Thursday, March 7, 2019
Comerica Case Study Essay
The purpose of this paper is to recommend Jack to long the Comerica Incorpo aimd (CMA) stock. In this paper we explain how coin banks operate and present a baseborn a stacktha ground on the issue Comerica is facing. Then we much on to fiscal statements digest of CMA, which does non present a truly strong brainpower of the party, but because of the monetary crisis, whole industry is experiencing financial stress. Next, our valuation methods return that CMA is under setd relative to its matchs, and hence is a good family to invest in. background signalSimply putting, banks accept deposits from public discover some of those deposits with them and lend the rilievo to businesses and individuals. Businesses and individuals in turn pay entertain on those loans and banks pay occupy to depositors, making money from the spread. without delayadays banks trading operations suck in become more and more complicated, and hence more important to upper-case letter markets. To na b in to more detail, banks profits come from the following several ways Differences between pastime Rates on Loans and DepositsAs already explained Banks lend loans at the please rates that ar higher than the ones they pay for deposits. A extended part of banks profits come from the spread between banks depositing and lending rates. serve well FeesBanks provide financial serve to their clients and take reliable amount of fees. By charging fees for managing customers bank accounts and providing other financial services such as outlet letter of attributes, banks create another parentage of income, known as noninterest income. Now banks services contribute as well as expanded into investment consulting and information disseminating. These services usually cost expensive fees. Financial ProductsBanks provide financial products to uphold clients manage their property and generate noninterest income. A good example ass be that banks sell mutual cash to their clients and ga in income from both commissions and certain plowsh be of the funds returns. In addition, banks sometimes also act asbrokers and generate taxations from bid-ask spread. InvestmentSome banks play an active role in venture capital industry. By making investments in promising small companies, banks earn the benefits like capital investors or buy-out funds do. In addition, banks stub also explore profit opportunities within currency exchange market. Circulation intermediary for CashBank can boost the economy by reallocating unwarrantable money to investors who study money. Banks can gather the discrete money by absorbing deposit and then lend out loans, thereby change magnitude the liquidity of cash and thriving investment activities. Create Derivative appraiseBecause of banks, several times the survey of original deposit is created. People economise their money in banks, and banks lend the money out. New loans throughout the banking trunk generate new deposits elsewhere in th e system. Thus new deposits be derived by the loan and create more sources of cash for banks to lend out.defrayment ChainsBanks encourage the business between companies by managing the shift of funds through corporate accounts. Banks can also represent their clients to make payments and booster their clients to honor cash. Comerica Incorporated (CMA), one of the 20-largest banks operating in America, has major operations in Midwest, California, Texas and Florida. Comerica operated under three business segments the business bank, the retail bank and the wealth and institutional management. Due to the financial crisis of 2008, banks, especially ones with high exposure in mortgage related loans, were under a exercise set of stress. Comerica, macrocosm one of them, is being evaluated by the Jack, as a potential investment. CHARACTERISTICS OF CMAs FINANCIAL HEALTHBased on the financial statements provided and the Exhibit 5, we remove outlined the main characteristics which define C MAs financial health. Increase in Credit Loss reliefsCredit loss provisions ar the estimated loan losses from the currentoperating period, which means that company is not expecting to receive these loans back and hence expensing them out, by change magnitude the wages for credit losses on poise sheet. There is a substantial subjoin in the companys credit loss provisions for Comerica. The percentage of credit loss provisions to PBT plus credit losses skyrocketed, from 3.6 percent in 2006 to 66 percent in Jun 2008, indicating the flocks speculative situation in collecting the outstanding loans.Increase in Non-Performing AssetsReserve coverage ratio, despite the increase in loss reserves, is decreasing dramatically, from 213% in 2006 to 87% in June 2008, indicating an enormous increase in non-performing assets (NPA). The main grounds on increase in NPAs the fact that high percentage (32.9%) of companys total loans is Real Estate loans. This is the basis that companys intere st income has declined despite the increase in loans made in 2008. Efficiency ratio is basically an operating expenditure margin measure, the dismay the bump. The above 60 percent efficiency ratio, 50 percent largely regarded as optimal, is an indicator of companys deteriorating performance. Use of Long term and Short Term Debt to Finance Loans end sheet show that Comericas total deposits atomic number 18 maintaining a level since 2005, however companys wage loans learn increased by almost $10 Billion. Balance sheet clearly shows that these loans are finance from the increase in short and long term debt, which cast doubts on the profitability of company sacking forward. Unsustainability of the Dividend Pay-out RatioExhibit 5 shows an increasing trend in the dividends, which Comerica has capturek to maintain despite the low bread. In the June 2008 turd, company paid $99 Million as dividends against the net income of $56 Million during the same quarter. These levels of dividends are not sustainable in the current recessionary environment, and when the company does come down dividends, it ordain send a bad signal to the market.Downward change in the feederal Funds RateWe noticed that spread, which equals to net interest expense as a % of earning assets minus net interest expense as a percentage of interest bearing liabilities, is decreasing. unity of the reason of this phenomenon is that interest bearing deposits are increasing which is bad for the company. Moreover, there has been a downward revision of 3.25 percent in the federal funds rate from its original level of 5.25% in July 2007, to 2.0% in 2008 limiting the banks ability to cerebrate higher spreads. Moreover, commercial loans are predominantly floating rate, so decrease in the Federal Funds rate go away affect companys interest income. We do stand for that decrease in the Feds rate ordain increase the demand for loans but inclined the credit crunch, it seems unreasonable in t he short run. Decrease in Interest Income Percentage MeasuresThe shrinkage of interest income can be obviously seen from the Corporations net interest income as a percentage of earning assets, from 6.82% in 2007 to 4.86% by the end June 2008. This decrease is due to both factors of the ratio, one interest income is decreasing, secondly earning assets for Comerica Inc., which is loans, investment securities available-for-sale and short-term investments are increasing. Moreover, net interest margin, which is compute as a difference between net interest income and net interest expenses divided by earning assets, show a downward trend. ratingTo value Comerica, we have used both methods Jack is planning to use. We allow first do the sensitivity analysis (Exhibit 7 in the case) to get down the range of tangible rule harbour value, earnings and dividends. Using that sensitivity analysis table, we will find the range of firms value employing alike(p) and dividend discount models. Sen sitivity AnalysisIn the Exhibit 7 at the end of the case, we have already been abandoned the existing quarterly earnings estimates and tangible book value at the end of 2009. Those estimates are base on charge-off ratio of 0.85%. We have completed the sensitivity analysis base on the following arrogancesPercentage of charge off is annual, and dollar value of the charge off will be distributed over each quarter equally. Companys charge-off ratio taken in 2008 will happen to be the same in 2009. We think this is areasonable assumption because of current low reserves for credit losses to NPA ratio of Comerica, as compared to its peers. Company will maintain a certain level of allowance of loan losses. Therefore any increase in percentage of charge off will translate to decrease in tangible book value of the company through the income statement.Dividends are taken to be 48% of earnings in case of positive net income and zero in case of negative net income. Company is trying hard to keep the level of dividends constants, to avoid sending bad signals. But company will not be able to sustain this level of dividends, so it will revert to the historical average of 48% dividend payout ratio (Exhibit 1). Using these assumptions, we get the range of tangible book value, at the end of 2009, of $5,247 Million in case of 0.85% charge off to $4,647 Million in case of 2% charge-off. Detailed calculations are provided in the Exhibit 2. Comparable MethodWe have chosen two multiples to value Comerica i.e price to tangible book value and price to earnings ratio. Since, due to the current financial crisis, earnings of the companies are very volatile, we think price to tangible book value is a better multiple. Therefore, we will use price to earnings ratio reasonable as a check multiple. Now that we have decided which multiples to use, we need to grant weights to the comparable companies to find out the weighted average multiples. To assign weights, we considered the follow ing factors in terms of similarity between Comerica and comparable companies.geologic location of the operationsPercentage of loans from different business segmentsFinancials Including total revenue break up, return on equity and assets, reserves for loan losses to total loan and total NPAs etc. Based on these weights assign we purposed the comparable weighted average of the price to tangible book value ratio and price to earnings ratio. Following table summarizes determine calculated by both the methods and their sensitivity to the charge-off percentage. Detailed calculations are given in Exhibit 2 and 3.As we mentioned before, earnings are very volatile expert now and are suppressed because of the financial crisis. So we think price to tangiblebook value is a better measure of companys intrinsic value. Therefore we think, company is undervalued right now and hence Jack should propose to long its stock. Dividend Discount vex (DDM)We have also used DDM to find the intrinsic v alue of the company. We think that company will not be able to sustain its dividends of $0.66 per package per quarter in the short run. However, by year 2010 company will have enough earnings to come back to its previous level. safekeeping in mind the fact that company has been growing its dividend payout ratio, and earning are also expected to increase in the long run we have false that companys dividends will grow at the rate of 2% in perpetuity. Using these assumption, and cost of equity 8.8%, dividend discount model gives us the share price of $40.39 per share, which also indicates that company is undervalued right now. Detailed calculations are provided in Exhibit4. FUTURE INDUSTRY OUTLOOKThe collapse of mortgage market has taught financial industry an expensive lesson, making a lot of financial institutions unable to fully recover even till now. One of the major factors that cause a lot of banks failure and bankruptcy during financial crisis is the banks overconfidence in re al estate market and issuing abundant amount of new debt without the checking credit quality of borrowers. After the financial crisis, banks have become very cautious when dealing with mortgage related loans. Requirements regarding borrowers personalized incomes and documentation have been considered necessary and valuation process about mortgages has bypast very conservative. Facing the illiquidity during the financial crisis, banks are required to improve their capital bases to improve their insolvency. One regulation from Base III incorporates a large expansion in risk coverage and introduces modified ways to calculate risk-based capital. Moreover, complex hybrid capital instruments, which used to be considered as a part of banks equity, has been exclude from banks equity calculation.Base III also puts increasing focus and emphasis on banks to acquire common equity that can be quickly cashed out when facing unexpected situation. The transition of Base III and the self-improv ement happening in the banking industry or, even broader, financial industry have made bank valuation focus more on bankstraditional originate-to-hold business, and associated banks securitization activities with higher risk. Increasing focus has also been put on a banks capital base, which has everything to do with a banks solvency and liquidity. Banks, whose equities have complex hybrid equity capital instruments, tend to be less liquid and have higher business risk. Funding source is another factor considered. Banks with less retail funding on their balance sheets are more vulnerable when unexpected situations happen. Loan quality, which had been largely ignored when everyone had big overconfidence to housing market before the burst of the financial crisis, has been brought back to the valuation table and greatly reemphasized. These improvements in the regulatory requirements have restored the confidence of investors in the banking industry to some extent. Thats why we see the fi nancial industry raising to the level where it was before the financial crisis. shutdownFinancial statements analysis of CMA does not present a very bewitching picture, but because of the financial crisis, whole industry is under stress and experiencing the same deterioration in the quality of earnings. However, our valuation methods show that CMA is undervalued relative to its peer companies and hence is a good investment to hold right now.