Banks For Beginners: A Summary of Ann Cuneaz NAIC Article, BITS March 2004

1. Banks For Beginners:A Summary of Ann Cuneaz NAIC Article, BITS March 2004 Kevin Gillogly Happy Destiny Investment Club February 14, 2005

2. Banks For Beginners • Banks main product is money. • Money is a commodity like oil or gas or gold or silver. • A dollar bill is worth the same as another dollar bill • Banks make a profit by lending money at a higher interest rate than they give to depositors • Banks make a profit from many non-lending related activites www.bivio.com/hdic

3. Think Like A Banker • Deposits made to banks are an asset to the depositor BUT a liability to the bank • Loans made by banks are a liability to recipient BUT an asset to the bank www.bivio.com/hdic

4. Bank Terminology: Interest Expense • Banks pay interest on their customer’s deposits. • They want this as low as market conditions allow • This is an expense to the bank • It is called “interest expense” on the Income Statement www.bivio.com/hdic

5. Bank Terminology: Interest Income • Banks loan money to their clients • They want the interest rate they charge to be as high as market conditions allow • This is income to the bank • It is called “interest income” on the Income Statement www.bivio.com/hdic

6. Bank Terminology: Net Interest Margin aka The Spread • The difference between “interest expense” and “interest income” is called the “interest rate spread” or “net interest margin” • Banks want the “spread” to be as large as possible www.bivio.com/hdic

7. Bank Terminology: Non-Interest Income • Banks also have non-lending related income • This includes ATM fees, min. monthly fees, check overdrafts, trust services, and many other similar activities • Banks can also make money off of investments • This is called “non-interest income” on the Income Statement www.bivio.com/hdic

8. Bank Terminology: Non-Interest Expense • Banks also have non-lending related expenses • This includes salaries, rent / mortgage, equipment, and marketing costs • This is called “non-interest expense” on the Income Statement www.bivio.com/hdic

9. Bank Terminology: Loan Loss Provision • Banks also have to account for loans that go bad • Banks are required to set aside a percentage of funds to cover these bad loans • Banks that loan money out to “high-risk” customers have a larger loan loss provision than banks that loan money to “low-risk” customers • The set aside money is known as “loan loss provision” on the Income Statement www.bivio.com/hdic

10. Finding A Proxy For Bank Revenue • Banks do not have a line for revenue on the Income Statement • So we have to develop a “proxy” or substitute for bank revenue • They are several ways to find a “proxy” for bank revenue and no one way is perfect www.bivio.com/hdic

11. NAIC Method of a Bank Proxy For Sales Is: • Net Interest Income (the “spread”) • Using a net number smoothes out the changes due to changes in interest rates • Minus the Loan Loss Provision • Plus Non-Interest Income • Plus Tax Equivalent Adjustment (TEA) • TEA adjusts tax exempt interest income to a “pre-tax” dollars • TEA is generally < 2% of revenue www.bivio.com/hdic

12. Value Line & Creating a Bank Proxy for Revenue • VL does a better – though not – perfect way of calculating the Bank Proxy For Revenue • VL has lines for Net Interest Income, Loan Loss Provision, Non-interest Income, and Non-Interest Expense • VL does not have the bank TEA • S&P “tearsheets” have TEA • VL data needs to be both calculated and hand entered • VL data can be entered automatically but this requires a subscription that’s $$$ www.bivio.com/hdic

13. OPS & Using A Bank Proxy For Revenue • OPS uses gross interest income (not net) • Revenue numbers are influenced by interest rates • Rising interest rates raise revenue; • Lowering interest rates reduce revenue • OPS is fast to download • OPS is far cheaper than a VL subscription • $25 vs. $600+ • OPS has nine years of quarterly data www.bivio.com/hdic

14. OPS vs. Value Line Data • OPS data will result in lower historic sales growth rates in low interest rate environments than Value Line data • OPS data will result in higher historic sales growth rates in high interest rate environments than Value Line data www.bivio.com/hdic

15. Bottom Line on Value Line vs. OPS • The differences between the two data sources is small • Keep focused on the big picture YOUR JUDGMENT of the future www.bivio.com/hdic

16. Estimating Future EPS • Look at the trend lines on the front of the SSG • Look at the trends of recent quarterly data in PERT-A • Preferred Procedure • A Revenue Based estimate of future EPS AND • Ralph Seger method • Total Assets method www.bivio.com/hdic

17. Estimating Future EPS • Looking at the trends on the graphs and in PERT-A are the same • Preferred Procedure, which is based in part on the figure in 2A, is not as good a method for banks • Many believe that the pre-tax profit margin (2A) is not as important for banks • See Total Assets Method www.bivio.com/hdic

18. Ralph Seger Method for Projecting Future EPS • To forecast it, look at: • Historic growth of book value per share; • Historic growth of dividend per share; • Historic growth of EPS • Choose the lowest growth rate and make your judgments from that point www.bivio.com/hdic

19. Total Assets Method For Projecting Future EPS • Enter Total Assets in lieu of Sales Proxy on the front of the SSG • Rationale: Asset growth is critical to a bank • Gives a more reliable pre-tax margin (2A) by calculating Return on Assets (ROA) • ROA is considered a better measure of Bank performance than pre-tax profit on sales (2A) • ROA can also be found in the S&P ‘tearsheet” www.bivio.com/hdic

20. Valuing Banks Stocks • Section 3 of the SSG (Value) is same for both banks and non-banks • However, P/Es for banks tend to have an inverse relationship to the outlook on interest rates • When interest rates fall; bank P/Es will rise • When interest rates rise; bank P/Es will fall • Use this knowledge when forecasting future P/Es for banks www.bivio.com/hdic

21. Conclusion of Banks For Beginners • Banks have differences that should be recognized before you complete your SSG. Differences are not insurmountable • Need to find a proxy for revenue • OPS vs. NAIC vs. Ralph Seger vs. Total Assets • Pre-tax profit margin (2A) is not as important as Return on Assets (ROA) to judging bank management efficiency • Bank P/Es are inversely related to interest rates • Need to settle on a data source • Should be the same source as your source for rest of portfolio • OPS vs. Value Line www.bivio.com/hdic