Bank acquisition prices increased steadily during the five-year period of 2002 through 2006. Expansion by acquisition was common throughout this period, as banking organizations generally believed that it was better to enter a new market by purchasing an existing bank than by building a branch network from the ground up. Acquiring banks paid a significant price-to-book premium for target banks, and by the end of 2006, valuations were at record levels. This article will discuss some of the key factors affecting the bank acquisition valuation trend during this five-year period.
To analyze the trend, data from 565 U.S. commercial banks acquired from January 1, 2002, to December 31, 2006, were reviewed, including data related to geographic location, composite CAMELS and RFI/C ratings, core deposit ratios, intrastate acquisitions versus interstate acquisitions, and the asset size of the target institution. The performance of the S&P 500 over this five-year period was also factored into the analysis. The average price-to-book premium for the 565 commercial banks acquired during this time period was 2.47, while the average price-to-book premium for the entire U.S. was 2.26 in 2002 and climbed to 2.56 in 2006.
Overall, it was expected that target institutions with high core deposit ratios and composite CAMELS and RFI/C ratings of strong or satisfactory would receive the highest price-to-book premiums, and that interstate acquisitions would command higher price-to-book premiums due to acquiring banks' willingness to expand boundaries and develop new customer bases. It also was expected that price-to-book premiums would increase as the S&P 500 index rose and also as the total asset size of the target institution rose. The analysis confirmed these hypotheses.
There is a prevalent belief that the most important factor in real estate is location, location, location. Geographic location also appears to be important in banking, and it had a significant impact on price-to-book premiums during the five-year period. In general, banks in the areas with the strongest real estate markets and population growth had a higher price-to-book premium. The banks acquired within the Federal Reserve's Atlanta District had a 2.75 average price-to book premium, which was the highest average in the U.S., followed by Dallas and San Francisco, respectively (Fig. 1). The state of Nevada had the highest average price-to-book premium at 3.08, followed by Florida at 2.95.
Locally, institutions acquired in the Third District received a 2.47 average price-to-book premium during the five-year period. The largest acquisition in the Third District was Bank of America Corp.'s purchase of MBNA Corp. for $35 billion in 2005, and the price-to-book premium was 2.51. The largest acquisition in the nation during this time period was JP Morgan Chase & Co.'s acquisition of Bank One for $58 billion in 2004, and the price-to-book premium was 2.56.
CAMELS and RFI/C Ratings
In theory, financial institutions that have a solid overall performance should expect to receive a higher price-to-book premium, as solid overall performance commonly results in composite CAMELS or RFI/C ratings of strong or satisfactory; therefore, examination and inspection ratings should impact the price-to-book premium paid. The data analysis confirmed that the composite CAMELS or RFI/C rating of the acquired institution had a significant impact on the price-to-book premium paid.1
The average price-to-book premiums paid for 1- and 2-rated banks were 2.56 and 2.49, respectively. The average price-to-book premiums paid for 3- and 4-rated banks were 2.08 and 1.62, respectively (Fig. 2). A strong or satisfactory composite rating would commonly indicate that a bank is generating a higher rate of return on average assets; is well capitalized with sound asset quality and liquidity; and, therefore, may be considered more desirable and possibly easier to integrate into the acquiring organization.
Core Deposit Ratio
A target bank's ratio of core deposits to total assets had a strong impact on the price-to-book premium. Target banks with core deposit ratios exceeding 40 percent received a 3.5 average price-to-book premium, while those with a core deposit ratio less than 10 percent had a 1.52 average (Fig. 3). Acquiring organizations appear to be willing to pay a higher price for targets with high core deposit ratios, which typically is a good indicator of a strong customer base and may result in greater operating stability and lower risk.
Intrastate vs. Interstate Acquisitions
Acquiring organizations appear to be willing to pay a higher price for out-of-state target financial institutions. During the 2002-2006 time period, 38.7 percent of all bank acquisitions were interstate acquisitions. These interstate transactions had a 10.1 percent higher price-to-book premium than intrastate transactions. Interstate targets received a 2.62 price-to-book premium on average versus 2.38 received by intrastate targets. One of the reasons for the higher premium for interstate transactions is that footprint expansion of marketing boundaries and development of a new customer base may help to offset acquisition costs.
Total Asset Size
The total asset size of target financial institutions had an impact on the acquisition price, and the price-to-book ratio appears to increase with the total asset size of the institution. Institutions with total assets of less than 100 million received a 2.21 average price-to-book premium. Institutions with total assets of less than 1 billion received a 2.49 average price-to-book premium, while those with total assets exceeding 1 billion received a 2.57 premium on average. Acquirers may be able to achieve economies of scale more quickly by acquiring several mid-sized institutions instead of purchasing a large number of small institutions; therefore, they appear to be willing to pay a higher premium for larger institutions.
The S&P 500
Price-to-book premiums appear to fluctuate with the performance of the S&P 500. In 2002, the S&P 500 declined by 22.10 percent, bottoming out at 768.63 in October, while the average price-to-book ratio for the year hit a trough at 2.26. In 2003, the S&P 500 increased by 28.68 percent, and the average price-to-book premium increased to 2.41. By the end of 2006, the S&P 500 closed at 1480.30, and the average price-to-book premium reached 2.56.
In 1994 there were 10,450 financial institutions in the U.S., and by July 2007 the number had decreased to 7,357. While the number of financial institutions declined during this time period, total assets increased from $4.01 trillion to $10.1 trillion. Consolidation is expected to continue in the banking industry; however, merger and acquisition activity slowed in 2007, and the issues in the credit markets may have affected the ability of some banking organizations to pursue such opportunities. The nationwide average price-to-premium paid for acquisitions during 2007 (as of November) fell to 2.18, and the number of deals, which peaked at 28 in January for 2007, declined to 12 in October 2007.
Multiple factors influence the price-to-book premium paid for financial institution acquisitions: geographic location, CAMELS or RFI/C ratings, core deposit ratios, intrastate vs. interstate acquisitions, targets' total asset size, and the S&P 500 performance. This information is useful for helping the institution being acquired to better prepare itself for a merger and also for helping to ensure a fair transaction for both parties. As Thomas Jefferson once said, "Never buy what you do not want because it is cheap; it will be dear to you."
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.