Integrated Bank Analysis and Valuation: A Practical Guide to the ROIC Methodology
By S. Chen
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Integrated Bank Analysis and Valuation - S. Chen
Integrated Bank Analysis and Valuation
A Practical Guide to the ROIC Methodology
Sandy Chen
Cenkos Securities plc, UK
© Sandy Chen 2014
All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages.
The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988.
First published 2014 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries
ISBN: 978–1–137–30745–3
This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin.
A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.
Contents
List of Figures
List of Tables
Preface
Acknowledgements
Glossary of Terms
Introduction: Fundamentals of Bank Analysis and Valuation
1 Other Approaches to Bank Analysis and Valuation
Operating performance ratios
Regulatory ratios
Example of analysis and valuation in practice: HSBC
2 ROIC for Banks Methodology
Distinguishing between operating performance and capital leverage
The fundamental link between analysis and valuation: value creation
Some guiding principles
ROIC analysis: a step-by-step guide
Calculating Invested Capital
Calculating Return on Invested Capital (ROIC)
ROIC valuation: calculating value-added margin
Aggregative value creation/destruction
Forecasting with ROIC
Making forecasts in practice
Integrating forecasts with valuation
3 Case Studies
1. Bank of China
2. Barclays
3. Citigroup
4. Credit Suisse
5. Deutsche Bank
6. JP Morgan Chase
7. Lloyds Banking Group
8. RBS
9. Standard Chartered
Index
List of Figures
List of Tables
Preface
This book grew out of conversations with leading fund managers who use ROIC (Return on Invested Capital) models to help them with their investment decisions about banks. The gist of these conversations was that the ROIC methodology could translate the bewildering complexity of bank jargon into a simpler, clearer language while also showing how changes in a bank’s key value levers can affect its valuation.
This book was written for analysts in general: non-bank analysts in both buy-side and sell-side institutions who would like to learn how to analyse banks, bank analysts who would like to link their analyses to fundamental valuations, and analysts for regulators and governments who would like to model the potential impact of new policies.
It is easy to go astray when analysing banks – with the Basel III regulations, for example. In this book, I focus on describing the ROIC for Banks Methodology, how at the company I currently work for we construct our models for ROIC analysis, and then how this links to a fundamental valuation for the bank.
A bit of background: Back in the 1990s, while working at a large investment bank, my colleagues and I spent several years developing a detailed, cash flow–based approach to analysing and valuing banks, which was then abandoned as being too complicated to use in the real ‘I need the answer now, not next week!’ world.
The ROIC-based approach to banks described in this book reflects the practicalities of trying to analyse and value banks in a timely manner. In practice, as a sell-side analyst, when a bank reports its results, we spend the first hour or two spotting the key points for the ‘initial morning comment’. By the end of the afternoon, we should have been able to both update our ROIC model and take a revised view on the valuation for that bank for a ‘further comment’ to be published. The ROIC methodology is a way of doing ‘battlefield triage’ on a bank’s results, enabling the analyst to process a lot of complex information quickly and efficiently in order to spot the key points in a bank’s performance and then link that to valuation.
For putting new banks under coverage, my experience has been that roughly a week is required to go through a bank’s historical financial statements and put them into the ROIC for Banks template. This compares to roughly a month when doing it without a standardised, integrated model for both bank analysis and valuation.
On the ROIC for Banks website, you will find this template as well as detailed spreadsheets for each of the banks covered in this book. I have included them to show readers how the models actually work. The links between a bank’s financial statements as reported and the ROIC for Banks model are shown clearly, and key assumptions can be altered to see the potential impacts on valuation.
To be clear, using the ROIC for Banks approach does not mean giving up all the other tools for bank analysis and valuation. What, I would suggest, makes the methodology relatively unique is that it can translate this complexity into clarity – and then link it directly to valuation.
Acknowledgements
I’d like to thank my former boss, Patrick Barton, who developed key parts of this framework, and James Alexander at Prudential/M&G, who has been a stalwart supporter of ROIC for Banks for over a decade. I also thank my employer, Cenkos Securities, for allowing me to indulge my tendency to lecture.
Most of all, I’d like to thank my gorgeous wife, Carol Jarvest, for always being loving, through thick and thin.
Glossary of Terms
Book value per share This is calculated by dividing shareholders’ equity by the number of common shares at the end of a period.
Common Equity Tier 1 ratio This measures a bank’s core capital strength; it is calculated by dividing Common Equity Tier 1 capital by risk-weighted assets.
Compensation ratio This ratio measures a bank’s personnel expenses as a percentage of net operating income; it is calculated by dividing personnel expenses by net operating income.
Contractual maturity mismatch This compares a bank’s assets and liabilities by maturity buckets, e.g. within one week, one week to one month. Also called gap analysis.
Cost–income ratio This ratio measures a bank’s operating efficiency; it is calculated by dividing a bank’s operating expenses by its net operating income.
Derivatives These are a wide range of financial products that are calculated by (or derived from, thus derivatives) referring to another financial data item. For example, a call option is a derivative that refers to