On the Valuation of Large Systemic U.S. Banks

Abstract

We examine the stock market valuation of large and systemic U.S. banks over the period 2003Q4-2014Q1. These are the banks included in a series of supervisory capital review and stress tests conducted annually since 2009 by the Federal Reserve. We extend Gordon’s growth model of stock valuation, allowing both dividend and cost of equity to be variable over time. We establish a dynamic relationship between the market price-to-book ratio of equity and measures of the cost of equity, the expected growth of net income and modified dividend payout ratio. We find that the price-to-book ratio of equity is a valid valuation model. We also find large heterogeneity in the degree to which market price-to-book ratios of these banks are temporarily above or below their long-run equilibrium valuation. These divergences are persistent over time with only about a quarter of the gap closing each quarter. Price-to-book ratios under-react to changes in fundamental variables. So, good news leads temporarily to relative undervaluation and bad news to relative overvaluation.We also show that the observed short-run divergences of market from fundamental price-to-book ratios are related systematically to observable bank characteristics. These relationships are not immutable as many patterns changed after the recent financial crisis. In particular, before the crisis, the market tended to temporarily overvalue leverage and asset growth but these patterns came to an end with the onset of the crisis. Finally, we examine the role of bank opacity and find that after the crisis higher bank opacity is associated with higher discounts of market from fundamental valuation in the short run. Market sentiment contributes to such divergences also. Periods of higher exuberance in the financial markets are associated with higher relative overvaluation.