Bankers: What is the value of your strategy?

A colleague and I recently had a healthy discussion about what agenda items to include at strategic planning retreats. He was strongly in favor of showing summary level financial projections for "business as usual" at the financial institution. Showing value creation, or erosion, from doing the same things you have been doing will highlight the need for staying the course or strategic change, in his opinion.

He is right. So often we get bogged down in philosophical debates on what to do about branches, technology, loan growth, expense control, and yes, vision, that we forget that whatever strategic direction the group decides should find its way, long term, to the FIs bottom line to increase the value of the franchise.

It does not matter if you are a stock held bank, mutual bank, or credit union. Your strategic direction should increase the value of the franchise, whether you measure aggregate value (mutual, credit union), or shareholder value (stock bank). Why would you initiate strategic change if it doesn't result in increased value? Even the non-stock bank/CU wants to live another day. Perhaps their Boards of Trustees have a lower capital appreciation hurdle. But doing nothing and eroding the value of the franchise is a sure sign that you will not have the resources or relevance to continue serving your other, non-shareholder constituencies into the future.

So what is enhanced franchise value? Since I have been involved in banking, investors focus on two metrics: price/earnings and price/book. The market places a multiple on these metrics. For example, I used Tompkins Financial Corporation's core earnings per share in the below table. The market currently values TMP at 14.8x earnings. Assuming the market continues to value TMP at 14.8x, you can arrive at the per-share valuation of the stock. For you non-shareholder owned institutions, use an industry p/e and apply it to your aggregate earnings to come up with your franchise value.

The projected business as usual eps grew at a compound annual growth rate (CAGR) of 5.4%. The Board may have determined that this was not enough. So strategic change must take place. After debating strategy and what success would look like in executing strategy, the bank was projected to increase earnings at a 10.4% CAGR. The Board's expectations on capital appreciation was 8%, because the bank's dividend yield was 3.32%. This would equate to a shareholder total return of 11.32% (8% capital appreciation plus a 3.32% dividend yield). The strategy, therefore, is projected to increase the value of the franchise.

Now, my firm does not serve TMP so the above numbers are only hypothetical. Except that I used actual core eps from 2007-12 for the business as usual row. I also have no inside information on what the Board of TMP expects in capital appreciation or total shareholder return. I only use the above as an example.

But in the throes of developing strategic direction, and the future of your bank, is it not important to demonstrate, in financial terms, what success would look like and how it adds value to business as usual?

What are your thoughts?

~ Jeff

Note: Even though my bank stock portfolio is currently making me look like an investment genius, mostly because of industry-wide price performance, I make no investment recommendations in this blog, or anywhere for that matter. You should not invest in any security based on what I type on these pages.

Bank Shareholders Are Only One Seventh of the Equation

I am guilty. Guilty of elevating increasing shareholder value to Napoleonic heights. I annually rank the top five financial institutions by total return to shareholders. I write about developing a strategic plan that results in financial returns that satisfy shareholders. I confess, I contributed to the notion that the shareholder matters above all else.

But many, if not most state business corporation laws don't agree. Take my home state, Pennsylvania, Title 15, Subchapter B Fiduciary Duty, Section 515 Exercise of Powers Generally...

"In discharging the duties of their respective positions, the board of directors, committees of the board and individual directors of a domestic corporation may, in considering the best interests of the corporation, consider to the extent they deem appropriate:

(1)  The effects of any action upon any or all groups affected by such action, including shareholders, members, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.

(2)  The short-term and long-term interests of the corporation, including benefits that may accrue to the corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the corporation.

(3)  The resources, intent and conduct (past, stated and potential) of any person seeking to acquire control of the corporation.

(4)  All other pertinent factors."

So, as I read (1) above, shareholders are certainly in the mix of parties impacted by a board decision. But so are members, employees, suppliers, customers, creditors, and communities of a corporation. I don't think the order in which the law was written constitutes a ranking. As I read it, and mind you I've never passed the bar, all constituencies have equal weighting.

Shareholder held banks are not not-for-profits. They make money to grow, be safe and sound, invest in personnel and technology, give back to their communities, and yes increase the value of their franchise for shareholders. Boards should be mindful that profits are as much for other interested constituencies as the shareholders. In other words, to a board member, hearing an employee say "I love working here", a customer say "I love banking here", should resound similarly to a shareholder saying "this is a great investment".

Banks used to be owned primarily by retail investors. As the industry consolidated, banks became larger, and retail investors became weary due to the financial crisis, institutional owners filled the breach. These investors care little about the employee that loves to work there, or the customer that raves about extraordinary service. Well, they do care if it ends up dropping more money to the bottom line that can be returned to shareholders in some fashion.

Institutional shareholders are much stronger, and more concentrated and vocal advocates for shareholder returns than the retail shareholder, who once took pride in investing in the local bank. Just because they are louder, should they be at the front of the line? Or should we all read our respective state's business corporation law on fiduciary duty of directors?

~ Jeff

The Grand Mishandling of Strategic Projections

After nineteen years in financial services, I am finally witnessing the tide turn in bank and credit union strategic planning. What once was an annual budgeting exercise, is now beginning to take the more productive path of identifying and paving the way to the financial institution (FI) of the future. The one that makes clear either-or choices to ensure future relevance for their customers, employees, communities, and shareholders (if stock owned).

But the fate of strategic plan projections, for the most part, remains mired in the old-school budgeting process. When asking senior leaders what success would look like if they executed their plan well, the answer is all-too-frequently what leaders reasonably think they can achieve. In other words, success looks like next year's budget.

In February, I proposed that FIs evaluate strategic alternatives as a regular part of the strategic planning process. To use the present value of future earnings streams to determine if the strategy is actually adding value. Developing strategic projections so you have an extremely high likelihood of achieving them may not yield the answer you want. What if your Board expects senior management to increase the value of the FI by 10% per year, and you project a 5% increase in earnings because you feel comfortable you can succeed? You will erode the value of the franchise.

The Board may decide to turn the keys over to someone capable of increasing franchise value. See the chart below for the decrease in the present value of tangible book value per share versus the nominal increase in tangible book. If you were a Board member of this franchise, what would you do?

In my opinion, FI strategic plans should have three scenarios:

Scenario 1: Stretch. These projections should depict "what success should look like" in executing your strategy. I am not proposing creating projections that cannot be achieved, a risk that an investment banker told me often happens when FIs evaluate their strategic alternatives. If I were to handicap these projections, I would give senior leaders at least a 40% likelihood of achieving them. The more strategic leaders gain credibility with the Board and their shareholders (if publicly owned) at achieving stretch goals, the greater the likelihood the FI earns its independence. Creating overly optimistic or "hockey stick" projections only erodes credibility with your constituencies. "Stretch" are the projections that should be discounted to determine the present value of the strategy.

Scenario 2: Base. These projections take more the form of budgets. They are estimates of what senior leaders reasonably believe they can attain. As mentioned, present valuing these projections may not yield the answer you want. But in setting Board and regulator expectations, these projections are likely to be around 70% achievable.

Scenario 3: Stress. These projections serve to identify the things that can go wrong, and their impact on your FIs balance sheet and capital ratios. FIs tend to do this within their ALCO process regarding swings in interest rates. But interest rate risk is only one form of risk that can pose significant challenges. By modeling the most likely stressors, senior leaders can develop contingencies in advance to improve their balance sheet and profitability.

In my experience, FIs tend to use scenario 2. Why? In my opinion it is because they want to manage expectations, and it is how it has always been done via budgets. Another reason may be the uncertainty in projecting out several years. Banking, unlike many other industries, has significant macro issues that are beyond bankers' control which impact their balance sheets and income statements. Because of these uncertainties, we shy away from what our financials will look like in the future.

But if, through strategic planning, we set our sights on the bank we want to become, we should model what that would like like in our financial statements. Not doing so dilutes our credibility and accountability to our Board, our shareholders, and ourselves.

How does your FI use strategic projections?

~ Jeff

Note: The above chart represents the actual tangible book value per share of a Northeast FI from 2005-2010. If the Board of this FI expected a 10% annual return, they were sorely disappointed.