1. Banks For Beginners: A Summary of Ann Cuneaz NAIC Article, BITS March 2004 Kevin Gillogly Happy Destiny Investment Club February 14, 2005

2. www.bivio.com/hdic 2 Banks For Beginners Banks main product is money.  Money is a commodity like oil or gas or gold or silver.  A dollar bill is worth the same as another dollar bill Banks make a profit by lending money at a higher interest rate than they give to depositors Banks make a profit from many non-lending related activites

3. www.bivio.com/hdic 3 Think Like A Banker Deposits made to banks are an asset to the depositor BUT a liability to the bank Loans made by banks are a liability to recipient BUT an asset to the bank

4. www.bivio.com/hdic 4 Bank Terminology: Interest Expense Banks pay interest on their customer’s deposits. They want this as low as market conditions allow This is an expense to the bank It is called “interest expense” on the Income Statement

5. www.bivio.com/hdic 5 Bank Terminology: Interest Income Banks loan money to their clients They want the interest rate they charge to be as high as market conditions allow This is income to the bank It is called “interest income” on the Income Statement

6. www.bivio.com/hdic 6 Bank Terminology: Net Interest Margin aka The Spread The difference between “interest expense” and “interest income” is called the “interest rate spread” or “net interest margin” Banks want the “spread” to be as large as possible

7. www.bivio.com/hdic 7 Bank Terminology: Non-Interest Income Banks also have non-lending related income This includes ATM fees, min. monthly fees, check overdrafts, trust services, and many other similar activities Banks can also make money off of investments This is called “non-interest income” on the Income Statement

8. www.bivio.com/hdic 8 Bank Terminology: Non-Interest Expense Banks also have non-lending related expenses This includes salaries, rent / mortgage, equipment, and marketing costs This is called “non-interest expense” on the Income Statement

9. www.bivio.com/hdic 9 Bank Terminology: Loan Loss Provision Banks also have to account for loans that go bad Banks are required to set aside a percentage of funds to cover these bad loans Banks that loan money out to “high-risk” customers have a larger loan loss provision than banks that loan money to “low-risk” customers The set aside money is known as “loan loss provision” on the Income Statement

10. www.bivio.com/hdic 10 Finding A Proxy For Bank Revenue Banks do not have a line for revenue on the Income Statement So we have to develop a “proxy” or substitute for bank revenue They are several ways to find a “proxy” for bank revenue and no one way is perfect

11. www.bivio.com/hdic 11 NAIC Method of a Bank Proxy For Sales Is: Net Interest Income (the “spread”)  Using a net number smoothes out the changes due to changes in interest rates Minus the Loan Loss Provision Plus Non-Interest Income Plus Tax Equivalent Adjustment (TEA)  TEA adjusts tax exempt interest income to a “pre- tax” dollars  TEA is generally < 2% of revenue

12. www.bivio.com/hdic 12 Value Line & Creating a Bank Proxy for Revenue VL does a better – though not – perfect way of calculating the Bank Proxy For Revenue VL has lines for Net Interest Income, Loan Loss Provision, Non-interest Income, and Non-Interest Expense VL does not have the bank TEA  S&P “tearsheets” have TEA VL data needs to be both calculated and hand entered VL data can be entered automatically but this requires a subscription that’s $$$

13. www.bivio.com/hdic 13 OPS & Using A Bank Proxy For Revenue OPS uses gross interest income (not net)  Revenue numbers are influenced by interest rates  Rising interest rates raise revenue;  Lowering interest rates reduce revenue OPS is fast to download OPS is far cheaper than a VL subscription  $25 vs. $600+ OPS has nine years of quarterly data

14. www.bivio.com/hdic 14 OPS vs. Value Line Data OPS data will result in lower historic sales growth rates in low interest rate environments than Value Line data OPS data will result in higher historic sales growth rates in high interest rate environments than Value Line data

15. www.bivio.com/hdic 15 Bottom Line on Value Line vs. OPS The differences between the two data sources is small Keep focused on the big picture YOUR JUDGMENT of the future

16. www.bivio.com/hdic 16 Estimating Future EPS Look at the trend lines on the front of the SSG Look at the trends of recent quarterly data in PERT-A Preferred Procedure  A Revenue Based estimate of future EPS AND Ralph Seger method Total Assets method

17. www.bivio.com/hdic 17 Estimating Future EPS Looking at the trends on the graphs and in PERT-A are the same Preferred Procedure, which is based in part on the figure in 2A, is not as good a method for banks  Many believe that the pre-tax profit margin (2A) is not as important for banks  See Total Assets Method

18. www.bivio.com/hdic 18 Ralph Seger Method for Projecting Future EPS To forecast it, look at:  Historic growth of book value per share;  Historic growth of dividend per share;  Historic growth of EPS  Choose the lowest growth rate and make your judgments from that point

19. www.bivio.com/hdic 19 Total Assets Method For Projecting Future EPS Enter Total Assets in lieu of Sales Proxy on the front of the SSG Rationale: Asset growth is critical to a bank Gives a more reliable pre-tax margin (2A) by calculating Return on Assets (ROA) ROA is considered a better measure of Bank performance than pre-tax profit on sales (2A) ROA can also be found in the S&P ‘tearsheet”

20. www.bivio.com/hdic 20 Valuing Banks Stocks Section 3 of the SSG (Value) is same for both banks and non-banks However, P/Es for banks tend to have an inverse relationship to the outlook on interest rates  When interest rates fall; bank P/Es will rise  When interest rates rise; bank P/Es will fall Use this knowledge when forecasting future P/Es for banks

21. www.bivio.com/hdic 21 Conclusion of Banks For Beginners Banks have differences that should be recognized before you complete your SSG. Differences are not insurmountable Need to find a proxy for revenue  OPS vs. NAIC vs. Ralph Seger vs. Total Assets Pre-tax profit margin (2A) is not as important as Return on Assets (ROA) to judging bank management efficiency Bank P/Es are inversely related to interest rates Need to settle on a data source  Should be the same source as your source for rest of portfolio  OPS vs. Value Line