Is the RoE of your bank above or below the fog boundary?
How much RoE should a bank achieve?
How much return on equity (RoE) should a bank make? The answer to this question is not evident. Some argue that banks can in the current environment only achieve RoEs in the low single digits. Others believe 10 percent is a fix minimum. And prior to the financial crisis, a prominent bank CEO even announced 25 percent as target.
To answer this question, it is important to understand the link between the RoE and share price of a bank. The share price is essentially the sum of all future profits discounted to today. Hence, a bank creates positive value for its shareholders if it achieves an RoE higher than the discount rate used by the market. This discount rate is called the Cost of Equity (CoE). Unfortunately, the Cost of Equity is not directly observable. However, as a rule of thumb a price-to-book value above 1 indicates that the bank will sustainably generate RoEs higher than its Cost of Equity. Or put differently, the market believes that the bank will generate added value for its shareholders.
A common key performance indicator to measure and report value creation is Economic Profit (also known as Economic Value-added). Technically, Economic Profit is computed as a firm’s after tax profit – shareholders’ equity * CoE. The product of the latter is also named capital charge. While somewhat less common, Economic Profit can equivalently be calculated as (RoE – CoE) * shareholders’ equity. I like the second formula, because it nicely shows that Economic Profit is positive if and only if the RoE is larger than the CoE.
In essence, the CoE of a bank is the threshold above which a positive RoE starts to contribute value for the bank’s shareholders. Similar as for the fog boundary in the mountains, it makes a large difference whether you are above or below a certain level, but the level itself is less relevant.
As many banks in Europe trade below their book value, bank shareholders are mostly left in the fog. Only a minority of banks are managed in a way that their shareholders are above the fog and enjoy sunshine.
Orbit36 can help your bank to find the bright spots.