scenarios.
38
Table 15 ABC Bank’s PBV and price-to-tangible-book value ratios compared to its peer
companies
Company
Price on
Name
09/09/09
Book value
per share
on 2Q09(1)
Tangible
PBV
book value
Multiple
per share
on 2Q09(1)
PBV
(Tangible)
ROE
Multiple
ABC Bank
$ 10.29
$ 18.68
0.55x
$ 10.84
0.95x
2.2%
U*B
$ 21.75
$ 10.37
1.91x
$ 5.16
4.21x
8.25%
O*B
$ 10.49
$ 9.59
1.09x
$ 6.47
1.62x
3.96%
F**R
$ 17.92
$ 11.85
1.51x
$ 10.12
1.77x
9.76%
M**I
$ 16.09
$ 24.01
0.67x
$ 12.19
1.32x
-4.23%
F**B
$ 10.55
$ 13.61
0.54x
$ 8.58
0.86x
-10.72%
Peer Group Mean
-
1.14x
-
1.96x
-
Peer Group Median
-
1.09x
-
1.62x
-
(1) The book values per share and the tangible book value per share on 2Q09 were acquired from SEC
filing 10-Q for second quarter of 2009 document of the companies. <http://www.sec.gov/>
39
Figure 1 Relationship between ABC Bank’s provision for loan losses and Milwaukee
ISM rolled forward one quarter (Inverse scale) from 2003 Q1 to 2009 Q2.
ISM-Milwaukee index (Rolled Forward One Quarter)
$180
30
$160
35
$140
40
$120
45
$100
50
$80
55
$60
60
$40
65
$20
70
$0
75
1Q 2003
2Q 2003
3Q 2003
4Q 2003
1Q 2004
2Q 2004
3Q 2004
4Q 2004
1Q 2005
2Q 2005
3Q 2005
4Q 2005
1Q 2006
2Q 2006
3Q 2006
4Q 2006
1Q 2007
2Q 2007
3Q 2007
4Q 2007
1Q 2008
2Q 2008
3Q 2008
4Q 2008
1Q 2009
2Q 2009
3Q 2009
4Q 2009
ABC Bank's Provision for Loan Losses
Loss Provisions
* The ISM-Milwaukee index data were obtained from The Institute for Supply Management-Milwaukee (ISMMilwaukee). (http://www.ismmilwaukee.org/)
40
Figure 2 Stock performance comparison of ABC Bank, S&P 500 index and regional
bank index from 5/1/2009 to 9/1/2009
ABC Bank
S&P 500
KRE
140%
120%
100%
80%
60%
40%
20%
0%
2009/5/1
2009/6/1
2009/7/1
2009/8/1
2009/9/1
41
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