Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region

December 2017 HCM Viewpoint Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region hcm.com Introductory Note Banks in the Gulf region have been gaining in importance Regardless of your industry, please contact us if you can in recent years, both locally and in foreign markets. Yet, in benefit from an approach that connects these topics to the current context of continuing pressure on oil prices sound business strategy and financial stewardship. and questions on regional stability, it is valid to ask how well Gulf banks are doing in terms of value creation, both on an Value Creation: External and Internal Metrics absolute and relative basis. It is equally valid to ask whether the share price movements of these banks in recent years As depicted in Figure 1, the market capitalization of the 46 accurately reflect the internal value creation taking place Gulf banks1 covered by this study lies between USD 379 and at these institutions. USD 37’570 million as of 31 December 2016. The banking sector represents a significant part of the stock market This HCM viewpoint provides a comparative overview of in the Gulf region – ranging from 26 (Saudi Arabia) to 69 46 banks in the Gulf region. It finds that value creation in percent (Bahrain) of public stock market capitalization. the Gulf banking sector has generally increased in recent years, though not at all banks. Further, it finds a plausible In general, company performance can be measured using correlation between internal value creation and changes external and internal indicators of value creation, which in share price for most banks. For others, however, should be seen as two sides of the same coin. stock returns cannot be fully explained by internal value creation. From an external perspective, one way to capture value is using Total Shareholder Return (TSR). In this viewpoint, Looking at 2016, it appears that internal performance we use TSR relative to the Dow Jones Islamic Market GCC of banks in the Gulf region was to a large extent linked to Index. Using this metric, we find that many banks in the macroeconomic fundamentals and the perceived ability Gulf region have significantly increased their market value of each country to sustain GDP growth and liquidity in recent years, particularly those from the UAE and Qatar. levels under the pressures mentioned above. The value The median TSR value relative to the Dow Jones Islamic perception by investors, as measured by TSR, further Market GCC Index was 9.8 percentage points (p.p.) above reflects shareholders’ views on the commodity markets the index in 2012-2016. and the resilience of Gulf economies in the near future. From an internal perspective, a widely used performance The goal of this study is not to provide any definitive measure is Economic Profit (EP). Because it also reflects performance evaluation of any bank or any sector, but risk, EP can have certain advantages over other measures of to illustrate alternative and complementary methods performance. Notably, it reflects managerial performance for measuring performance. It also aims at helping each and value added to shareholders’ wealth resulting from bank in its internal discussion on what key performance elements such as timely cost management decisions. indicators (KPIs) are most relevant to it. However, EP provides investors with an incomplete picture Measuring performance is beneficial not just for knowing of business results, particularly on a comparative basis: where one stands (ex-post value capturing), but perhaps more importantly for driving the desired value creation ■ EP is an absolute measure. This complicates (ex-ante). HCM’s work in the Gulf and around the world is comparison of companies of different size without to help boards of directors and senior management work applying additional calculations and making on those factors that can impact value generation. This adjustments. includes strategies for governance, financial steering, compliance, and compensation. We use a variety of ■ EP has a “past-looking” bias. It accumulates past financial and non-financial methodologies, including success (e.g, strong brand) or past failures (e.g., corporate culture. inefficient retail banking network). As an example, 1 This study uses as a basis the Top 50 GCC Banks compiled by the Gulf Business magazine. However, this study does not include four banks for which no comprehensive data was available for the 2011-2016 period. 2 © 2017 HCM International Ltd. All rights reserved. Figure 1: Overview of Gulf banks performance Market Capitalization Economic Profit Change in EP Relative TSR Company Country (USD million) (EP) Dynamic (USD thousand) (p.p) 31.12.2016 2012-2016 2011-2016 2012-2016 Qatar National Bank Qatar 37'570 14% 736 32 Al Rajhi Banking Corporation KSA 27'303 -3% -129 -20 First Gulf Bank UAE 15'748 15% 413 199 National Bank of Abu Dhabi UAE 14'296 3% 90 61 Samba KSA 12'988 -4% -88 10 Emirates NBD UAE 12'850 18% 804 202 National Bank of Kuwait Kuwait 11'994 -10% -271 -44 Abu Dhabi Commercial Bank UAE 10'513 4% 118 171 Saudi British Bank KSA 10'001 0% 7 8 Kuwait Finance House Kuwait 9'267 5% 176 -27 Riyad Bank KSA 9'241 -3% -71 8 Banque Saudi Fransi KSA 8'390 -1% -24 -18 Masraf Al Rayan UAE 7'745 13% 102 22 Dubai Islamic Bank UAE 7'496 20% 318 256 Qatar Islamic Bank Qatar 6'743 6% 59 12 Alinma Bank KSA 6'041 36% 234 36 Arab National Bank KSA 5'907 4% 60 -20 Ahli United Bank Bahrain 4'381 -5% -66 28 Alawwal Bank KSA 4'253 -11% -96 70 Commercial Bank of Dubai UAE 3'968 1% 9 181 Commercial Bank of Qatar Qatar 3'441 -35% -520 -49 Union National Bank UAE 3'402 -7% -80 71 Bank Albilad KSA 3'304 11% 59 76 Abu Dhabi Islamic Bank UAE 3'278 7% 92 69 Bank Muscat Oman 3'064 -3% -46 -34 Mashreq UAE 2'997 10% 192 -54 Saudi Investment Bank KSA 2'847 1% 10 12.5 Boubyan Bank Kuwait 2'802 28% 84 -59 Qatar International Islamic Bank Qatar 2'611 2% 6 15 Doha Bank Qatar 2'477 -27% -236 -40 Gulf Bank Kuwait 2'395 2% 12 -83 RAKBANK UAE 2'260 -22% -210 36 National Bank of Bahrain Bahrain 2'220 -13% -36 65 Burgan Bank Kuwait 2'047 -2% -27 -47 Commercial Bank of Kuwait Kuwait 2'009 28% 159 -75 Al Khalij Commercial Bank Qatar 1'681 -9% -35 -8 National Bank of Fujairah UAE 1'655 -5% -16 -2 Al Ahli Bank Kuwait Kuwait 1'590 -15% -78 -80 Bank AlJazira KSA 1'515 14% 92 -19 Arab Banking Corporation KSA 1'151 -13% -189 -24 Bank of Bahrain and Kuwait Bahrain 1'150 -5% -21 14 Bank Dhofar Oman 1'136 -4% -14 -38 Sharjah Islamic Bank UAE 1'017 18% 53 102 National Bank of Oman Oman 909 -11% -41 0 Al Baraka Bank Group Kuwait 563 -2% -26 -58 Ithmaar Bank Bahrain 379 13% 70 56 © 2017 HCM International Ltd. All rights reserved. 3 EP Dynamic Insight EP2016 - EP2011 EP Dynamic = Average Trailing Revenue2011-2015 EP = Net Income - (Total Equity x Cost of Equity) EP does not sufficiently capture the efforts of a bank also be a drawback. For example, some inconsistencies that has moved from a situation of negative EP to a can arise when using net income as a proxy for value after breakeven point. From an EP perspective, such bank debt capital charge. Furthermore, even though all six will still be seen as performing poorly when compared countries reviewed in this viewpoint require listed financial to a bank that started with a positive EP. The latter institutions to use IFRS standards, this does not exclude would be perceived as more successful even if it is only the possibility of a bank using some form of short-term harvesting its past success. income management as a way to give the appearance of better performance. Thus, we find the EP Dynamic Thus, rather than using EP as the sole internal measure indicator to be more valid when used with at least five- of value creation, in this study we use EP Dynamic. This year time horizon, in order to limit the effect of short-term approach is widely used by economic professionals. HCM income management. successfully uses EP Dynamic with its clients, making in each case relevant adjustments. Value Creation Measured by EP Dynamic In this study, we have slightly modified the formula to reflect Figure 2 shows cumulative EP Dynamic for the Gulf banks certain 2012-2016 changes in value creation.1 EP Dynamic under review. The median EP Dynamic level is 0.9 percent, is based on two variables: (1) EP, which after deducting which is significantly lower than in the previous two years.3 capital charge, becomes a pure economic measure of net In particular, EP growth in 2015-2016 was positive only for value to investors, and (2) revenue, which corrects EP for 14 banks under review (mostly from UAE and Kuwait). size differences.2 The performance of the banking sector in the Gulf region A deeper look into EP Dynamic sheds light on its two reflects adverse economic conditions due to the pressure underlying components: change in the EP margin (EP of lower oil prices. Being largely dependent on oil exports, divided by revenue) and growth in economic profitability. the Gulf economies experienced a low economic growth, This approach captures how efficiently the value was which led to liquidity shortage and weak loan growth in the created, rather than the mere fact that EP was positive or banking sector.

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