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Expected growth in EPS is a critical input to the estimate of any stock's "fair value." The higher the growth, the higher the P/E multiple, all other things being equal.

What drives growth in bank EPS? Banks generate both spread income (they borrow at some rate and lend at a higher one) and fee income (they charge fees for a variety of services, plus penalties for bad behavior like bounced checks). While both types of income are important, spread income is larger for most banks, and asset size drives spread income. So asset growth is a key driver of EPS growth.

But many banks have been highly acquisitive, issuing large numbers of shares to effect transactions. So growth in assets per share ("A-PS"), rather than growth in total assets, is the more relevant driver of EPS growth. And shareholders care about per share growth, not aggregate growth.

To summarize in the form of an equation:

(A-PS) x (RoA) = EPS

where "RoA" stands for return on assets. So if RoA can increase only modestly in the long run, if at all, long run EPS growth has to come from long run A-PS growth.

The chart below shows compound annual growth in total assets and A-PS for several large banking institutions:

15-year CAGR

Year-end assets ($BN)

Institution

Ticker

Total assets

Assets per share (A-PS)

1997

2012

Largest

JPMorgan Chase

(NYSE:JPM)

13.2%

5.2%

$366

$2,359

Bank of America

(NYSE:BAC)

15.2%

0.7%

265

2,210

Citigroup

(NYSE:C)

6.8%

-5.9%

697

1,865

Wells Fargo

(NYSE:WFC)

20.3%

10.8%

89

1,423

Fast growth

US Bancorp

(NYSE:USB)

26.1%

10.4%

11

354

Capital One

(NYSE:COF)

28.7%

19.7%

7

313

New York Community

(NYSE:NYCB)

24.7%

12.2%

2

44

Laggards

Regions

(NYSE:RF)

11.7%

-3.0%

23

121

KeyCorp

(NYSE:KEY)

1.3%

-3.6%

74

89

Huntington

(NASDAQ:HBAN)

5.1%

-3.0%

27

56

First, look at how much total assets have grown at the largest banks. JPMorgan Chase (JPM) and Bank of America (BAC) are both well north of $2 TN in assets, with an asset growth rate in the teens for 15 years. Citigroup (C) is smaller than JPM and BAC, but grew total assets more modestly and avoided large acquisitions. Wells Fargo (WFC) is smaller than C but still huge. It grew assets and A-PS more rapidly than JPM, BAC or C.

Second, look at how small A-PS growth is relative to total asset growth. There are two explanations. The first is acquisitions. A large acquisition causes a big increase in total acquirer assets but only a modest increase in A-PS. A-PS might even fall in the short run, but the acquirer hopes when a deal is struck that deal synergies will make long run A-PS higher. Otherwise the deal creates little value or ends up destroying some. Sober deal pricing and competent execution are critical.

The other reason for some banks' modest/negative A-PS growth is that they were compelled to undertake large, dilutive equity issuances in the wake of the 2008 financial crisis. C In particular saw its A-PS crater because of this, but Regions Financial (RF), KeyCorp (KEY) and Huntington Bancshares suffered setbacks as well. Do you look at those capital raises as "black swans," and calculate A-PS growth rates around them, or do you take them as evidence that banks grow slowly but still can be risky?

Third, look at how modest A-PS growth is. Among the largest banks, WFC is "best in class," with a 10.8% A-PS CAGR. JPM is considered by some to be "best in class," and yet delivered only 5.2% compounded A-PS growth. Why the gap? Both banks were acquisitive, but WFC's 2008 acquisition of Wachovia increased its A-PS by an astronomical 65%. But this one deal doesn't explain the A-PS differential over the long run. WFC's quarterly A-PS growth rates over the last 15 years have just been better than JPM's. WFC has had a materially higher RoA, and higher RoA banks can grow equity and assets faster than low RoA banks.

It seems that RoA is a more important driver of long-term A-PS growth than acquisitions.

From an investor's standpoint, combing through the past is useful only insofar as it can shed some light on what the future holds. What's the use of the above analysis? With respect to the big banks, you need to decide whether acquisitions boosted or depressed long run historical A-PS growth. Let's be magnanimous and assume it helped. Then projected A-PS growth has to be lower, simply because there aren't enough sizable, properly-priced targets. JPM is currently the largest US bank, with $2.4 TN in assets. What's the largest US bank that it could buy (leaving regulatory considerations, availability and EPS dilution aside)? Probably US Bancorp (USB), which is 15% as large in terms of assets. An "at-market" deal would decrease JPM's A-PS by 15%. WFC is smaller, with "only" $1.4 TN in assets, but it faces a similar dearth of sizable targets.

If you're a long-term bank stock investor, you need compelling evidence to think that any bank's long run A-PS growth will be higher than 6%, especially a big bank. WFC and USB provide such evidence. For banks in low-growth markets or with a predisposition to doing overpriced deals, the growth figure could be a lot lower than this. Bank valuations don't seem to consistently reflect this fact.

In addition to my postings on Seeking Alpha, I plan to begin sending out a periodic note on topics of interest to bank stock investors. Please E-mail me at WintersReport@gmail.com if you would like to be added to the distribution list.

Source: How Fast Can Banks Grow?