2024-01-11 18:18:49 ET
Summary
- I sell a stock for one of three reasons: busted investment thesis, accounting irregularities, or the stock exceeds my Fair Value Estimate.
- A Fair Value Estimate is the price at which an investor is indifferent to owning a stock.
- There are several good valuation metrics that may be used to determine FVEs for bank stocks.
- This article highlights three specific FVEs metrics I use. I trust you will find these useful.
Introduction
I believe buying a stock requires considerable due diligence including understanding business fundamentals, management effectiveness, the corporate narrative, and future expectations.
However, nearly exclusively, my criterion for selling a stock rest upon just one of three simple reasons:
-
the original investment thesis is busted
-
there is any hint of “accounting irregularities”
-
the stock exceeds my fair value estimate (FVE)
In this article, we will explore the third bullet point; specifically, as relates to bank stocks.
What Is Fair Value?
I define a stock's Fair Value to be the price whereby I am indifferent to owning it. My FVE is based upon an assessment of the company's current and future valuation metrics. By definition, Fair Value is an interpretive judgement; though it's underpinned by data.
A Fair Value Estimate is not the same as evaluating whether a given company is fundamentally a good or bad business. That's a separate exercise.
Here's an analogy:
By most measures, a Lexus is a fine automobile. Many consider it a best-in-class vehicle. However, a Lexus is not a good value at any price. Let's say my Fair Value Estimate for a base Lexus ES350 is $40,000. If I was offered a brand-new base 2024 Lexus ES350 for $80,000, I would very likely walk away. If I was offered the exact same car for $20,000, I might ask if I could buy two. Indeed, the reverse is also true. If I kept my car tip-top and some guy offered me $50,000 for one of my $20,000 Lexus' a year after I bought it, there's a high probability I would sell.
This kind of thing happens on Wall Street every day.
How May I Determine Fair Value?
IMHO, this depends upon a few factors.
-
within what stock sector or industry does the stock reside?
-
what works? (this one seems simple, but I've seen many who get tripped up on it)
The process for determining the FVE for a stock is not a cookie-cutter exercise. In my experience, the majority of stocks may be valued using the basic toolkit. However, there are some general exceptions. These exceptions include:
-
banks
-
regulated utilities
-
start ups
-
extremely fast growers
- highly cyclical companies
This article focuses upon the first category: bank stocks .
Note: While I believe using technical analysis may be helpful when attempting to determine price level support or resistance, this article concentrates upon bread-and-butter fundamental valuation metrics.
Example: Bank OZK
In my last article to you, I covered my favorite regional bank stock; Bank OZK ( OZK ). Details are found here .
Bank OZK is an Arkansas-based regional bank with $5.5 billion market cap. The bank is noteworthy due to its somewhat unique business model engineered by its longstanding CEO, George Gleason.
Despite its relative size and business model, basic bank valuation metrics appear to provide acceptable FVE results.
Here's what's in my toolkit:
-
historical price-and-earnings
-
the Graham Number
-
bank stock internal valuation formula
Notably, when generating FVEs for bank stocks, I do not rely upon GAAP cash flow, free cash flow, or EBITDA.
Price-and-Earnings
Let's begin with an overarching investment philosophy. I believe over time; price follows earnings or cash flow. In the case of banking stocks, I focus upon earnings. In most cases, I highlight unadjusted GAAP earnings. However, I recognize there may be exceptions. Bank OZK isn't one of those exceptions. We will evaluate my FVE using GAAP earnings figures.
Let's look at a seven-year FAST graph illustrating Bank OZK's stock price-and-earnings.
fastgraphs.com
In my recent OZK article, I pointed out that for the specified period, the trimmed average P/E was just 9.5x. In that article, I went on to explain:
Here we find the average multiple is just 9.5x. There is some rationale behind Mr. Market's action; in recent years, Bank OZK earnings have trended up, but the move has been lumpy. Compounding matters, current forward Street estimates have been soft.
However, the last several years have seen developments create uncertainty. These include the C19 crisis, an inflation surge, rapidly rising interest rates, and fears about a CRE meltdown. Looking back at the first FAST graph, one can see the 2015 to 2019 earnings trajectory was far more consistent. Looking forward, I believe earnings will behave more comparably to the pre-C19 period.
What was the P/E relationship between 2015 to 2019? Let's look.
fastgraphs.com
In the period leading up to 2019, we see the trimmed P/E average was 14.7x.
Using current 2024 Street estimate of $5.85, the FVE at 10x earnings is $58 and at 14.5x is $85. That's a pretty big spread.
Therefore, an investor must make an interpretive decision.
Is the go-forward P/E more likely to reflect the more recent 2018 to 2023 period, or revert to the 2015 to 2019 period?
Given the general backdrop and corporate narrative, I contend the answer lies somewhere in between. Here's some rationale:
For a variety of reasons, recent years have seen bank stocks fall from investors' favor; thereby compressing multiples. At some point, bank stock multiples should expand and revert to the mean. On the other hand, Bank OZK earnings growth has slowed from pre-2020 levels, though management has nonetheless shown a penchant for beating Street estimates. On balance, investors appear to be in a "show me" mode awaiting Bank OZK's return to ratable earnings growth.
Considering the aforementioned, I believe a 12x earnings multiple is reasonable.
What about the E (earnings estimate)?
Part of what makes investing challenging is good investors don't care where a stock has been, they care about where it's going. Therefore, looking forward is more important that looking backwards.
Through experience, I've found that consensus Street estimates tend to be reasonable, though sometimes lean towards being overly optimistic. As an investor, I recommend two considerations when using Street estimates:
First, utilize management guidance when provided. Street estimates can be a check on management guidance; these are often aligned. However, my first inclination is to accept good management guidance versus Street estimates.
Second, check the track record. Good management teams meet or beat guidance and / or Street consensus consistently. There are several good resources to assist researching this. FAST Graphs provides a good record. TDAmeritrade also provides good data. Here's their Bank OZK recap:
ameritrade.com
We see over the past 15 quarters, OZK management beat consensus Street estimates 8 times, missed only twice, and met estimates 5 times. Given a meet-or-beat 13 of the past 15 quarters, it would be reasonable to premise 2024 estimates should be approximately accurate. As I opined above, and based upon management commentary, my view is the bank may surprise to the upside.
Applying the current 2024 Street estimate to a 12x P/E, Bank OZK has a $70 FVE.
Today, OZK has just an 8.5x P/E.
The Graham Number
The Graham Number (or Benjamin Graham's number) was created by Benjamin Graham, the godfather of fundamental investing. This formula measures a stock's fundamental value by taking into account the company's EPS and book value per share. Here is the formula:
grahamvalue.com
The Graham Number is the highest price an investor should pay for the stock. According to the theory, a stock price below the Graham Number is considered undervalued.
The formula represents a general valuation test when seeking to identify stocks that are currently selling for a good price. The 22.5 figure is included in the calculation to account for Graham's belief that the P/E ratio should not be over 15x and the BVPS (book value per share) should not be over 1.5x (thus, 15 x 1.5 = 22.5). Graham was a genius at providing investors with simple “rules of thumb” to boil down investment concepts into easy-to-understand nuggets.
From Graham's book, “ The Intelligent Investor, ” I offer you some additional parameters he referenced in conjunction with the formula:
- not less than $100 million of annual sales
- current assets should be at least twice current liabilities. (this may be interpreted for financial stocks)
- long-term debt should not exceed the net current assets
- some earnings for the common stock in each of the past 10 years
- uninterrupted dividend payments for at least the past 20 years
- minimum increase of at least one-third in per-share earnings in the past 10 years
- current price should not be more than 15 times average earnings of the past three years; therefore, the past three years' EPS should be averaged
- current price should not be more than 1½ times the book value.
For Bank OZK, running the numbers indicates a $67 FVE.
Bank Stock Internal Valuation Formula
The third bank stock valuation methodology is one I've used for many years. I would like to introduce it to you.
Here is the workup:
A = Rf + b (Re – Rf)
then
B = RoTCE / A
then
FVE = B x TBV
where,
Rf is the risk-free return, usually the 10-year U.S. T-note
b is the beta for the bank stock
Re is the expected rate of return
RoTCE is the bank's return on tangible common equity
TBV is the bank's tangible book value per share
For Bank OZK, here's the inputs:
Rf = 4.0%
b = 1.34
Re = 7%
RoTCE = 17.68% YTD through 9/30/23
TBV = $34.50 as of 9/30/23
Inserting into the formula, the FVE = $76
Summary
As expected, the trio of valuation metrics did not provide identical answers. However, these may be viewed altogether before making an overall FVE judgment.
Using P/E 12x and current 2024 EPS estimates, FVE $70
Using the Graham Formula, 3-year average EPS, FVE $67
Using the Bank Stock Internal Valuation Formula, FVE $76
Considering all the inputs and ancillary data, my current Bank OZK Fair Value Estimate is ~$70.
A recent OZK bid is ~$48.50. Therefore, I believe the stock is significantly undervalued.
Let's Try It with Bank of America
This bank stock valuation process may be used for most any bank stock.
To demonstrate, let's look at the FVE results when going through the paces for a large bank: Bank of America ( BAC ).
Bank of America is one of the four largest U.S. based banking institutions. I last wrote you midyear 2022 about BAC and had been adding to an existing position. That article is found here .
In conjunction with a long-term investment thesis, I offer the following bullet points:
-
Bank of America is a well-managed, well-capitalized, and shareholder-friendly financial institution.
-
The stock represents an investment in the overall growth and well-being of the United States economy.
-
Management focuses the bank upon responsible growth: seeking to grow slightly faster than GDP and aims for positive Operating Leverage. Positive Operating Leverage is defined as delta percentage revenue less delta percentage non-interest expense resulting in a positive number.
BAC stock is one of my largest positions.
Using the same three FVE processes, does BAC stock appear overvalued, on par, or undervalued?
Price-and-Earnings
fastgraphs.com
In this case, after reviewing the long-term and medium-term charts, I utilized the eight-year chart indicating a trimmed average 13x P/E.
Applying the current 2024 $3.25 EPS estimate, I obtain a $42 FVE.
Graham Number
Bank of America 3-year average EPS = $3.35
9/30/23 book value per share = $32.65
Running these inputs through the formula, the resultant FVE is $50.
Bank Stock Internal Valuation Formula
Here are the inputs for Bank of America:
Rf = 4.0%
b = 1.39
Re = 7%
RoTCE = 16.09% YTD through 9/30/23
TBV = $23.79 as of 9/30/23
After inserting inputs into the formula, the resultant FVE = $47
Summary
Using P/E 13x and current 2024 EPS estimates, FVE $42
Using the Graham Formula, 3-year average EPS, FVE $50
Using the Bank Stock Internal Valuation Formula, FVE $47
Considering all the inputs and ancillary data, my current Bank of America Fair Value Estimate is ~$44.
A recent BAC bid is ~$33.60. Therefore, I believe the stock is significantly undervalued.
Conclusions
I believe understanding and applying defensible valuation methodologies is a hallmark of the best investors. How to value bank stocks is a niche within the larger universe of overall security valuation. In this article, we reviewed Bank OZK, a smaller regional bank; and Bank of America, one of the largest banking institutions in the world.
Determining bank stock FVEs may be performed using a variety of tools; three specifics I find of particular use are provided in this article.
- historical price-and-earnings (GAAP diluted EPS)
- the Graham Number
- a custom bank stock internal valuation formula
As with any valuation exercise, interpretation and judgment is part of the exercise. Forward financial expectations must be gauged in light of the previous record of consistency. Valuation multiples as well as other inputs must be viewed historically or adjusted, if necessary, based upon data and probabilistic assumptions.
Good valuation work should be data-driven and defensible.
For example, in this article, my valuation work leans optimistic based upon the following historical backdrop:
Over the past few years, many financial stocks have been beaten down. Given economic activity and Fed actions, this is unsurprising. Historically, bank stocks tend to be hardest hit when there is economic is uncertainty, and the Fed tightens credit. At such time the Fed begins to ease rates again, financial and bank stocks tend to enjoy some of the biggest rebounds.
Long and strong OZK and BAC.
Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2024 investments.
For further details see:
How To Determine The Fair Value Of Your Bank Stocks