Sammon, Bill, Independent Banker
Can bank valuations hold in a tough stock marketing environment?
In the public market for community bank stocks, most companies trade versus their price to earnings multiple. Some community banks are still trade versus their book value, but this is typically in the case where there are not enough earnings to trade off of. The goal for all publicly traded banks is to trade at price-to-earnings (P/E) multiples above their peer group. Community banks that trade at premiums have a greater ability to use their stock for acquisitions and a strong P/E multiple can also act as a deterrent from unwanted offers for the bank.
From a price-to-earnings standp oint, community banks continue to trade close to 10-year highs on multiples despite many macro trends that are adversely affecting the sector. For any bank that will need to tap the capital markets in the near future, these influences should be watched closely. Looking to the recent past will also reveal how negative influences can affect valuations.
A look at Chart 1 shows how community banks below $2.5 billion in assets have traded over the last 10 years. During that period banks have been valued as high as 17.8 times, earnings and as low as 11.4 times in the past decade. As you can see, the community bank sector saw a dramatic shift in multiples in the late 1990s and a number of factors played into that decline. Merger and acquisition activity was very strong and multiples in the community bank sector reflected this.
The jump in multiples from 1996 to 1997 reflects a market where there was much speculation on who would be the next community bank to go. As the M&A market cooled, bank stock multiples due to "take out" speculation pulled back. In addition to M&A activity, interest rates have had and will continue to have a dramatic effect on the entire sector.
The Fed's interest rate tightening in the late 1990s also had an effect on bank stock multiples. Historically, bank stock investors get nervous in a rising interest rate environment in anticipation of net interest margin pressure and potential hits to the securities portfolio.
Sector rotation can also play a role in where commu nity bank stocks are valued. Anyone who was an investor in 1998 and 1999 can remember looking at the tech stock market in amazement as huge paper gains were created on a daily basis. When this type of activity is taking place, it is difficult for a broker to get an investor excited about a bank with a 15 percent return on equity when millionaires are being created by listening to the next idea that hits the air waves of CNBC. The tech stock boom pulled significant dollars away from bank stocks and added to the downward trend in our sector.
Today, investors are struggling with these strong valuation levels in the face of a difficult operating environment, especially when no apparent catalyst is emerging that could propel bank stock valuation levels higher over the near-term. Anticipation that the Fed may end or pause its tightening cycle could provide a bounce for the community bank valuations over the near-term. …