Rumors are swirling that Germany and France are attempting to delay implementation of the Basel Committee on Banking Supervision’s “Basel III” regulations imposing a 6% Tier 1 capital requirement on global banks by 2015, which would be 50% higher than the 4% requirement that is currently required. The Tier 1 capital ratio is a complicated calculation, but the gist of the numerator is bank equity (both common and preferred) and the denominator is risk-weighted total assets, where safe assets like cash and government securities are given a weight of zero, mortgage loans (i.e. secured by property) are weighted 0.5, and unsecured loans are weighted 1.0.

Basel III would also require banks to maintain a tangible common equity (TCE) ratio of at least 4.5% by 2015, up from only 2.0% today. TCE is a more stringent measure of capital than Tier 1 and is composed of only common equity (minus a deduction for goodwill).

Are Bank Stocks Good Values?

U.S. bank stocks, as measured by the Regional Bank HOLDRs (NYSE: RKH), have risen strongly so far in 2012. That could mean the economy is recovering, or we could just be experiencing a lull in the economic storm — in which case buying banks now would be a huge trap. Thus, it is more important than ever to value banks correctly. And that’s not easy. Financial service companies are arguably the most difficult to value.

One can readily tell from the Basel III regulations that equity is the most important measure of a bank’s ability to pay back creditors. It turns out that bank equity also plays a critical role in valuing bank stocks.

Banks Are Different

Normally, when calculating a non-banking business’ free cash flow, we add back non-cash charges to net income, adjust for changes in working capital (inventory, accounts receivable, accounts payable, etc.), and subtract capital expenditures. But because retail banks are in the business of buying and selling money, defining necessary metrics like debt and working capital becomes confusing at best.

Let’s say you run your own bank called the Bank of Mom and Dad. Your kids deposit their allowances, and then you lend out cash to your relatives, like that crazy uncle who is always building the next great mousetrap. The deposits from your kids are short-term loans and show up on the balance sheet as liabilities (after all, the money is not yours). Seems easy enough, but you use these deposits to fund your lending activity (that’s how you make money). So, they are more like inventory, an asset that drives revenue.

You can also borrow money for operational needs, but it’s nearly impossible for an outsider to tell whether a bank is borrowing for operational or long-term capital purposes.

Faced with the fluid nature of a bank’s assets and liabilities, investors need metrics they can use to correctly value bank stocks.

Show Me the Equity

So, let’s walk through a basic bank valuation. For space and simplicity, we’ll only look two years out.

First off, you need a valuation model that ignores cash flow and focuses instead on a bank’s shareholder equity (assets minus liabilities). This is because banks have “mark-to-market” accounting, which makes book value (for non-financials, an almost arbitrary figure because of the wide disparity between assets cost and current market value) a surprisingly reliable indicator of current value.

Therefore, to value a bank stock, we can employ an “excess return” model using its current book value (shareholders equity) as a reliable starting point. The model calculates the additional book value that the bank will create each year and discounts this value back to the present at the cost of equity.

Dividends (as measured by the payout ratio) must be subtracted out because, well, the bank isn’t keeping this money (it’s paying it out to you, the shareholder), so it’s not increasing its book value. For our purposes, we’ll assume return on equity (ROE) is 15%, cost of equity is 11%, and the dividend payout ratio is 50%. The table below illustrates the increase in book value over two years.

To get the excess return, multiply the difference between the bank’s ROE and its cost of equity by its book value (the assumption being that ROE is higher than the cost of equity — otherwise, why be in business?). Don’t forget to discount for present value for year 1 and beyond.

Finally, calculate a terminal value (excess return divided by the difference between cost of equity and the terminal growth rate), which assumes a constant rate of growth forever (usually equal to the long-term average growth rate of the economy as a whole — we’ll use 3%) , and add that into the mix (again, properly discounted back to the present).

Add it all up, divide by the number of shares (let’s assume 100), and you get a per-share value:

Bank Stock Multiples Are the Quick and Easy Valuation Method

If all those formulas scared you, there is a quicker (but less precise) method: Examine the bank’s relative valuation based on multiples. Be sure to use equity-based multiples, though, for the reasons discussed above. I recommend price-to-earnings or price-to-book value.

Using firm-wide multiples (those based on debt and equity) will cause problems, so avoid those involving enterprise value, cash flow, or revenues, such as EV-to-EBITDA or price-to-sales.