Banks For Beginners: A Summary of Ann Cuneaz NAIC Article, BITS March 2004 Kevin Gillogly Happy...

Banks For Beginners:A Summary of Ann Cuneaz NAIC Article, BITS March 2004Kevin Gillogly

Happy Destiny Investment Club

February 14, 2005

www.bivio.com/hdic 2

Banks For Beginners

Banks main product is money. Money is a commodity like oil or gas or gold or

silver. A dollar bill is worth the same as another dollar bill

Banks make a profit by lending money at a higher interest rate than they give to depositors

Banks make a profit from many non-lending related activites


Think Like A Banker

Deposits made to banks are an asset to the depositor BUT a liability to the bank

Loans made by banks are a liability to recipient BUT an asset to the bank


Bank Terminology: Interest Expense Banks pay interest on their customer’s

deposits. They want this as low as market conditions

allow This is an expense to the bank It is called “interest expense” on the Income

Statement


Bank Terminology: Interest Income Banks loan money to their clients They want the interest rate they charge to be

as high as market conditions allow This is income to the bank It is called “interest income” on the Income

Statement


Bank Terminology: Net Interest Margin aka The Spread The difference between “interest expense”

and “interest income” is called the “interest rate spread” or “net interest margin”

Banks want the “spread” to be as large as possible


Bank Terminology: Non-Interest Income Banks also have non-lending related income This includes ATM fees, min. monthly fees,

check overdrafts, trust services, and many other similar activities

Banks can also make money off of investments

This is called “non-interest income” on the Income Statement


Bank Terminology: Non-Interest Expense Banks also have non-lending related

expenses This includes salaries, rent / mortgage,

equipment, and marketing costs This is called “non-interest expense” on the

Income Statement


Bank Terminology: Loan Loss Provision Banks also have to account for loans that go

bad Banks are required to set aside a percentage

of funds to cover these bad loans Banks that loan money out to “high-risk”

customers have a larger loan loss provision than banks that loan money to “low-risk” customers

The set aside money is known as “loan loss provision” on the Income Statement


Finding A Proxy For Bank Revenue Banks do not have a line for revenue on the

Income Statement So we have to develop a “proxy” or substitute

for bank revenue They are several ways to find a “proxy” for

bank revenue and no one way is perfect


NAIC Method of a Bank Proxy For SalesIs: Net Interest Income (the “spread”)

Using a net number smoothes out the changes due to changes in interest rates

Minus the Loan Loss Provision Plus Non-Interest Income Plus Tax Equivalent Adjustment (TEA)

TEA adjusts tax exempt interest income to a “pre-tax” dollars

TEA is generally < 2% of revenue


Value Line & Creating a Bank Proxy for Revenue VL does a better – though not – perfect way of

calculating the Bank Proxy For Revenue VL has lines for Net Interest Income, Loan Loss

Provision, Non-interest Income, and Non-Interest Expense

VL does not have the bank TEA S&P “tearsheets” have TEA

VL data needs to be both calculated and hand entered

VL data can be entered automatically but this requires a subscription that’s $$$


OPS & Using A Bank Proxy For Revenue OPS uses gross interest income (not net)

Revenue numbers are influenced by interest rates Rising interest rates raise revenue; Lowering interest rates reduce revenue

OPS is fast to download OPS is far cheaper than a VL subscription

$25 vs. $600+ OPS has nine years of quarterly data


OPS vs. Value Line Data

OPS data will result in lower historic sales growth rates in low interest rate environments than Value Line data

OPS data will result in higher historic sales growth rates in high interest rate environments than Value Line data


Bottom Line on Value Line vs. OPS The differences between the two data

sources is small Keep focused on the big picture YOUR

JUDGMENT of the future


Estimating Future EPS

Look at the trend lines on the front of the SSG

Look at the trends of recent quarterly data in PERT-A

Preferred Procedure A Revenue Based estimate of future EPS

AND Ralph Seger method Total Assets method


Estimating Future EPS

Looking at the trends on the graphs and in PERT-A are the same

Preferred Procedure, which is based in part on the figure in 2A, is not as good a method for banks Many believe that the pre-tax profit margin (2A) is

not as important for banks See Total Assets Method


Ralph Seger Method for Projecting Future EPS To forecast it, look at:

Historic growth of book value per share; Historic growth of dividend per share; Historic growth of EPS

Choose the lowest growth rate and make your judgments from that point


Total Assets Method For Projecting Future EPS Enter Total Assets in lieu of Sales Proxy on

the front of the SSG Rationale: Asset growth is critical to a bank Gives a more reliable pre-tax margin (2A) by

calculating Return on Assets (ROA) ROA is considered a better measure of Bank

performance than pre-tax profit on sales (2A) ROA can also be found in the S&P

‘tearsheet”


Valuing Banks Stocks

Section 3 of the SSG (Value) is same for both banks and non-banks

However, P/Es for banks tend to have an inverse relationship to the outlook on interest rates When interest rates fall; bank P/Es will rise When interest rates rise; bank P/Es will fall

Use this knowledge when forecasting future P/Es for banks


Conclusion of Banks For Beginners Banks have differences that should be recognized

before you complete your SSG. Differences are not insurmountable

Need to find a proxy for revenue OPS vs. NAIC vs. Ralph Seger vs. Total Assets

Pre-tax profit margin (2A) is not as important as Return on Assets (ROA) to judging bank management efficiency

Bank P/Es are inversely related to interest rates Need to settle on a data source

Should be the same source as your source for rest of portfolio

OPS vs. Value Line

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