ThinkingApplied.com Mind Tools: Applications and Solutions

Understanding Banks' Earnings:
An Evaluation & Forecasting Technique
Part 4

Lee Humphries

##### IV. Projecting Future EPS

We made 1% improvements in each ratio's value in order to compare the ratios' dollar-and-cents effect on EPS.  The resultant rankings can guide management in setting and prioritizing performance goals.  Emphasis should be placed on improving those ratios whose 1% changes produced the greatest EPS increases.

Projecting EPS using the ratio method

Begin by determining target values for the critical ratios.  This is simple except in the case of the efficiency ratio.

Finding the new efficiency ratio can be confusing because its value is not only a function of the non-interest expense but also of the asset turnover, the interest rate, and the total equity ratio.  Use the following formula to calculate it.

New Efficiency Ratio  =

[improvement factor  *  original \$ non-interest expense]  ÷  original \$ average assets
new turnover  -  [new interest rate  *  (1  -  new total equity ratio)]

Once you have determined target values for the critical ratios, use Exhibit 8 to project future earnings.

Critical ratios. Enter the target values in the appropriate cells of Column E.

Compensating ratios. Make sure that cell E2 is set equal to [100% - E9 - E10)] ÷ E8.
Make sure that cell E6 is set equal to [100% - F2].

Latest year EPS. Enter the EPS for the latest year in cell F16. The calculated EPS will appear in cell F15.  The difference between it and the most recent EPS will appear in cell F17.

Projecting EPS using the dollar method

As an alternative to the ratio method, future EPS can be projected from dollar and share amounts.  Use Exhibit 8 in a different way.

Column A. Enter the target dollar and share numbers in the appropriate cells of Column A.

Column C. Except for C7, the tax rate, all the cells of Column C should contain the division formulas indicated in Column B.

•     Treat C7 differently.  The dollar tax amount (A13) is dependent on the tax rate (C7), not the other way around.  So, enter the applicable tax rate by hand in cell C7, leaving blank both the tax cell (A13) and the pretax earnings cell (A14).

As before, the projected EPS will appear in cell F15, and the difference between the projected EPS and that of the most recently completed fiscal year will appear in cell F17.

The synergy of simultaneous improvements.  The EPS increase from simultaneously-made improvements will exceed the sum of the EPS increases from independently-made improvements.

In Section III we found our example bank's major earnings drivers to be (in declining importance): the efficiency ratio, the average interest rate paid on total average liabilities, the asset turnover, the number of common shares outstanding, and dollar amount of assets (where the ratios for common equity, preferred equity, and preferred charge are unchanged).

Let us suppose that the bank's goal for the coming year is to achieve a 1% improvement in those five values while maintaining the current values of the loan loss provision rate, the interest income percentage, the tax rate, the equity ratios, and the preferred charge.

When the effects of these five improvements are calculated independently and summed, the result is an EPS increase of about 22 cents—a gain of just under 8%.  But when the effects of these five improvements are calculated simultaneously, the EPS increase is almost 33 cents, a gain of nearly 12%.

That difference arises because one improvement magnifies the effect of another.  Recall that the return on assets is the product of the profit margin times the asset turnover.  Both the profit margin and the turnover rate have increased.  So when these two improved ratios are multiplied together, each improvement enhances the other.

This synergy happens in other places as well.  The combination of the two adjustments to book value—reflecting a simultaneous increase in dollar assets and decrease in common shares outstanding—raises the book value more than the sum of their independently calculated outcomes.

Ultimately, the improvements in book value, profit margin, and asset turnover all magnify each other.  Why?  Because EPS equals the net return on common equity times the book value.  And the net return on common equity embodies the improvements in the profit margin and the asset turnover.

##### V. Limits to Improvement

Where will EPS growth come from?  There is a limit to the improvement that can be made in the value of most critical ratios.

The interest rate paid on average liabilities is significantly influenced by forces beyond the bank's control; the loss provision rate is unlikely to decline once credit quality has reached a consistently high level; the ratio of non-interest revenue to total revenue is constrained by the scarcity of some non-interest revenue opportunities and the risk of others; the efficiency ratio can be driven only so low; and strategies to reduce the effective tax rate must conform to the tax code.

Asset turnover is difficult to increase once non-interest-earning assets have been minimized, lower yielding instruments have been converted into higher yielding ones, and fees have been introduced and elevated to market limits.  And because the equity component of total assets can't drop below a percentage mandated by regulators and lenders, a bank cannot indefinitely improve its earnings by increasing its leverage.

As the above ratios stabilize, whether at ideal or less-than-ideal values, so does the net return on common equity.  EPS is the product of the net return on common equity times the book value; so, once the net return on common equity has stabilized, EPS growth can only come from an improvement in book value.  Faced with these circumstances, a bank must increase its dollar equity, reduce its common shares outstanding, or both.  Otherwise, its EPS will stagnate.