Banks become growth stocks

In the lending world, one of the things we need to do is get comfortable with the notional value of a potential portfolio company. What is the business worth, why and would could happen to increase or degrade that value?

In your early days on Bay Street (or Wall Street or in The City) you try to put into practice many of the valuation techniques you were taught in an academic setting (or the school of hard knocks); methodologies such as PEG ratios and discounted cash flow analysis. Sounds easy enough, except when an industry that traditionally grows modestly becomes a cash machine. With ROEs that are beyond the norm. What do you do?

Increase the forward trading multiple applied? Increase the long term growth rate in the DCF? Particularly when that industry is heavily regulated by the government?

The industry I’m referring to is the North American financial institution sector.

If you are looking for some stats, here is one to think about.

U.S. commercial banks saw their trading revenue increase by over 30% in 2006. Primarily driven by commodities and hedge funds. Pretty exciting stuff, and hard for a bank CFO to factor into their business plan. Or their capital allocation budget.

And it is also difficult to predict how sustainable this revenue is. Unlike the predictability of checking accounts (they will be there in 3 years), it would be hard for a bank CFO to know where oil or natural gas will trade 3 years from now. Now the hedge funds will probably have their capital in 3 years, and they’ll be trading something, so perhaps it doesn’t matter.

But do bank multiples increase as a result of this revenue growth (the classic PEG ratio)? Or do they contract due to the increased volatility of those earnings?

Or does it matter? In this world of 30 second stock hold periods, does it really matter what the business should be valued at?

As my late friend Dalton Camp replied when he told me circa 1999 that a tech stock he owned went up $30 that day (it was Yahoo!), and I inquired about the company in the hopes of finding something out about the product/service/solution being offered by this darling stock.

“What does it do?,” I asked. “It goes up.”

MRM