American Banker

For Investors, Profit Growth Forecasts Proving Irrelevant

J.P. Morgan Chase & Co., FleetBoston Financial Corp., and Bank of New York Co. are among a bevy of financial institutions that have announced profit plunges recently.

Von Eric W. Aboaf and Christopher J. Madaus

First published on November 15, 2002
Min. Lesezeit


J.P. Morgan Chase & Co., FleetBoston Financial Corp., and Bank of New York Co. are among a bevy of financial institutions that have announced profit plunges recently. The string of disappointments is putting the final nail in the coffin of earnings growth forecasts as a lure for analysts. With so many companies missing their marks, Wall Street no longer believes CFOs' and CEOs' earnings guidance. When a company announces disappointing earnings even once—and almost all have done so over the last year—investors flee to more old-fashioned, less fuzzy indicators such as return on equity and fee income. Senior executives need to kick the habit of talking up earnings and focus on managing their businesses to drive indicators that matter. Two years ago long-term growth forecasts ranked alongside return on equity as the strongest predictors of a high price/earnings ratio. At the time companies like Capital One Financial Corp. enjoyed price/earnings ratios of around 30, mainly because of a profit growth forecast of better than 15%. Then, as the recession took hold and earnings began to disappoint, promises of future expansion stopped producing a price/earnings boost for companies. Today growth forecasts—by management or Wall Street analysts—appear to have zero impact on price/earnings ratio. Capital One still forecasts double-digit earnings growth, but its price/earnings ratio has dropped 73%. On the other hand, return on equity has remained an important indicator of enduring quality throughout the business cycle. Mellon Financial Corp. and Bank of New York have both consistently achieved 20% or higher return on equity, and their price/earnings ratios stayed in the top third for the industry. The reason? Return on equity is hard to fudge. This metric appropriately nets out loan writeoffs—important signs of a bank's health—whereas growth forecasts minimize the effects of bad loans. Fee income, too, has regained ground as a predictor of share price. This year fee income became the No. 1 driver of price/earnings ratios in the financial services market. Companies reliant on fee income have fared better than many others. For example, Bank One Corp., with a price/earnings multiple of 15, and Wachovia Corp., at 21, have been rewarded for fee levels in excess of 40% of revenue, while Sovereign Bancorp Inc. and Comerica Inc., with fees accounting for less than 30% of revenue, struggle to keep their price/earnings multiples in double digits. The unfortunate news for banks hoping to please investors is that not all fee income is created equal. In the long run, recession-proof income—like insurance premiums, cash management fees, and deposit account charges—counts for more than cyclical income such as fees from trading, transaction processing, investment banking, and investment management. For example, SouthTrust Corp.'s stable revenue mix helps it maintain a price/earnings ratio premium of about 17% over the regional banking average of 12.34. Why? A solid 70% of its fee income comes from noncyclical sources: retail banking, cash management, and custody and trust services. Also, BB&T Corp. has achieved a similar price/earnings premium through growing insurance and deposit account fee income during the last five years. By contrast, companies dependent on cyclical income are suffering price/earnings downgrades. Even Mellon, whose high return on equity keeps its price/earnings multiple ahead of the pack, suffered an almost 50% drop, from 41 in December of last year to 26 at the end of September, by virtue of the company's dependency on processing and transaction fees. For Morgan Chase, the news has been doubly bad. First, its stock tumbled as highly cyclical trading fees and investment banking income suffered under the recession. Then, a third-quarter dip of 8.7% in investment management and private banking revenue showed that the economic downswing had bitten into areas traditionally considered protected from the jaws of recession. The protection proved a thin veneer: When the stock market fell, assets under management dropped, taking fees with them. Seeing this effect, investors became wise to the relative stability of different types of fee income. Morgan Chase's stock price suffered accordingly, hitting a five-year low and dropping more than 40% in the last four months. The fee-income effect is also at play among asset managers. Federated Investors Inc. and Neuberger Berman LLC have seen their price/earnings multiples fall substantially in the last two years as asset management fees proved vulnerable to recession. Even BlackRock Inc., the fast-growing asset management star that focuses on the traditionally safer fixed-income segment, has seen its price/earnings multiple drop by almost 30% in two years, from 25 to a low of 18 today, despite increasing its assets under management by more than 40% over the same period. With asset managers suffering dramatic downgrades, it won't be long until banks begin to reconsider their passionate aspiration to transform themselves into investment companies. Deposit service fee income suddenly counts more than investment management fees. Given the importance of stable fee income to investors today, there's a danger that more price/earnings ratios will take a tumble as analysts absorb disappointing earnings news. In the short term, bank CEOs and CFOs need to focus on boosting return on equity. Over the medium term, they should build higher levels of stable fee income. Most of all, they should stop making bullish growth forecasts. The market is tired of hearing them. Mr. Aboaf is a partner in Bain & Co. Inc.'s New York office; Mr. Madaus is a manager in Bain's Boston office.

J.P. Morgan Chase & Co., FleetBoston Financial Corp., and Bank of New York Co. are among a bevy of financial institutions that have announced profit plunges recently.

The string of disappointments is putting the final nail in the coffin of earnings growth forecasts as a lure for analysts. With so many companies missing their marks, Wall Street no longer believes CFOs' and CEOs' earnings guidance.

When a company announces disappointing earnings even once—and almost all have done so over the last year—investors flee to more old-fashioned, less fuzzy indicators such as return on equity and fee income. Senior executives need to kick the habit of talking up earnings and focus on managing their businesses to drive indicators that matter.

Two years ago long-term growth forecasts ranked alongside return on equity as the strongest predictors of a high price/earnings ratio. At the time companies like Capital One Financial Corp. enjoyed price/earnings ratios of around 30, mainly because of a profit growth forecast of better than 15%. Then, as the recession took hold and earnings began to disappoint, promises of future expansion stopped producing a price/earnings boost for companies.

Today growth forecasts—by management or Wall Street analysts—appear to have zero impact on price/earnings ratio. Capital One still forecasts double-digit earnings growth, but its price/earnings ratio has dropped 73%.

On the other hand, return on equity has remained an important indicator of enduring quality throughout the business cycle.

Mellon Financial Corp. and Bank of New York have both consistently achieved 20% or higher return on equity, and their price/earnings ratios stayed in the top third for the industry. The reason? Return on equity is hard to fudge. This metric appropriately nets out loan writeoffs—important signs of a bank's health—whereas growth forecasts minimize the effects of bad loans.

Fee income, too, has regained ground as a predictor of share price. This year fee income became the No. 1 driver of price/earnings ratios in the financial services market. Companies reliant on fee income have fared better than many others.

For example, Bank One Corp., with a price/earnings multiple of 15, and Wachovia Corp., at 21, have been rewarded for fee levels in excess of 40% of revenue, while Sovereign Bancorp Inc. and Comerica Inc., with fees accounting for less than 30% of revenue, struggle to keep their price/earnings multiples in double digits.

The unfortunate news for banks hoping to please investors is that not all fee income is created equal. In the long run, recession-proof income—like insurance premiums, cash management fees, and deposit account charges—counts for more than cyclical income such as fees from trading, transaction processing, investment banking, and investment management.

For example, SouthTrust Corp.'s stable revenue mix helps it maintain a price/earnings ratio premium of about 17% over the regional banking average of 12.34. Why? A solid 70% of its fee income comes from noncyclical sources: retail banking, cash management, and custody and trust services. Also, BB&T Corp. has achieved a similar price/earnings premium through growing insurance and deposit account fee income during the last five years.

By contrast, companies dependent on cyclical income are suffering price/earnings downgrades. Even Mellon, whose high return on equity keeps its price/earnings multiple ahead of the pack, suffered an almost 50% drop, from 41 in December of last year to 26 at the end of September, by virtue of the company's dependency on processing and transaction fees.

For Morgan Chase, the news has been doubly bad. First, its stock tumbled as highly cyclical trading fees and investment banking income suffered under the recession. Then, a third-quarter dip of 8.7% in investment management and private banking revenue showed that the economic downswing had bitten into areas traditionally considered protected from the jaws of recession. The protection proved a thin veneer: When the stock market fell, assets under management dropped, taking fees with them.

Seeing this effect, investors became wise to the relative stability of different types of fee income. Morgan Chase's stock price suffered accordingly, hitting a five-year low and dropping more than 40% in the last four months.

The fee-income effect is also at play among asset managers. Federated Investors Inc. and Neuberger Berman LLC have seen their price/earnings multiples fall substantially in the last two years as asset management fees proved vulnerable to recession. Even BlackRock Inc., the fast-growing asset management star that focuses on the traditionally safer fixed-income segment, has seen its price/earnings multiple drop by almost 30% in two years, from 25 to a low of 18 today, despite increasing its assets under management by more than 40% over the same period.

With asset managers suffering dramatic downgrades, it won't be long until banks begin to reconsider their passionate aspiration to transform themselves into investment companies. Deposit service fee income suddenly counts more than investment management fees.

Given the importance of stable fee income to investors today, there's a danger that more price/earnings ratios will take a tumble as analysts absorb disappointing earnings news.

In the short term, bank CEOs and CFOs need to focus on boosting return on equity. Over the medium term, they should build higher levels of stable fee income. Most of all, they should stop making bullish growth forecasts. The market is tired of hearing them.

Mr. Aboaf is a partner in Bain & Co. Inc.'s New York office; Mr. Madaus is a manager in Bain's Boston office.