SPERM, DIRECTION AND THE COST OF CAPITAL

It is a well documented fact that men will not stop and ask for directions. Nature compensates for this fact and is the reason why it takes million of sperm to find an egg (despite that fact that the egg is the relative size of Mississippi). Under the microscope you can see hundreds of sperm head off in a different direction unable to let their ego roll down the window and ask for guidance. In similar fashion, many bank managers do not stop and ask what their weighted cost of capital is telling them. Understanding the weighted average cost of capital ("WACC") is vitally important for the creation of value. WACC is the measure of how much a bank pays to finance its long-term operations and is the volume weighted cost of its equity, debt, subdebt and trust preferred capital. The average community bank runs about 75% equity and 25% debt with an average cost of 10.50% and 4.10%, respectively. By applying the allocations to the respective costs, we find that the average community bank has a weighted cost of capital of around 9%. To put this in perspective, WACC for community banks range from 6% to 12% depending on the size and mix of debt to equity. National banks, the lowest being Citigroup and Bank of America, have a WACC of around 5.04%. Now, there are a couple of important points here, as understanding WACC gives direction as to bank performance. For starters, since debt is so much cheaper than equity, moving the mix of debt to equity to the highest allowable debt ratio, reduces the cost of capital (this is why we like trust preferred debt so much). Just moving to 50% equity to 50% debt ratio, the cost of capital would be reduced to near 7%. To a much less extent, increasing liquidity also helps bring down volatility further reducing the cost of equity, and hence, capital. There is a paradox here because when a bank is very thinly traded, it trades at a fraction of the market's volatility. In the parlance of the market, this means having a beta below 1.00%. Very thinly traded community banks normally have calculated betas of 0.70, or volatility that is 70% that of the market. Ironically, as the CEO works with analysts and institutional investors, volatility increases to a point before it decreases. A typical thinly traded (as opposed to very thinly traded, as in our earlier example) has a beta of 1.35 or 35% more than the market. As bank stock moves from thinly traded to liquid, beta comes back down to 1.00%. Most large community banks have betas of around 1.10%. One key take away here is using the WACC to figure out if you are adding value to your shareholders or not. By calculating your net operating profit after taxes ("NOPAT") and then deducting your bank's average cost of capital in dollars, the difference is the risk-adjusted excess return above the cost of capital, or your economic value added ("EVA"). If EVA is negative, this gives management direction that they should either return equity to their shareholders (thereby lowering their cost of capital) or increase earnings. When a majority of banks produce negative EVA (as is currently the case), the WACC points in the direction that return expectations must come down for bank investors. Getting directions is never easy, but taking the time to understand what the environment is telling you could result in a birth of better earnings down the road.