Comerica Case Study Essay

The purpose of this paper is to recommend pitch to massive the Comerica In unifiedd (CMA) stock. In this paper we explain how banks operate and present a small back ground on the issue Comerica is facing. Then we more on to monetary statements abstract of CMA, which does not present a very strong outlook of the company, but because of the financial crisis, whole industry is experiencing financial stress. Next, our valuation methods show that CMA is nethervalued relative to its peers, and thereof is a good company to invest in.BACKGROUNDSimply putting, banks accept deposits from public keep some of those deposits with them and lend the rest to businesses and individuals. Businesses and individuals in turn requital interest on those loans and banks pay interest to depositors, making money from the spread. Nowadays banks operations have become more and more complicated, and hence more all important(p) to crownwork markets. To get in to more detail, banks profits come from the fo llowing several ways Differences in the midst of Interest measures on lends and DepositsAs already explained Banks lend loans at the interest rates that ar higher(prenominal) than the ones they pay for deposits. A large part of banks profits come from the spread between banks depositing and loaning rates. Service FeesBanks provide financial services to their clients and charge certain amount of fees. By charging fees for managing customers bank accounts and providing other financial services such as publish letter of denotations, banks create another source of income, known as noninterest income. Now banks services have also expanded into investment consulting and information disseminating. These services commonly cost expensive fees. Financial ProductsBanks provide financial products to help clients manage their property and generate noninterest income. A good example can be that banks apportion mutual finances to their clients and gain income from both commissions and ce rtain percentage of the funds returns. In addition, banks sometimes also act asbrokers and generate revenues from bid-ask spread. Investment close to 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 can also explore profit opportunities within currency exchange market. Circulation Intermediary for CashBank can boost the delivery by reallylocating idle money to investors who need 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 ValueBecause of banks, several times the value of original deposit is created. People except their money in banks, and banks lend the money out. New loans throughout the banking system generate new deposits elsewhere in the system. Thus new deposits are derived by the loan an d create more sources of cash for banks to lend out.Payment 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 help 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 lead 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 lot of stress. Comerica, being one of them, is being evaluated by the Jack, as a potential investment. CHARACTERISTICS OF CMAs FINANCIAL HEALTH ancestord on the financial statements provided and the Exhibit 5, we have outlined the main characteristics which define CMAs financial health. Increase in Credit Loss ReservesCredit loss nutrition are 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 increasing the allowance for ascribe losses on balance sheet. There is a substantial increase 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 Corporations tough 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 ample increase in non-performing assets (NPA). The main reason on increase in NPAs the fact that high percentage (32.9%) of companys perfect loans is Real body politic loans. This is the reason that companys interest income has ebbd despite the increase in loans made in 2008. Efficiency ratio is basically an operating cost margin measure, the lower the better. The above 60 percent efficiency ratio, 50 percent generally regarded as optimal, is an indicator of companys deteriorating performance. Use of enormous Term and Short Term Debt to Finance LoansBalance sheet show that Comericas total deposits are maintaining a level since 2005, however companys net loans have increased by almost $10 Billion. Balance sheet clearly shows that these loans are finance from the increase in short-term and long term debt, which cast doubts on the profitability of company going forward. Unsustainability of the Dividend Pay-out RatioExhibit 5 shows an increasing trend in the dividends, which Comerica has tried to maintain despite the low earnings. In the June 2008 quarter, 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 cut dividends, it provide send a bad signal to the market.Downward Revision in the Federal 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 explosive charge liabilities, is decreasing. One 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 charge higher spreads. Moreover, commercial loans are predominantly floating rate, so simplification in the Federal Funds rate will affect companys interest income. We do think that decrease in the Feds rate will increase the demand for loans but given the credit crunch, it seems unreasonable in the short run. Decrease in Interest Income Percentage MeasuresThe shrinking of interest income can be obviousl y 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 cod 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 figure as a difference between net interest income and net interest expenses divided by earning assets, show a downward trend. VALUATIONTo value Comerica, we have used both methods Jack is planning to use. We will first do the sensitiveness analysis (Exhibit 7 in the case) to remember the execute of tangible book value, earnings and dividends. Using that sensitivity analysis table, we will find the range of firms value employing comparable and dividend discount models. Sensitivity AnalysisIn the Exhibit 7 at the end of the case, we have already been given the existing quarterly earn ings estimates and tangible book value at the end of 2009. Those estimates are based on charge- take ratio of 0.85%. We have completed the sensitivity analysis based on the following assumptionsPercentage 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 continue 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(a) 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 impairment 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 just as a check multiple. Now that we have decided which multiples to use, we need to assign weights to the comparable companies to find out the weight average multiples. To assign weights, we considered the following factors in terms of similarity between Comerica and comparable companies.Geological location of the operatio nsPercentage 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 designate we calculated the comparable weighted average of the price to tangible book value ratio and price to earnings ratio. Following table summarizes values 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 amend 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 Model (DDM)We have also used DDM to find the intrinsic value of the company. We think that company will not be able to sustain its dividends of $0.66 per share per qu arter in the short run. However, by stratum 2010 company will have enough earnings to come back to its previous level. Keeping 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 assumed 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 unavailing 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 real estate market and issuing huge amount of new debt without the checking credit quality of borrowers. Afte r the financial crisis, banks have become very cautious when traffic with mortgage related loans. Requirements regarding borrowers personal incomes and documentation have been considered necessary and valuation process about mortgages has gone very conservative. Facing the illiquidity during the financial crisis, banks are ask to improve their capital bases to improve their insolvency. One regulation from Base III incorporates a significant 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 enactment of Base III and the self-improvement happening in the banking industry or, even broader, financial industry have made bank valuation focus more on bank straditional 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 neglected 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 regulative requirements have restored the confidence of investors in the banking industry to some extent. Thats why we see the financial industry raising to the level where it was before the financial crisis. certaintyFinancial statements analysi s of CMA does not present a very pretty picture, but because of the financial crisis, whole industry is under stress and experiencing the same adulteration 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.