Heath A. Hamby

Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts.When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.Transactional ValueFair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.The accounting profession defines fair value in ASC 820 as:The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.The IRS defines fair market value in Revenue Ruling 59-60 as:The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2Expropriated ValueStatutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.In 1950, the Delaware Supreme Court offered this interpretation of fair value:“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:Unaffected stock price immediately before the transaction announcement in an efficient market (with regards to both volume and information) is the best indication of valueDeal price is a reliable indicator if the analysis excludes the benefit of synergiesNo recognized valuation methods have been ruled outThe discounted cash flow method is generally one of the preferred valuation methods if unable to observe efficient transaction prices that occurred before the transactionThe observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:Immediately before the effectuation of the corporate action to which the shareholder objects excluding any appreciation or depreciation in anticipation of the corporate action objected to;Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; andWithout discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to §281302 (a)(5).Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:Strategic Control Value is best described as Investment Value, based on individual investment requirements and expectations. The strategic control level of value is not generally consistent with FMV, in that it considers the motivations of a specific buyer as opposed to a hypothetical buyer. In other words, the “strategic control premium” is often deemed to be outside both the fair market value and statutory fair value standards. Most bank M&A deals take place at this level of value given cost save assumptions that are common in the industry. In a statutory fair value appraisal, deal value generally may not include the benefit of synergies.Financial Control Value is most often consistent with the fair market value and statutory fair value standards because (i) the underlying premise is a going concern; (ii) it typically does not include any premiums that might be paid by a buyer with specific motivations and the ability to implement synergistic structural and financial changes; and (iii) no minority interest or marketability discounts are applied.Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.ConclusionMercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)

2020 was a tough year for most of us. Schools and churches closed, sports were cancelled, and many lost their jobs. There were a select few, however, that thrived during 2020. Jeff Bezos and Elon Musk saw a meteoric rise in their personal net worth over the past 12 months. Mortgage bankers are another group showered with unexpected riches last year (and apparently this year).As shown in Figure 1, long-term U.S. Treasury and mortgage rates have been in a long-term secular decline for about four decades. Last year, long-term rates fell to all-time lows because of the COVID induced recession after having declined modestly in 2019 following too much Fed tightening in 2018. The surprise was not an uptick in refinancing activity, but that it was accompanied by a strong purchase market too. Housing was and still is hot; maybe too hot. Overlaid on the record volume (the Mortgage Bankers of America estimates $3.6 trillion of mortgages were originated in 2020 compared to $2.3 trillion in 2019 and $1.7 trillion in 2017 and 2018) was historically high gain on sale (“GOS”) margins. The industry was capacity constrained after cutting staff in 2018 when rates were then rising. Private equity and other owners of mortgage companies set their eyes on the public markets after many companies attempted to sell in 2018 with mixed success at best. During the second half of 2020, Rocket Mortgage ($RKT) and Guild Mortgage ($GHLD) made an initial public offering and began trading while seven other nonbank mortgage companies have either filed for an IPO or announced plans to do so. Also, United Wholesale Mortgage ($UWMC) went public by merging with a SPAC. The inability of several (or more) mortgage companies to undergo an IPO at a price that was acceptable to the sellers has an important message. The industry was accorded a low valuation by Wall Street on presumably peak earnings even though many mortgage companies will produce an ROE that easily exceeds 30%. The assumption is that earnings will decline because rates will rise and/or more capacity will reduce GOS margins. While it is likely 2020 will represent a cyclical peak, no one knows how steep (or gentle) the descent will be and how deep the trough will be. Mortgage companies may produce 20% or better ROEs for several years. One may question the multiple to place on 2020 earnings, but book value could double in three or four years if conditions remain reasonably favorable. Community and regional banks with mortgage operations have benefitted from the mortgage boom, too. Although various bank indices were negative for the year, it could have been much worse given investor fears surrounding credit losses and permanent impairment to net interest margins given the collapse in rates. In a sense, outsized mortgage banking revenues funded reserve builds for many banks and masked revenue weakness attributable to falling NIMs. The average NIM for banks in the U.S. with assets between $300 million and $1 billion as of September 30, 2020 is shown in Figure 2. The NIM fell 45bps from 3Q19 to 3Q20 due to multiple moving pieces but primarily reflected an increase in liquid assets because deposits flooded into the banking system and because the reduction in the yield on loans and securities was greater than the reduction in the cost of funds. Unless the Fed is able (and willing) to raise short-term policy rates in the next year or two, we suspect loan yields will grind lower as lenders compete heavily for assets with a coupon (i.e., loans) because liquidity yields nothing and bonds yield very little. Deposit costs will not offset because rates are or soon will be near a floor. Fee income and expense management are more critical than ever for banks to maintain acceptable profitability. When analyzing the same group of banks (assets $300M - $1B), banks with higher GOS revenues as a percentage of total revenue tended to be more profitable. As shown in Figure 3, median profitability was ~15% greater in the trailing twelve months for banks more engaged in mortgage activity than those that were not. Selling long-term fixed-rate mortgages for most banks is a given because the duration of the asset is too long, especially when rates are low. The decision is more nuanced for 15-year mortgages with an average life of perhaps 6-7 years. With loan demand weak and banks extremely liquid, most banks will retain all ARM production and perhaps some 15-year paper as an alternative to investing in MBS because yields on originated paper are much better. As for 30-year mortgages, net production profits for 3Q20 increased above 200bps according to the MBA for the first time since the MBA began tracking the data in 2008. Originating and selling long-term fixed rate mortgages has been exceptionally profitable in 2020. Mortgage banking in the form of originations is a highly cyclical business (vs servicing); however, it is a counter-cyclical business that tends to do well when the economy is struggling and therefore core bank profitability is under pressure. We have long been observers of the mortgage banking conundrum of “what is the earnings multiple?” It is a tougher question for an independent mortgage company compared to a bank where the earnings are part of a larger organization. Even when outsized mortgage banking earnings may weigh on a bank’s overall P/E, mortgage earnings can be highly accretive to capital. In the February issue of Bank Watch, we will explore how to value a mortgage company either as a stand-alone or as a subsidiary or part of a bank to understand in more detail the true valuation impacts of mortgage revenue. Originally appeared in Mercer Capital’s Bank Watch, January 2021.

The January Bank Watch provided an overview of the mortgage industry and its importance in boosting bank earnings in the current low-rate environment. As we discussed, mortgage volume is inversely correlated to interest rates and more volatile than net interest income. In this article, we discuss key considerations in valuing a mortgage company/subsidiary, including how the public markets price them.Valuation ApproachesSimilar to typical bank valuations, there are three approaches to consider when determining the value of a mortgage company/subsidiary: the asset approach, the market approach, and the income approach. However, since the composition of both the balance sheet and income statement differ from banks, several nuances arise.Asset ApproachAsset based valuation methods include those methods that write up (or down) or otherwise adjust the various tangible and/or intangible assets of an enterprise. For a mortgage company, these assets may include mortgage servicing rights (“MSR”). The fair value of the MSR book is the net present value of servicing revenue minus related expenses, giving consideration to prepayment speeds, float, and servicing advances. MSR fair value tends to move opposite to origination volume. For example, MSR values tend to increase in periods marked by low origination activity. Other key items to consider include any non-MSR intangible assets, proprietary technology, funding, relationships with originators and referral sources, and the existence of any excess equity.Market Approach Marketmethods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Historically, publicly traded pure-play mortgage companies were a rare breed; however, the COVID-19 mortgage boom has produced several IPOs, and others may follow. There are many publicly traded banks that derive significant revenues from mortgage operations, especially in this low-rate environment.The basic method utilized under the market approach is the guideline public company or guideline transactions method. The most commonly used version of the guideline company method develops a price/earnings (P/E) ratio with which to capitalize net income. If the public company group is sufficiently homogeneous with respect to the companies selected and their financial performance, an average or median P/E ratio may be calculated as representative of the group. Other activity-based valuation metrics for the mortgage industry include EBITDA, revenues, or originations.Another relevant indicator includes price/tangible book value as investors tend to treat tangible book value as a proxy for the institution’s earnings capabilities. The key to this method lies in finding comparable companies with a similar revenue mix (high fee income) and profitability.When examining the public markets, there are generally two types of companies that can be useful in gathering financial and valuation data: banks emphasizing mortgage activities and non-bank mortgage companies.Group 1: Banks with Mortgage Revenue EmphasisFigure 1 details the first step in identifying a group of banks with significant mortgage operations. First, financial data from the most recently available quarter (4Q20) regarding banks with assets between $1 billion and $20 billion were identified. Once that broad group of banks is identified, it is then important to segment the group further to identify those with significant gain on loan sales as a proportion of revenue and particularly those with higher than typical mortgage revenues/originations as opposed to SBA or PPP loan originations.Group 2: Non-Bank Mortgage CompaniesNon-bank mortgage companies found favor with the public markets in 2020 as beneficiaries of the sharp reduction in mortgage rates. In 2021 investor sentiment has faltered due to the impact of rising long-term rates on consensus earning estimates. Several companies undertook IPOs, while another company went public via merging with a SPAC. This expanded the group of non-bank mortgage companies from which to derive valuation multiples and benchmarking information. Figure 2 includes total return data for non-bank mortgage companies. Notable transactions include the following: Rocket Mortgage (NYSE: RKT) raised $1.8 billion via an IPO at an approximate $36 billion valuation in August; Guild Holdings (NASDAQ: GHLD) raised ~$98 million in a November IPO; United Wholesale Mortgage (NYSE: UWM) went public in the largest SPAC deal in history (~$16 billion) that closed in 2021; and Loan Depot (NYSE: LDI) went public during February by raising $54 million. Other pending IPOs based upon public S-1 filings include Caliber Home Loans and Better.com. Amerihome Mortgage Company had filed a registration statement but apparently obtained better pricing through an acquisition by Western Alliance Bancorp (NYSE: WAL) during February that was valued at ~ $1.0 billion at announcement, or about 1.4x the company’s tangible book value. While this activity is positive for mortgage companies, the IPOs were downsized in terms of the number of shares sold with pricing below the initial target range or at the low end of the range as investors hedged how far and how fast earnings could fall in a rising rate environment. For guideline M&A transactions, the data is often limited as there may only be a handful of transactions in a given year and even fewer with reported deal values and pricing multiples. However, meaningful data can sometimes be derived from announced transactions with transparent pricing and valuation metrics. After deriving the “core” earnings estimate for the mortgage company as well as reasonable valuation multiples, other key valuation elements to consider include: any excess equity, mortgage servicing rights, unique technology solutions that differentiate the company, origination mix (refi vs. purchase; retail vs. correspondent or wholesale), geographic footprint of originations/ locations, and risk profile of the balance sheet and originations (for example, agency vs. non-agency loans). Income ApproachValuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. For banks, the discounted cash flow (“DCF”) method can be a useful indication of value due to the availability and reliability of bank forecast/capital plans. However, due to the volatile and unpredictable nature of mortgage earnings, this method faces challenges when applied to a mortgage company. In certain situations, the DCF method may not be utilized due to uncertainties regarding the earnings outlook. In others, the DCF method may be applied with the subject company’s level of mortgage origination activity tied to a forecast for overall industry originations and historical gain on sale margins.Given the potentially limited comparable company data and the difficulty associated with developing a long-term forecast for a DCF analysis, the single period income capitalization method may be useful.This method involves determining an ongoing level of earnings for the company, usually by estimating an ongoing level of mortgage origination activity and a pretax margin and capitalizing it with a “cap rate”. The cap rate is a function of a perpetual earnings growth rate and a discount rate that is correlated with the entity’s risk. Whereas we would likely use recent earnings in the market approach, in the income capitalization method it makes sense to normalize earnings using a longer-term average, which considers origination and margin levels over an entire mortgage operating cycle.Mortgage earnings and margins are cyclical. Due to the volatile nature of mortgage earnings, a higher discount rate is normally used. Therefore, a mortgage company’s earnings typically receive a lower multiple than a bank’s more stable earnings.ConclusionA mortgage subsidiary can be a beneficial tool for community banks to increase earnings and diversify revenue. This strategy, while clearly beneficial now, can be utilized throughout the business cycle. As rates fall and net interest income faces pressure, gains on the sale of loans should increase (and vice versa) to create counter-cyclical revenues. As we’ve discussed, the inherently volatile income from a mortgage subsidiary is not usually treated equally to net interest income in the public markets. Although, when it comes to price/tangible book value multiples, profitability is critical whether it is driven by mortgage activity or not. There are many factors to consider in valuing a mortgage company.If you are considering this line of business to diversify your bank or desire a valuation of a mortgage operation, feel free to reach out for further discussion.Originally appeared in Mercer Capital’s Bank Watch, February 2021.