Earlier this week (HERE), we covered the how the Growth Efficiency Ratio (GER) can be used to analyze how efficiently a bank can grow. We highlighted an aspect of the efficiency ratio that while it is descriptive as to how a bank’s overhead compares to its revenue, a bank could stop or slow growth to improve its efficiency ratio. Growth is equally or more important than efficiency to many investors and bank operators, and so the growth efficiency ratio takes into account both factors. In this article, we look at the calculation and use of the Growth Efficiency Differential Ratio (GEDR).
How to Calculate
The Growth Efficiency Differential Ratio is simply different between two bank’s Growth Efficiency Ratio. If Bank A has a GER of 46 and Bank B has a GER of 17, then the GEDR is 29. Conversely, if you want to compare Bank B to A, then the GEDR is -29.
As an aside, some readers commented that the GER is a volatile number which is true to the extent that earnings are volatile. If you are one of those banks that often have extraordinary items, derivative fluctuations, gain/loss or similar, then you probably want to use an earnings number with those items removed. In similar fashion, banks can apply the growth efficiency ratio to assets, deposits, fees or any other important metric.
What the Ratio Tells You
The GEDR is helpful on two related counts when it comes to M&A and when deciding on strategic priorities. The greater the differential, the faster your breakeven and the better your return on a potential acquisition. In the case where Bank A is acquiring Bank B, Bank A would want to move Bank B onto its platform as fast as possible to gain efficiencies. Conversely, if Bank B were to acquire Bank A, Bank B should consider moving onto Bank A’s platform as that is the more efficient generator of growth. Of course, likely it is not an either-or decision, so the goal and Key Performance Indicators during a merger should be to improve the ratio taking the most efficient technology, human capital, and processes from both banks. Thus, a two-year integration goal for Bank A acquiring Bank B is to move their GER from 40 to 45 post merger.
The GEDR also allows banks to best select potential acquisition targets. In the majority of the cases, it banks with higher GERs that acquire banks with lower GERs.
Banks with high GERs trade at higher multiples and while not purely calculable, as a general rule of thumb, banks with high consistent GERs such as those above 26 trade at multiples two to six times greater than banks with average GERs. Thus, if you produce $4mm per year in net income and you have a GER of 2, you might want to invest $1mm or more to make your platform more efficient and your growth stronger in order to add 4x to your value. This allows for a rough ROI calculation and can serve as a framework to evaluate strategic options.
Setting Strategy From The Ratio
Since growth and efficiency are two important factors in bank valuation, it pays to look at any investment through that lens. Adding another business development officer, moving to a more efficient lending platform, online account opening, increasing mobile usage, rolling out cash recyclers at commercial clients and any other project that your bank can dream up should all be viewed along the dimensions of what level of growth can it produce and at what cost.
We will quickly add that this calculation nicely handles risk. Projects that reduce risk theoretically result in more stable revenue. Thus, if you apply either the GER or the GEDR over a longer period of time such as three years, value can be implied by how well a project reduces the volatility of earnings. A nice steadily growing efficient earnings stream is more valued in the market than an erratic growing efficient revenue stream.
Ironic Geographic Expansion
This calls into questions strategic projects that increase earnings but do nothing to increase efficient growth. For example, adding another branch and expanding into a new geography is interesting in that it potentially adds revenue, but if expansion also increases cost, then it may not do anything for your growth efficiency. In fact, it may hurt it.
This has far reaching and ironic ramifications. Thousands of banks are pursuing strategic initiatives that they believe will help maintain their independence but the execution makes them MORE likely to be acquired. Adding earnings, but not efficiency, just means that a more efficient growth bank will be salivating more over the prospect of acquisition.
More M&A Ramifications
As implied above, if you want to increase the probability of purchase (but not necessarily the price), adding inefficient earnings growth is a great strategy.
However, by creating a more efficient growth platform, banks increase their franchise value and open up more M&A options. Having a wide GEDR allows for more creative transactions and transactions that have quicker breakeven time periods. Alternately, having a high GEDR allows a bank to pay more for a transaction as it knows the efficiency of its current platform.
Putting This Into Action
If your goal is to increase the value of your bank, then strategic initiatives should be prioritized as to those that have the greatest positive impact on the growth efficiency ratio. When your bank can execute along those lines plus be acquisitive, what you get is a virtuous cycle of value more efficient platforms generate more productive acquisitions which result in greater future efficiency.
Banks that ignore these tenants will find themselves on the losing end of that cycle which is core to our belief that we will quickly be down to between 2,000 and 4,000 banks over the next five years as the efficiency disparity increases.
Submitted by Chris Nichols on February 23, 2017