- This article suggests a valuation method based on TBV + 10 x dividend to value financial stocks as an asset plus income purchase with the most easily obtainable data.
- This valuation method suggests that Huntington Bancshares Incorporated is undervalued by about 15% at its current price of ~$14.5.
- A financial dashboard is also developed to better anchor the discussion under the context of the sector and other peers.
Investment thesis and background
This article suggests a valuation method based on TBV + 10 x dividend to value financial stocks as an asset plus income purchase with the most easily obtainable data. This valuation method suggests that Huntington Bancshares Incorporated (NASDAQ:HBAN) is undervalued by about ~15% at its current price of ~$14.5.
I've studied some of the financial businesses in detail and owned some of them over the years. I have been organizing my past notes and published several of them now as listed below. And I thought it would be helpful to share the dashboard I use to track them. I will detail the structure of the dashboard later. Overall, green means good, red means bad, and yellow mean average. So an ideal long candidate will show a lot of green and no red.
I will update the dashboard regularly, and keep organizing my notes and gradually add new stocks into it. So if you are so inclined, you could follow this series and be alerted when I do.
This dashboard reflects my underlying philosophy to analyze financial stocks, focusing on three areas:
1. Valuation. And I use three metrics to gauge a stock valuation:
- The usual PE ratio to gauge its absolute valuation
- The PEGY, a modified PE growth ratio to gauge its valuation relative to growth. The PEGY ratio was defined as the PE ratio divided by the sum of dividend growth rate and dividend yield. The dividend yield was included in the definition with the rationale that if a stock offers a high dividend yield currently, there is no need to require a high growth rate anymore to support a reasonable expected return.
- The IV Z-score to gauge its relative valuation in term of its historical premium/discount relative to the IV value. The investment value ("IV") is based on IV = TBV + 10 x Dividend as to be detailed later. The look-back period is seven years in the calculation of the Z score. Larger Z score suggests larger undervaluation compared to its own historical record. Though a Z score that is significantly above 1, it is an alarm for further look as it is out of the normal range of market fluctuation and there might be a more fundamental reason.
Some readers have commented that the use of IV ignored the role of shared repurchases. And my thoughts are twofold. First, any model needs to strike a balance between simplicity and completeness. My style/goal is "only" to be approximately right and avoid disastrous. Second, share repurchases, if made wisely, should also be reflected in increases in TBV and dividend per share.
- The current ROE to gauge its current profitability
- The historical ROE to gauge if current ROE is in line with past records. The look-back period is seven years with outliers excluded.
- The historical ROA to gauge historical record. The look-back period is seven years with outliers excluded.
- To gauge safety in the short term, the metric used is the coverage of dividend, i.e., the dividend payout ratio. I feel pretty safe for anything that is below ~40%.
- The tier 1 leverage ratio is used to gauge safety in a longer term and fundamental way. Whenever it is not reported, it is estimated by ratio between asset and tangible book value. A ratio above 5% is deemed safe for a bank, and only those below this threshold will be highlighted.
Overall impression on the financial sector
Based on the above discussion, it can be seen that the financial sector is slightly overvalued as a whole. If we use XLF's valuation to represent the sector, the Z-score is at negative 0.66 - overvalued but within the normal range of fluctuation. The most overvalued stocks are the diversified banks like MS and JPM, for understandable reasons. At the current elevated market valuations, they are the "safe haven" should a correction occurs and investors are willing to pay a higher premium.
The least overvalued (or most undervalued) are USB, HBAN, BK. Their current valuations are lower than the historical average. And the Z score is between 0.4~0.9, within normal market fluctuations. HBAN is the most undervalued stock in this pack in terms of the Z-score.
With the above overall discussion, we now move on to the specifics of IV and HBAN.
Valuation of financials and my general approach
Although any investment, no matter how good it is in terms of safety and certainty, becomes a bad investment if made at the wrong price. The financial section is no exception. My method for valuing financial stocks is to calculate the investment value ("IV") based on the formula. More details can be found in my earlier writings.
IV = TBV + 10 x dividend
The following chart also shows an example of this method applied to HBAN. As can be seen, it captured the market price very nicely. As seen from this chart, when the market price fluctuates below the IV, it presents good entry opportunities followed by handsome total returns - though you do have to be able to stomach the short term volatility.
Source: author based on data from Yahoo Finance
Warning and clarification
Here a strong warning is in order. I am NOT suggesting you go out and start buying every/any financial stock that is selling below its IV. As investors, we face many risks. Two of the major risks are A) quality risk or value trap, i.e., paying a bargain price for something of horrible quality, and B) valuation risk, i.e., paying too much for something of superb quality.
For me, the IV valuation is mainly to avoid the type B risk AFTER the type A risk has been eliminated already. A miserable company cannot become a good investment in the long run no matter how cheap you bought it. But a good company can become a bad investment if bought at a high price. The optimal zone lies in the middle as shown, which represents an optimal trade-off between quality and valuation and hence reduces risks. I certainly did not invent this approach, and plenty of people (Buffett being the most famous one) have thought about and written about it before. If you are interested, Joel Greenblatt's little book, entitled "The Little Book That Still Beats the Market", probably is the best starting point on this general philosophy.
I also did not invent the TBV + 10 x Dividend formula. Others have thought about it before. For example, Thomas Au's book entitled "A Modern Approach to Graham and Dodd Investing" gave an excellent treatment on this topic. The main advantages of this approach are:
1. It relies on the two most easily obtainable data with the least amount of ambiguity (more on this later). Many times, a few members with good certainty are much better than a bunch of numbers subject to ambiguous interpretation.
2. It is more of end-result driven approach. If a business (especially a financial business) is doing a wonderful job, then it should be reflected in a growing tangible book value and/or growing dividend in tandem. Otherwise, something must be missing.
HBAN: profitability and growth
With the above backdrop, now let's look at HBAN more closely. HBAN is a regional bank. It operates through more than 800 offices mainly in the states of OH, IL, IN, KY, MI, PA, and WV. In these states, it provides a full spectrum of banking services including mortgage, investment, trust, brokerage, et al.
HBAN has delivered stable returns as shown below throughout different market conditions. Return on asset ("ROA") has been averaged around 1.0% over the past decade, on par with the golden standard for a bank. And its return on equity ("ROE") has been averaged around 9.8%, again on par with the industry gold standard. Besides its consistent and stable profitability, the business has also been growing at a good pace. As shown in the next figure below, over the past decade, book value and TBV have been growing more at 10.4% and 8%, respectively.
Source: author based on Seeking Alpha data.
Source: author based on Seeking Alpha data.
Valuation of financial stock as a bond
In general, I invest in stocks as an equity investor, meaning I value them based on their future earnings. Based on analysis of their business moats and their return on capital employed, I estimate their potential for perpetual growth of their future earning as detailed in one of my earlier articles.
But when it comes to investment in financial stocks, I focus more on the current asset value and income, essentially my valuation method becoming the evaluation of bond. As mentioned above, I estimate the IV of financial stocks by TBV + 10 x dividend. Here let me explain my thoughts and rational of this method in more details.
First, why do I use TBV? The short answer is that it is really the best we have for the current worth of a financial company. For a large financial institution holding trillions of dollars of assets and liabilities, I believe even the executives themselves do not exactly know the current value of their institution. If you find this hard to agree with, imaging a much smaller scale task - imagine ourselves trying to determine the current net worth of our household. Highly liquid assets such as stock holdings and bond holdings are easy and we can come up with an accurate number, but nonetheless the number fluctuates day to day and by quite a bit for some days. Now move on to less liquid assets such as our house and cars. The margin of error is now much larger because we need to make assumptions about the selling price, the selling costs, and how long it would take to sell them. Now move further onto even less liquid assets such as collectibles or intellectual properties, and the margin of error can become really large here.
The above uncertainties are multiplied by a LOT for large financial institutions. They would have trouble to follow the day-to-day fluctuation even for their liquid assets. And for their less liquid assets and intangible assets (such as intellectual properties, customer relationships, goodwill, etc.), they would have to estimate based on some assumptions. And at the end, TBV is as good as we can get to - even there is still uncertainties. To get a very rough sense of how much uncertainties there could be, the following chart shows the difference between the TBV and the book valve (including all the intangibles). As you can see, the difference between these two could be as large as more than 40% currently, and the average difference is about 33% in recent years.
Source: author and Seeking Alpha data.
Next, why do I use dividend rather than earning? The short answer is that dividend is more reliable and indicative of a financial institution's performance than earning. The following chart provides some insights. As seen, for HBAN over the past 10 years, dividend has been steadily increasing (at a rate of 19% CAGR impressively).
In contrast, as seen, earning fluctuates from year to year. On one hand, earnings are subject to many factors out of anyone's controlled: interest rate change, overall economy, or just bad luck. On the other, earnings are also more open and prone to accounting manipulation and interpretation.
Dividend overcomes the above issues with earnings. Dividend is not subject to any subjective interpretation. And it reflects management's view more clearly and directly - at least for business like HBAN who has a long track record of being good steward of their dividend. If it increases, it means management must have good confidence about their business at least in the near future. If it decreases, then that means the opposite. Simply and clear.
Source: author based on Seeking Alpha data.
Valuation and potential return
Based on the above discussion, the following three valuation metrics are evaluated:
- The usual PE ratio to gauge its absolute valuation
Current PE is 11.4, significantly lower than overall sector (represented by XLF) and also slightly lower than its own historical track record (which has a medium value of ~13x).
- The PEGY ratio
The current PEGY ratio is 0.56, which represents good valuation normalized by growth rate.
- The IV Z-score
The current IV Z-score is 0.89, suggesting undervaluation compared to its own historical. And the Z score is within -1 and 1, suggesting the undervaluation is within the normal range of market fluctuation. Given the undervaluation, volatility risks in short term are limited. But such a relatively mild undervaluation won't impact long term return too much either.
Overall, the stock is undervalued by about 15% based on the above metrics, providing a decent margin of safety under the current overall evaluated market condition.
Conclusion and final thoughts
This article analyzes HBAN based on a valuation method that uses TBV and dividend, the most two easily obtainable data points with the least amount of ambiguity. The method essentially approaches a banking stock as an asset plus income purchase. This valuation method suggests that HBAN is undervalued by about 15% at its current price of ~$14.5, providing a decent margin of safety under the current overall evaluated market condition.
Thx for reading! Any comments, additional thoughts, alternative ideas are greatly appreciated!
This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.
Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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