Best Stick To Cash

way to evaluate the investment prospects of the European banking sector.

The notion that

cash is irrelevant fails to draw the relatively straight forward distinction between the cash flows attributable to customers and depositors, and the cash flows which belong to equity shareholders, the ultimate owners of the bank.

One approach increasingly finding favor among investment analysts is to assess prospects by analysing potential future cash flows; and to measure past performance on the basis of "total shareholder returns": that is, by measuring how much an initial investment of a given amount, say Pound 100, would have grown over a period if all dividends had been reinvested in that bank's shares.

 

This measurement captures capital gains and the value of dividends, embracing all the wealth created for shareholders by management.

The theory is that total shareholder returns as a measurement is inextricably linked to cash flows, because dividends are paid out of the cash flows attributable to shareholders, and capital value and growth stem directly from the value of the future cash flows a bank can generate for shareholders.

A recent survey on the performance of the European banking industry was based on a sample of "universal" banks, which offer a range of services rather than being, say, specialist investment banks.

In only three of those territories represented did the banking sector outperform the local index; an investor in the other countries would have been better off investing in a basket of shares representing the local index, or better still, the same basket of shares but excluding the banks.

But can cash-flow based measures usefully be applied to the banking sector? Cash as a scarce resource is not an issue for banks: it is their stock in trade and there is a lot about.

Herein lies the first misconception about banks: cash flows are just as important for them as for any other business.

There are some significant differences between a bank and other businesses, but the notion that cash is irrelevant fails to draw the relatively straight forward distinction between the cash flows attributable to customers and depositors, and the cash flows which belong to equity shareholders, the ultimate owners of the bank.

The fundamental importance of the latter cash flow is the same whatever the nature of the business.

For example, it is the shareholders' cash flows which pays the dividends; maintains and grows the business; funds fixed and working capital growth; financial obligations, e.g.: tax, and is the source of regulatory capital.

It follows that the cash flow attributable to the shareholders is a crucial determinant of a bank's ability to meet its own financial obligations, to grow, and to pay dividends.

As part of the study, Price Waterhouse also examined the relationship between total shareholder returns as a cash-based measure of performance, and market-to-book value ratio as a relative measure of value that the market place ascribed to the banks in the sample.

The pronounced correlation strongly endorses supporting the use of cash-flow based measurements in the banking sector.

Plotting estimates of positive "equity spread" (i.e. the amount by which the return on equity exceeds the estimated cost of that equity) against total shareholder return produced a similar correlation. This further supports the notion that, like any other business, a bank must generate returns greater than its own cost of equity capital if it is to grow and produce a positive return for its shareholders.

According to the research, there is one further message here: growth for its own sake will not do the trick and ensure a handsome return for the investors.

It has to be growth which produces cash returns which exceed the cost of equity. The evidence showed European banks of all sizes have been pursuing growth as a primary aim, sometimes without regard to the fact that growth regardless of return generated can be destructive of shareholder value.

The study points out that cash flow based analysis of banks is not an academic preoccupation: investors are looking for the best return from the sector, while Price Waterhouse has a direct interest in helping its bank clients improve their performance.

One of the key tools used for this purpose are cash-flow models which look at the key drivers of cash flow within a bank. The first purpose is to see where a bank can achieve the greatest improvement in value by focusing enhancement measures on the cash-flow drivers of value that have the biggest impact.

This is accomplished by a combination of benchmarking comparisons of the key drivers with other banking institutions, and sensitivity analysis.

Analysis usually begins with high-level exercise using only information which is in the public domain. This is extremely valuable in getting the same perspective that investors have, even if more detailed information is made available by the bank.

If we can get it wrong, the study argues, then it is hardly surprising if investors sometimes do not place quite the same value on a bank that management would like to see, and this implies there are communication issues to sort out.

What Price Waterhouse finds of most concern, however, is that in all the numerous analyses it has carried out on European banks, the single key driver that has most impact in enhancing share-holder value remains reduction of the cost-income ratio.

This is particularly worrying against a popular opinion that the sector has in most cases been through the rigour of cost-cutting exercises and now the focus should be on revenue generation. Cost-income ratios in Europe span a huge range.

Banks point out that their sustainable level of costs to income is dependent on the kinds of business that they are in but one of the other worrying aspects is that financial services are often difficult to differentiate sufficiently on grounds that outweigh cost considerations.

In an industry that suffers from considerable over capacity, this bodes ill for the least efficient.

So what is the industry's response to these pressures? Is management generally rewarding itself and the staff on the basis of shareholder value created?

Not according to the study It plotted percentage increases in remuneration against total shareholder returns for their sample. The result showed no correlation between rewards and returns generated for the shareholders.

(The Banker)