This may be a stereotype, but the Germans are a precise people and while that precision often gets in the way of more creative pursuits (like cooking and valuation), it lends itself well to engineering and banking. For decades until the introduction of the Euro and the creation of the European Central Bank, there was no central bank in the world that matched the Bundesbank for solidity and reliability. Thus, investors and regulators around the world, I am sure, are looking at the travails of Deutsche Bank in the last few weeksand wondering how the world got turned upside down. I am sure that there are quite a few institutions in Greece, Spain, Portugal and Italy who are secretly enjoying watching a German entity be at the center of a market crisis. Talk about schadenfreude!
Deutsche Bank's Journey to Banking Hell
There are others who have told the story about how Deutsche Bank got into the troubles it is in, much more creatively and more fully than I will be able to do so. Consequently, I will stick with the numbers and start by tracing Deutsche Bank’s net income over the last 28 years, in conjunction with the return on equity generated each year.
If Deutsche Bank was reluctant to follow more daring competitors into risky businesses for much of the last century, it threw caution to the winds in the early part of the last decade, as it grew its investment banking and trading businesses and was rewarded handsomely with higher earnings from 2000 to 2007. Like almost every other bank on earth, the crisis in 2008 had a devastating impact on earnings at Deutsche, but the bank seemed to be on a recovery path in 2009, before it relapsed. Some of its recent problems reflect Deutsche’s well chronicled pain in investment banking, some come from its exposure to the EU problem zone (Greece, Spain, Portugal) and some from slow growth in the European economy. Whatever the reasons, in 2014 and 2015, Deutsche reported cumulative losses of close to $16 billion, leading to a management change, with a promise that things would turn around under new management. The other dimension where this crisis unfolded was in Deutsche’s regulatory capital, and as that number dropped in 2015, Deutsche Bank's troubles moved front and center. This is best seen in the graph below of regulatory capital (Tier 1 Capital) from 1998 to 2015, with the ratio of the Tier 1 capital to risk adjusted assets each year super imposed on the graph.
The ratio of regulatory capital to risk adjusted assets at the end of 2015 was 14.65%, lower than it was in 2014, but much higher than capital ratios in the pre-2008 time-period. That said, with the tightening of regulatory capital constraints after the crisis, Deutsche was already viewed as being under-capitalized in late 2015, relative to other large banks early this year. The tipping point for the current crisis came from the decision by the US Department of Justice to levy a $14 billion fine on Deutsche Bank for transgressions related to the pricing of mortgage backed securities a decade ago. As rumors swirled in the last few weeks, Deutsche Bank found itself in the midst of a storm, since the perception that a bank is in trouble often precipitates more trouble, as rumors replace facts and regulators panic. The market has, not surprisingly, reacted to these stories by marking up the default risk in the bank and marking down the stock price, most strikingly over the last two weeks, but also over a much longer period.
At close of trading on October 4, 2016, the stock was trading at $13.33 as share, yielding a market capitalization of $17.99 billion, down more than 80% from its pre-2008 levels and 50% from 2012 levels. Reflecting more immediate fears of default, the Deutsche CDS and CoCo bonds also have dropped in price, and not surprisingly, hedge funds sensing weakness have moved in to short the stock.
Revaluing Deutsche Bank
When a stock is down more than 50% over a year, as Deutsche is, it is often irresistible to many contrarian investors, but knee jerk contrarian investing, i.e., investing in a stock just because it has dropped a lot, is a dangerous strategy. While it is true that Deutsche Banks has lost a large portion of its market capitalization in the last five years, it is also true that the fundamentals for the company have deteriorated, with lower earnings and hits to regulatory capital. To make an assessment of whether Deutsche is now “cheap”, you have to revalue the company with these new realities built in, to see if the market has over reacted, under reacted or reacted correctly to the news. (I will do the entire valuation in US dollars, simply for convenience, and it is straightforward to redo the entire analysis in Euros, if that is your preferred currency).
As you can see from the graph of Deutsche’s profits and return on equity, the last twelve months have delivered blow after blow to the company, but that drop has been a long time coming. The bank has had trouble finding a pathway to make sustainable profits, as it is torn between the desire of some at the bank to return to its commercial banking roots and the push by others to explore the more profitable aspects of trading and investment banking. The questions in valuation are not only about whether profits will bounce back but also what they will bounce back to. To make this judgment, I computed the returns on equity of all publicly traded banks globally and the distribution is below:
|Global Bank Data|
I will assume that given the headwinds that Deutsche faces, it will not be able to improve its returns on equity to the industry median or even its own cost of equity in the near term. I will target a return on equity of 5.85%, at the 25th percentile of all banks, as Deutsche’s return on equity in year 5, and assume that the bank will be able to claw back to earning its cost of equity of 9.44% (see risk section below) in year 10. The estimated return on equity, with my estimates of common equity each year (see section of regulatory capital) deliver the following projected net income numbers.
|Year||Common Equity||ROE||Expected Net Income|
I am assuming that the path back to profitability will be rocky, with losses expected for the next two years, before the company is able to turn its operations around. Note also that these expected losses are in addition to the $10 billion fine that I have estimated for the DOJ.
b. Regulatory Capital
Deutsche Bank’s has seen a drop in it Tier 1 capital ratios over time but it now faces the possibility of being further reduced as Deutsche Bank will have to draw on it to pay the US DOJ government fine. While the DOJ has asserted a fine of $14 billion, Deutsche will negotiate to reduce it to a lower number and it is assessing its expected payment to be closer to $6 billion. I have assumed a total capital drop of $ 10 billion, leaving me with and adjusted regulatory capital of $55.28 billion and a Tier 1 capital ratio of 12.41%. Over the next few years, the bank will come under pressure from both regulators and investors to increase its capitalization, but to what level? To make that judgment, I look at Tier 1 capital ratios across all publicly traded banks globally:
|Global Bank Data|
I will assume that Deutsche Bank will try to increase its regulatory capital ratio to the average (13.74%) by next year and then push on towards the 75th percentile value of 15.67%. As the capital ratio grows, the firm will have to increase regulatory capital over the next few years and that can be seen in the table below:
|Year||Net Income||Risk-Adjusted Assets||Tier 1 Capital/ Risk Adjusted Assets||Tier 1 Capital||Change in Tier 1 Capital||FCFE = Net Income - Change in Tier 1|
The negative free cash flows to equity in the first three years will have to be covered with new capital that meets the Tier 1 capital criteria. By incorporating these negative free cash flows to equity in my valuation, I am in effect reducing my value per share today for future dilution, a point that I made in a different context when talking about cash burn.
Rather than follow the well-trodden path of using risk free rates, betas and risk premiums, I am going to adopt a short cut that you can think of as a model-agnostic way of computing the cost of equity for a sector. To illustrate the process, consider the median bank in October 2016, trading at a price to book ratio of 1.06 and generating a return on equity of 9.91%. Since the median bank is likely to be mature, I will use a stable growth model to derive its price to book ratio:
Plugging in the median bank’s numbers into this equation and using a nominal growth rate set equal to the risk free rate of 1.60% (in US dollars), I estimate a US $ cost of equity for the median bank to be 9.44% in 2016.
Using the same approach, I arrive at estimates of 7.76% for the banks that are at the 25th percentile of risk and 10.20% for banks at the 75th percentile. In valuing Deutsche Bank, I will start the valuation by assuming that the bank is at the 75th percentile of all banks in terms of risk and give it a cost of equity of 10.20%. As the bank finds its legs on profitability and improves its regulatory capital levels, I will assume that the cost of equity moves to the median of 9.44%.
Starting with net income from part a, adjusting for reinvestment in the form of regulatory capital in part b and adjusting for risk in part c, we obtain the following table of numbers for Deutsche Bank.
|Year||FCFE||Terminal Value||Cost of equity||Cumulative Cost of Equity||PV|
|Total value of equity||$31,838.74|
|Value per share =||$22.97|
Note that the big number as the terminal value in year 10 reflects the expectation that Deutsche will grow at the inflation rate (1% in US dollar terms) in perpetuity while earning its cost of equity. Note also that since the cost of equity is expected to change over time, the cumulated cost of equity has to be computed as the discount factor. The discounted present value of the cash flows is $31.84 billion, which when divided by the number of shares (1,386 million) yields a value of $22.97 per share. There is one final adjustment that I will make and it reflects the special peril that banks face, when in crisis mode. There is the possibility that the perception that the bank is in trouble could make it impossible to function normally and that the government will have to step in to bail it out (since the option of letting it default is not on the table). I may be over optimistic but I attach only a 10% chance to this occurring and assume that my equity will be completely wiped out, if it occurs. My adjusted value is:
Expected Value per share = $22.97(.9) + $0.00 (.1) = $20.67
Given my many assumptions, the value per share that I get for Deutsche Bank is $20.67. To illustrate how much the regulatory capital shortfall (and the resulting equity issues/dilution) and overhang of a catastrophic loss affect this value, I have deconstructed the value per share into its constituent effects:
|Unadjusted Equity Value =||$33.63|
|- Dilution Effect from new equity issues||$(10.66)|
|- Expected cost of equity wipeout||$(2.30)|
|Value of equity per share today =||$20.67|
Note that the dilution effect, captured by taking the present value of the negative FCFE in the first four years, reduces the value of equity by 31.69% and the possibility of a catastrophic loss of equity lowers the value another 6.83%. The entire valuation is pictured below:
I know that you will disagree with some or perhaps all of my assumptions. To accommodate those differences, I have set up my valuation spreadsheet to allow for you to replace my assumptions with yours. If you are so inclined, please do enter your numbers into the shared Google spreadsheet that I have created for this purpose and let's get a crowd valuation going!
Time for action or Excuse for inaction?
At the current stock price of $13.33 (at close of trading on October 4), the stock looks undervalued by about 36%, given my estimated value, and I did buy the stock at the start of trading yesterday. Like everyone else in the market, I am uncertain, but waiting for the uncertainty to resolve itself is not a winning strategy. Either the uncertainty will be resolved (in good or bad ways) and everyone will have clarity on what Deutsche is worth, and the price and value will adjust, or the uncertainty will not resolve itself in the near future and you will be sitting on the side lines. For those of you who have been reading my blog over time, you know that I have played this game before, with mixed results. My bets on JP Morgan (after its massive trading loss in 2012) and Volkswagen (after the emissions scandal) paid off well but my investment in Valeant (after its multiple scandals) has lost me 15% so far (but I am still holding and hoping). I am hoping that my Deutsche Bank investment does better, but I strapped in for a rocky ride!