Charting Banking XXIV: pre-tax pre-provision earnings
by PlanMaestro
If tangible common equity multiples have their issues, what is a good valuation alternative?
If you trust the bank to survive its credit headwinds while at the same time its total revenues are growing, or at least stabilizing, I think it is fair to use some sort of multiple of normalized earnings. And if that is the case, pre-tax pre-provision earnings are a good start.
- Why pre-tax? Two reasons. First, with all the recent losses many banks are not going to be paying taxes for a couple of years. And second, it makes easier the comparisons among banks and across time when taxes paid are fluctuating.
- Why pre-provision? Provisions are the main way credit issues get reflected in the income statement, building up reserves for consequent charge-offs. Therefore, if we want to isolate the earnings power from the credit issues this is the main line to subtract. The other way credit issues impact earnings is loses related to sales of real estate owned REO.
And the idea is that after getting a standardized PTPP, you can use your personal estimate on steady state provisions and taxes to get to an estimate normalized earnings. We will get to that later.
There is one little problem though: that is all the consensus on PTPP there is. Each analyst and company do their own adjustments:
- One-offs like goodwill write-downs and gains or loses on securities sold
- CVAs and other mark to market distortions
- REO gains and loses
- Depreciation and amortization
- Credit related operating expenses like mortgage servicing
And there is no consensus even on how to name pre-tax pre-provision earnings:
- pre-tax pre-credit earnings
- pre-tax pre-provision income
- pre-provision operating income
- core earnings
And of course each one of those come with its own abbreviation.
That makes life hard because you are not sure what each company or analyst is including and how to compare across companies and analysts. My opinion is that there is no way around it: you have to get your own estimates … and I will share one fast, but not very precise, recipe:
- Get cash from operations from the cash flow statement, and reverse the following adjustments
- Subtract back all working capital adjustments that are usually the lines that start with “increase” or “decrease”
- Subtract back stock compensation
- Subtract back tax provisions from the cash flow statement
- Subtract the equipment purchases (capex) from cash from investing
- Add back taxes (taxes provisions) from the income statement
Or the same, start from net income in the cash flow statement and add depreciation, amortization, provisions, one-time loses/gains, taxes, and subtract equipment purchases. Each company has different line disclosures in the cash flow statement so you still have to season to taste. But at least is much more standardized than using analysts and company estimates.
At the end, you get something very similar to what Buffett refers as owner’s earnings only that it does not include taxes. Among its benefits, it excludes non-cash charges and is somewhat conservative because it does not adjust for high administrative expenses related to foreclosures and REO administration (ie: Bank of America has 30,000 FTEs entirely dedicated to solving mortgage issues).
These are the numbers I am using as estimates for the Big 4 and the big challenger. Use them only as a reference. As I said, there is no way around it: you have to get your own estimates.
Do not try to be overprecise, I usually round up numbers trying to sin on the conservative side. Better to be roughly right than precisely wrong.
One way to double check the estimates is to compare profitability ratios (do it with tangible figures if you prefer) across companies and across time to have a better idea of the earnings power of the bank. These are some high level numbers across companies,
Now how to get from PTPP to a normalized valuation? Well, the long way is to do a discounted cash flow with normalized provision, taxes and growth. I will recognize that I prefer simplicity, with some common sense, and generally use a 10x multiple of PTPP:
- Very simple to calculate.
- 10x pre-tax is close to 15x after tax.
- 15x historic earnings multiples imply growing at the same rate as rest of the economy and returning just cost of capital.
- Big banks cannot grow a bigger share of the economy forever so a conservative multiple looks good.
- Substantial non-earning assets.
- Some of them still have high cost financing (prefs, trups, tarp), despite high liquidity, that will be reduced over time.
- The banks that I am interested in, the ones under some distressed valuations, will not pay taxes for years.
- Non crisis provisions of around 0.3% of revenues are less than what many banks pay in mortgage mess related expenses.
There is at least one big exception to these oversimplified assumptions, banks heavy in credit cards or similar lines based on a model of high normalized provisions in line with high net interest margins. A clear example of this is Capital One. My recommendation, go to previous 10Ks and double check the normalized provisions.
Having estimated a normalized value, it is good practice to go through the credit/legal issues and estimate how many years would take to solve them, apply your preferred margin of safety discount based on the company’s specific risks and growth prospects, and voilà.
That was today’s look inside the sausage factory.
Long BAC, C
PS: criticism of these numbers based on real figures is very much welcomed!
PS 2: I adjusted USB PTPP to reflect its 2011 growth after comments at the Corner
With these data, I am not sure why so many institutions like SNBC then. Its credit ratio is ok, but valuation is no where from being cheap.
So you are not long RF?
For the big banks, it is hard to understand their trading desk operations. I read some article two months ago that due to regulations, they are winding down their own proprietary trading desks, and only act as brokers, which would dramatically reduce their profits. How much impact of this would you estimate on BAC and C?
Volcker my friend, Volcker. All the large banks are closing prop trading. With a big tantrum, but they are doing it.
The long term profits of any retail bank is connected to its funding cost (if they do not do something stupid). And the large banks have the lowest funding cost of all banks. They will take those cheap funds and move it to something else less risky.
Even Goldman Sachs, that is not a retail bank, recognized the advantages of the Volcker rule. Viniar said recently that if they had the Volcker rule in the last decade they would have had the same profitability with less volatility.
The American banking system is morphing into the safest banking system in the world and it is also one of the cheapest.
And no, I am not long RF. I might be later in the cycle.
I see. So the long term profits are not higher for riskier assets, but just more votality? This is a bit surprising to me. I thought top banks like Goldman Sachs is really good at speculation and making a lot of profits from prop trading.
For BAC’s PPTP number, Q4 is sharply lower than Q3. Comparing closely of the two quarters, Q3 has over 4 Billion Other income, 1.4 B equity investment income and 1.6 B trading profits. Would you regard these numbers as one time gain/loss? Well, we could say that for the long term, these numbers would be some positive number in average, so let’s just deduct the 4.4 all other income from their Q3 PPTP, and that’s roughly the same as Q4, 6 Billion PPTP. Therefore yearly PPTP would be 24 B, which is way lower than your 42 B, though this still makes it a cheap investment for now.
Could you please share some thought on your concerns with RF? I think their valuation is not as cheap as BAC or C right now. The other concern I have is their below average NIM.
Could you please give some comments on the regional banks that I mentioned in your tips/contacts section? Thanks a lot!
I am still confused about the Volcker rule. If Goldman Sachs is restricted from prop trading, then how does it make money from its trading division any more? Just act like a broker? Can they still invest in equities like what Buffet does?
http://www.bloomberg.com/news/2012-02-14/goldman-sachs-seeks-exemption-for-bank-stakes-in-credit-funds-.html
http://www.bloomberg.com/news/2012-02-14/u-s-volcker-rule-faces-harsh-global-critics-months-before-it-takes-effect.html
http://ftalphaville.ft.com/blog/2012/02/13/879451/volcker-defends-volcker/
http://www.thestreet.com/story/11420115/1/bank-of-america-will-hit-20-hedge-fund-pro.html?cm_ven=GOOGLEN
Tom Brown bought BAC while John Paulson dumpped it.
I am still not sure how you come up with the $40 Billion PPTP number. If you look at the fourth quarter, and deduct the one time items, it would be about $4 Billion per quarter, so $16 B PPTP per year for now. It has sold many assets, so for now, it is more conservative to say $16 B. I am sure with its strong capital positions, it can grow back to $30 PPTP a few years later.
Let’s be conservative and say it is $20 PPTP two years later, then with a 15 P/E ratio, it should be $20. But if we assign a 8 P/E, it will be only $10. Right now other banks with better credit ratios like JPM has only 8 P/E, and capital one is only 6, so we would only see 15 P/E in a very good economy when people are no longer afraid of bank equities.
Plan…. A quick question for you about 30-89 PD.
I see banks like NBBC that consistently has 2% of 30-89 PD.
http://www.bankregdata.com/bkAQmet.asp?met=P30&inst=HC1076002
And banks like LNBB that consistently has 0.5% of 30-89 PD.
http://www.bankregdata.com/bkAQmet.asp?met=P30&inst=HC1071669
But both are able to report a profit while reducing the texas ratio. How does that happen? I just don’t understand how the math works out. My first theory was that NBBC charged off the 30-89 PD loans instead of letting them become the NPA, but that would require more provisions and thus reporting a loss. So this is really confusing to me. Could you please help me with this question?
The other question is the one I had a while ago regarding BAC’s PPTP earning. Could you please tell me how you come up with the $40 Billion per year figure? From their 4th quarter, it really looks like $16-20B…..
Hi, could you comment about this article
http://www.bloomberg.com/news/2012-03-15/stress-tests-pass-fed-s-flim-flam-standard-jonathan-weil.html
about Region Financial?
Thank you,
Giuseppe
Giuseppe, I do not have specific comments about Regions Financial. I have not done the same ammount of work as I have done with other banks. I will just focus on one paragraph of that article that is central to his argument and central to understand why so many people are so misguided when thinking about retail banks:
Then I went a step further and adjusted Regions’ remaining net worth to get a more realistic measure. In a crisis, what matters to investors and counterparties about a company’s assets is what they are worth, not what they are carried at on the company’s balance sheet. Just ask anyone who got a margin call back in 2008.
There are so many logical errors in that paragraph. These are just a few:
1. Retail banks are not investment banks: they have stable funding, they do not get margin calls. They do not need to mark to market assets they are planing to hold to maturity, and M2M can severely distort their real health. Check the recent stress test for how well most of them would perform. Do not do a static analysis when what is needed is a dynamic analysis over time.
2. Assets can be worth more: assets and liabilities can be worth more or less than stated in the books. When reserves are a high % of the NPAs, the NPAs are decreasing the assets, and the net interest margins are close to cyclical highs, the assets are probably worth more than stated in the books.
3. Realism is not obscurantism: To play for hidden fears instead of doing a real analysis, and you can see how well are performing the banks loans and also why they are doing so well across the whole Charting banking series, is called obscurantism … not realism.
Hey Plan –
New reader here; I’ve really enjoyed your banking series to date. I’ve been building a long position in BAC myself and just wanted to corroborate my analysis with yours. Like Muscleman, I’m curious how you reached $42B PTPP for BAC. Adjusting 2011 for one-time issues (Durbin, Regulation, provisioning, sale of CCB etc.), I get ~$25B PTPP.
There are a lot of qualitative reasons why I think BAC will prove to be a potential home-run over a longer time horizon; most notably, I’m encouraged by Moynihan’s insistence on refortifying the core business around a stronger and cleaner balance sheet before switching focus to earnings. The plethora of asset sales in 2011 continuing through this year alleviate my concerns about potential common raises as well. I would just like to get a better qualitative hold around longer term PTPP given 2011’s sharp drop from 2010.