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Fundamental Analysis in Banks: The Use of Financial Statement Information To Screen Winners From Losers
Fundamental Analysis in Banks: The Use of Financial Statement Information To Screen Winners From Losers
Presented by
Dr Partha S Mohanram
#2016/17-08
The views and opinions expressed in this working paper are those of the author(s) and
not necessarily those of the School of Accountancy, Singapore Management University.
Fundamental Analysis in Banks: The Use of Financial Statement Information to Screen
Winners from Losers
Partha Mohanram
Rotman School of Management
University of Toronto
partha.mohanram@rotman.utoronto.ca
Sasan Saiy
School of Accounting and Finance
University of Waterloo
ssaiy@uwaterloo.ca
Dushyantkumar Vyas
Dept. of Management University of Toronto, Mississauga
Rotman School of Management
University of Toronto
dushyantkumar.Vyas@rotman.utoronto.ca
February 2016
All errors are our own. We would like to thank Zahn Bozanic, Patricia Dechow, Urooj Khan, Yaniv Konchitchki,
Panos Patatoukas, Chandra Seethamraju, Richard Sloan, Xiao-Jun Zhang and seminar participants at the University
of California-Berkeley for their comments. Partha Mohanram and Dushyant Vyas wish to acknowledge financial
support from SSHRC-Canada.
Fundamental Analysis in Banks: The Use of Financial Statement Information to Screen
Winners from Losers
Abstract
Despite the importance of the banking sector to the economy, prior valuation studies in accounting
have tended to generally discard bank stocks. We examine returns to a fundamental analysis based
trading strategy for the U.S. bank stocks, using a bank fundamentals index (BSCORE) based on
thirteen bank specific valuation signals. A longshort strategy based on BSCORE yields positive
hedge returns for all but one year during the 19942013 period. Results are robust to partitions
based on size, analyst following and exchange listing status, and persist after adjusting for known
risk factors. Interestingly, we observe especially strong hedge returns during the 2007-2009
financial crisis. We further document a positive relation between BSCORE and future analyst
forecast surprises, earnings announcement period returns, and future performance-based
delistings. Finally, the results are significantly enhanced if we combine the BSCORE strategy with
a relative valuation strategy based on an intrinsic value approach. The results show that
fundamental analysis can provide useful insights for analyzing banks, beyond the usual focus on
metrics such as return on equity (ROE).
1. Introduction
This study examines the efficacy of financial statement driven fundamental analysis
strategy for screening bank stocks. Despite the importance of the banking sector to the wider
economy, most valuation research in accounting and finance excludes bank stocks. Bank stocks
represent a significant proportion of traded stocks in the stock market. The exclusion of bank stocks
may be partially justified as the financial statement based value drivers are substantially different
for banks as compared to other industries. For example, while working capital accruals are
important for general manufacturing stocks, specific accruals such as loan loss provisions are more
important for banks. Further, as the events pertaining to the financial crisis in 20072009 have
shown, there can be considerable uncertainty regarding the valuation of bank stocks. This suggests
that a fundamentals driven approach may be successful in separating winners from losers among
We build upon prior studies in accounting that document the usefulness of signals
constructed using historical financial statement data in predicting future accounting and stock
return performance (e.g. Lev and Thiagarajan 1993, Abarbanell and Bushee 1997, Bernard and
Thomas 1989, and Sloan 1996 among others). Our broad approach in this paper is similar to
Piotroski (2000), who documents the importance of traditional financial statement analysis in ex
ante identification of winners and losers among value stocks. Further, we are motivated by
Mohanram (2005), who tailors fundamental analysis contextually for growth stocks. In this paper,
1
We combine thirteen bankspecific valuation signals to create a bank fundamentals index
(BSCORE). We motivate our signals from the residual income valuation model developed in
Ohlson (1995), Feltham and Ohlson (1995) and other papers. The value of a stock depends on
three factors the ability to generate profitability in excess of the cost of equity (+), risk () and
growth prospects (+). Our choice of signals is also motivated by the guidance in Calomiris and
Nissim (2007) and Koller et al. (2010), who analyze valuation of bank stocks.
In particular, we combine signals that indicate changes pertaining to: (i) overall
profitability (ROE and ROA), (ii) components of profitability (spread, operating expense ratio,
noninterest income, earning assets, and loans to deposits ratio), (iii) credit risk (loan loss
provisions, nonperforming loans, and loan loss allowance adequacy), and (iv) indicators of future
growth (revenues, total loans, and trading assets). In the interest of generalizability, we keep the
list of signals parsimonious. We construct the signals in a manner similar to Piotroski (2000) with
an increase coded as 1 and a decrease coded as 0 for positive signals, and the converse for negative
signals. BSCORE is the sum of these 13 individual signals and varies from 0 to 13.
7.4% during our 19942013 sample period. Inconsistent with a riskbased explanation, we observe
positive returns for all but one year (2002) during our sample period (Figure 1). In fact, returns to
the BSCORE trading strategy are the strongest during the financial crisis years 20072009, when
tail risk in the banking sector materialized. Further lending robustness to the findings, we
document that the hedge returns are significant across size partitions, and survive controls for
commonly used risk factors. In addition, consistent with a mispricing based explanation, we
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observe a positive relation between BSCORE quintiles and analyst forecast surprises as well as
One criticism of financial statement driven fundamental analysis is that it ignores valuation
i.e. the fact that firms with poor fundamentals might have lower valuations and firms with strong
fundamentals might have strong valuations. Li and Mohanram (2015) show that combining
measures of quality (FSCORE and GSCORE) with a measure of cheapness, such as the
Value/Price or V/P ratio from Frankel and Lee (1998), significantly strengthens the efficacy of
fundamental analysis. In our analyses, we find that combining the BSCORE trading strategy with
the V/P approach (Frankel and Lee 1998) significantly enhances the hedge returns, with the time
Our results have obvious implications for researchers and practitioners focusing on
fundamental analysis. They suggest that a simple approach that aggregates signals related to
profitability, growth, and risk can be used to screen bank stocks that are likely to be expost
winners and losers in terms of stock returns. Further, our results indicate that the approach can be
In addition to investors, our paper could also be of potential interest to bank regulators.
According to some estimates, the size of the U.S. banking sector as measured by total banking
assets is as large as the annual GDP 1. The importance of banks to overall economic activity was
highlighted rather dramatically in the aftermath of the recent financial crisis that originated within
1
http://www.helgilibrary.com/indicators/index/bank-assets-as-of-gdp
3
a subset of the U.S. banks and thereafter developed into a fullfledged U.S. and global economic
downturn. The crisis has also highlighted the surprising inability of investors to judge the
implications of rather simple value and risk drivers such as financial leverage. Accordingly, a
systematic approach that utilizes simple publicly available data to predict performance of this
important subset of the economy is likely to be of interest to market participants, regulators, and
policymakers alike.
The rest of our paper is organized as follows. Section 2 discusses prior research in both
banking as well as fundamental analysis in order to motivate our approach. Section 3 describes the
individual components used in creation of the BSCORE index, the sample selection process and
descriptive statistics. Section 4 presents the empirical results, while Section 5 concludes.
2. Literature Review
Our paper builds on research from two streams banking and fundamental analysis. We briefly
describe the relevant research in both of these areas, and use the insights from prior research to
The valuation literature in accounting and finance typically deletes financial sector stocks.
This may partly be due to the fact that banks have a business model that is very different from non-
financial stocks. In contrast to the extant valuation literature, we conjecture that bank stocks are in
fact an ideal laboratory to examine returns to a trading strategy based on fundamental analysis due
Modern day banks are inherently different from other industries due to the inherent opacity
or complexity of their balance sheet (Morgan 2002, Macey and OHara 2003, Adams and Mehran
2003 and Koller et al. 2010). Morgan (2002) calls banks black holes of the universe. This
opacity arises, among other things, due to the limitations of the current accounting models in
conveying information about the extent of credit losses, and the pervasiveness of offbalance sheet
exposures among large banking institutions. Further complicating matter is the extent to which
nontraditional banking activities (such as securitization and investment banking activities) drive
bank value. Macey and OHara (2003) state that Not only are bank balance sheets notoriously
opaque, but as Furfine (2001) points out, rapid developments in technology and increased financial
sophistication have challenged the ability of traditional regulation and supervision to foster a safe
and sound banking system. This inherent opacity in banks financial statements suggests that
while a simple financial statementsbased valuation approach might not work as well for banks as
it does for other industries, an approach contextualized for the banking sector may be potentially
fruitful.
Calomiris and Nissim (2007) focus on an activity based valuation of bank holding
companies in the U.S. and document that the valuation drivers identified by their study explain
significant variation in banks markettobook ratios during the 20012005 sample period.
Further, they document that residuals from a regression of markettobook ratio on the activity
based value drivers predict future returns. However, these future returns are found to be impacted
by trading costs. Within the realm of financial institutions, but focussing on insurance companies
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instead, Nissim (2013) examines the accuracy of relative valuation methods in the U.S. insurance
industry, documenting inter alia the dominance of book value multiples over earnings multiples
As banks are highly leveraged, their valuation is more susceptible to macroeconomic and
market sentiment swings (Koller et al. 2010). For example, even though the broader U.S. economy
has pulled out of the recent downturn, investor sentiment regarding bank stocks remains
suppressed compared to the precrisis period. It is likely that this characteristic of bank stocks
renders them ripe for exploiting a fundamental analysisbased investment strategy. In other words,
when the broader market is concerned about market and industry-wide factors, a fundamental
investor can earn excess returns by screening stocks based on bankspecific value drivers.
Finally, the financial crisis period exposed the wild gyrations in the valuation of bank
stocks. If indeed this was a period of where valuations departed from fundamentals, it would also
provide an appropriate setting for the testing of a fundamentals-based investing strategy. Huizinga
and Laeven (2012) focus on the financial crisis period and show, using stock market value as a
benchmark, that banks overstated the value of their distressed (real estatebacked) assets. They
attribute these findings to noncompliance with accounting rules and regulatory forbearance. In a
similar vein, Vyas (2011) shows that financial institutions recorded losses in an untimely manner
compared to the devaluations being implied by the underlying asset markets. Calomiris and Nissim
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(2014) focus on the decline in bank markettobook ratios during the recent financial crisis, and
show that the declines cannot be fully attributed to delayed recognition of losses on existing
financial instruments.
Based on an examination of 51 large global banks before and after the crisis, Papa and
Peters (2014) document a lag between allowance for loan losses and market values. These findings
echo those reported in Huizinga and Laeven (2012), and Vyas (2011). Papa et al. (2015) focus on
net other comprehensive income (OCI), availableforsale and cash flow hedge financial
instruments gains or losses reported by 44 large global banks during 20062013, and document
that not only are losses on OCI more frequent than on the income statement, but that OCI has
While typically not focusing on bank stocks, there has been an extensive prior literature
focusing on the ability of financial signals to predict future stock returns. Ou and Penman (1989)
show that certain financial ratios can help predict future changes in earnings. Lev and Thiagarajan
(1993) analyze 12 financial signals purportedly used by financial analysts and show that these
signals are correlated with contemporaneous returns and future earnings. Abarbanell and Bushee
(1997) show that an investment strategy based on these signals earns significant abnormal returns.
Two studies that are most relevant to our paper are Piotroski (2000) and Mohanram (2005).
Piotroski (2000) uses financial statement analysis to develop an investment strategy for high BM
or value firms. Piotroski argues that value firms are ideal candidates for the application of financial
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statement analysis as they are often neglected by financial analysts. He combines nine binary
signals based on traditional ratio analysis into a single index called FSCORE. He shows that a
strategy of taking a long position in high FSCORE firms and a short position in low FSCORE
firms generates significant excess returns that are persistent over time, rarely negative, and not
driven by risk. Mohanram (2005) follows a similar approach as Piotroski (2000), but focuses on
low BM or growth stocks. He tailors the ratios to better suit growth stocks. He combines eight
binary signals into a single index called GSCORE, and shows that the GSCORE strategy is
successful in separating winners from losers among low BM firms. In this paper, we will attempt
3.1. Why Traditional Fundamental Analysis might not be effective in Bank Stocks
The fundamental analysis framework used in prior research can be broadly motivated by the
residual income valuation (RIV) model from Ohlson (1995), and Feltham and Ohlson (1995)
among others. The RIV model characterizes stock price as a function of book value and the present
value of the stream of future expected abnormal earnings. From the RIV model, it is easy to infer
that the value of a stock increases with a firms ability to generate abnormal profitability, and
further with the persistence and growth in abnormal profitability. On the other hand, the value of
a stock decreases with (systematic) risk, as future abnormal earnings are discounted further. 2
2
The use of residual income valuation by sell side analysts has been growing, as noted by Hand et al. (2015), especially
for analysts associated with certain brokerage houses such as Morgan Stanley and J.P. Morgan that have embraced
the RIV model. A search of research reports in the banking sector from the Investext database shows that bank stock
8
Motivated by this, prior research has identified signals associated with profitability, risk and
growth. Piotroski (2000) applies a variant of the Dupont framework in the subsample of value
stocks and creates an index labeled FSCORE, which combines signals associated with overall
profitability, asset turnover, profit margin, liquidity and solvency. Mohanram (2005) analyzes
growth stocks and also incorporates signals associated with earnings and revenue growth to create
Applying traditional ratio analysis in banks is problematic because many of the ratios use data
that is either not meaningful or not provided for bank stocks. For instance, the FSCORE metric
incorporates signals related to asset turnover, profit margin, accruals and the current ratio, which
in turn require data items such cost of goods sold, current assets, current liabilities and working
capital accruals. Similarly, the GSCORE metric includes signals related to research and
development, advertising and capital expenditures. Hence, these papers, either explicitly or
implicitly due to the data requirements, exclude bank stocks. This motivates our quest to develop
a customized set of fundamental signals that exante have the potential to be relevant for banks. 3
analysts from these brokerages use RIV models to calculate price targets. These analysts routinely forecast ROE (or
its variants such as return on economic equity) to arrive at their forecasts of net income / residual income.
3
A nave attempt to mechanically compute the FSCORE and GSCORE ratios from the Piotroski (2000) and
Mohanram (2005) papers in the subset of bank stocks is not very fruitful. FSCORE requires detailed information on
components of the income statement and balance sheet, which are often unavailable or inapplicable for banks.
GSCORE requires information on items such as R&D, Advertising and Capital expenditures, which are invariably
coded as zero (or missing) for banks. Out of our sample of 9,343 observations, FSCORE was computable for only
4574 observations, while GSCORE was computable for 9186 observations. Further, many of the signals were
meaningless and were mechanically set to zero or one. Finally, for both FSCORE and GSCORE, we were unable to
detect any meaningful relationship with future returns. This corroborates our maintained assumption that traditional
ratio based fundamental analysis is inapplicable in banks.
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3.2. Applying Fundamental Analysis to Bank Stocks: Construction of the BSCORE Index
Similar to the approach towards fundamental analysis in non-bank stocks, we look for signals
associated with (abnormal) profitability, risk and growth. Specifically, we categorize these signals
into four buckets overall profitability, components of profitability, credit risk, and growth. In
particular, we identify the following thirteen signals to screen winners from losers each year among
the population of bank stocks: (i) overall profitability (ROE and ROA), (ii) components of
profitability (spread, operating expense ratio, non-interest income, earning assets, and loans to
deposits ratio), (iii) credit risk (loan loss provisions, non-performing loans, and loan loss allowance
adequacy), and (iv) indicators of future growth (revenues, total loans, and trading assets). 4
For each individual metric, we construct an indicator variable that equals one if the
measure improved over the previous year, and zero otherwise. We decide to focus on changes
rather than levels for two reasons. First, this approach mirrors Piotroski (2000) who uses a similar
approach to identify firms with improving fundamentals. Second, this also has the advantage of
the firm serving as its own control, as the level of the ratios can be affected by a number of other
factors including the specific strategic choices a bank has made (e.g. physical branch vs online
banking), segments its operates in, size and geographic location. BSCORE is the sum of all of
4
Note that the categorization of signals into four buckets, while beneficial from an expositional point of view, is not
necessarily non-overlapping. For example, while the loans to deposits ratio indicates the ability of a bank to deploy a
relatively stable source of funding into revenue generating assets, the extent of reliance on deposits as a source of
funding also has implications for financial leverage and liquidity risk.
5
We also create a continuous version of BSCORE using the ranks of the variables underlying each signal. The results
are broadly similar. We prefer the 0/1 specification we use in the paper because of its simplicity and because of its
similarity with screening mechanisms typically used to pick stocks.
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3.2.1 Category 1: Overall Profitability
We employ two metrics to measure a banks overall profitability: ROE as a levered measure,
and ROA as an unlevered measure. We use these two correlated but distinct measures because, as
discussed below, leverage can have an ambiguous impact on profitability in banking sector.
1) Return on Equity (ROE): As pointed earlier, observers (e.g., Admati 2011) have argued
that banking analysts (and investors) are fixated on evaluating bank performance using the
accounting return on equity. Accordingly, we use ROE as the first fundamental signal to
screen bank stocks. A potential drawback is that if ROE is primarily driven by leverage,
then its use as a signal of firm value could be questionable during economic downturns
(when banks are more likely to deleverage and forego true value creating activities). Our
first signal (B1) equals 1 when ROE increases from t1 to t (ROEt > 0), and 0 otherwise.
2) Return on Assets (ROA): ROA will be less immune to problems pertaining to leverage
discussed above. Nonetheless, this measure would be prone to business-mix issues (i.e.,
some banks may derive more revenue as fees from underwriting or other banking
activities). Our second signal (B2) equals 1 when ROA increases from t1 to t (ROAt >
We employ five signals in this category. The first three signals (spread, operating expense
ratio, and non-interest income) are analogous to profit margin, while the remaining two signals
(earning assets and loans to deposits ratio) are measures of asset deployment efficiency.
11
3) Spread: We measure the spread on the banks loan portfolio as the ratio of net interest
income (interest income minus interest expense) earned during the year to average total
loans. Note that the sign of this signal is ambiguous as higher spread could simply reflect
higher risk on the loan portfolio. Our third signal (B3) equals 1 when the banks spread
4) Operating expense ratio: We use the expense ratio, defined as non-interest expense divided
by total revenue. This ratio measures how large a proportion of revenues gets used up in
operating and administrative expenses. For this ratio, revenues are generally defined as the
sum of net interest income (interest income interest expense) and noninterest income.
Our fourth signal (B4) equals 1 when expense ratio decreases from t1 to t
5) Noninterest income: It is defined as the ratio of noninterest income to total revenue. This
measure is particularly useful for larger universal banks that generate a significant portion
generally derive from higher value added services (such as investment banking and
brokerage) that are very profitable, or are associated with no direct costs (such as service
fees). Our fifth signal (B5) equals 1 when non-interest income increases from t1 to t
6) Earning Assets: Banks generate income from inter alia, loans and other investments that
yield interest or dividend income. Accordingly, we include the Earning Assets ratio,
defined as the ratio of earning assets to total assets. We expect that the ability of banks to
12
deploy its assets productively should be positively correlated with future realized
performance. Our sixth signal (B6) equals 1 when earning assets increase from t1 to t
7) Loans to Deposits: The last signal we consider in this category is the ratio of loans to
deposits. It measures the ability of a bank to efficiently deploy its primary source of funding
deposits to grow its primary earning asset loans. If the ratio is too low, it means
that the bank has a lot of unused funds and accordingly implies increased inefficiency. Note
that while this ratio is categorized as a component of profitability, it could also be a signal
of liquidity risk if the ratio is too high, it may impose additional risk or at least liquidity
problems on the bank, especially if a large number of depositors want to withdraw their
deposits simultaneously (although this problem has been sufficiently diminished with the
advent of deposit insurance). Our seventh signal (B7) equals 1 when the ratio of loans to
The typical recognition sequence for loan losses is (1) recognition of nonaccrual or non
performing status, (2) provision based on historical and current loss experience, (3) chargeoff
when the loss is realized, and (4) recovery of previously charged-off loans. Accordingly, we use
8) Loan Loss Provisions (LLP): LLP is perhaps the most important accrual for banks in
terms of absolute magnitude as well as its impact on overall profitability and capital
13
adequacy (Beatty and Liao 2011; Liu and Ryan 2006). Accordingly, we define LLP as the
ratio of annual loan loss provision to total loans. Our eighth signal (B8) equals 1 when LLP
9) Non-performing loans (NPL): We acknowledge the limited horizon problem in loan loss
accruals (due to the incurred loss model). Hence, we also employ a more forwardlooking
metric measured as the ratio of non-performing loans to total loans. NPL is a noisy but
perhaps the timeliest measure of the extent of economic losses in a banks loan portfolio.
Note that NPL is not reflected in the main body of financial statements, but is found in
notes to the financial statements. Our ninth signal (B9) equals 1 when the level of non
10) Allowance Adequacy: banks with greater loan loss allowance adequacy are generally better
able to absorb expected credit losses without impairing capital during periods of distress
(e.g., Beatty and Liao 2011). Accordingly, we measure allowance adequacy as the ratio of
loan loss allowance to non-performing loans. Our tenth signal (B10) equals 1 when the
We employ three signals to measure growth: Change in total revenue measures growth in
overall income, while changes in loans and trading assets measure the banks growth in traditional
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11) Total Revenue: This measure is defined as the sum of net interest income (interest income
interest expense) and noninterest income, and in itself does not distinguish between the
sources of revenue (traditional vs. non-traditional). Two measures defined below Loans
and Trading Assets use such decomposition. Our eleventh signal (B11) equals 1 when the
12) Loans: Regulators and market participants often evaluate banks on the basis of their ability
to grow their total loan portfolio. On the one hand, increasing the loan base results in
increased revenue, but on the other hand it could also signal increased credit risk. These
concerns generally become acute during periods of financial distress when banks are
reluctant to extend credit due to systemic credit risk fears. Our twelfth signal (B12) equals
1 when the banks total loans increase from t1 to t (Loanst > 0), and 0 otherwise.
13) Trading Assets: One measure of a banks involvement in nontraditional banking activities
is the extent of reliance on trading activities, measured as trading assets divided by total
assets or as the ratio of trading income to total income. Our thirteenth signal (B13) equals
1 when the banks trading assets increase from t1 to t (Trading_Asstest > 0), and 0
otherwise.
The signals that constitute BSCORE are simple enough and can be constructed by an investor
who has regular access to basic financial information. In our empirical tests, we will test the
association of BSCORE with future returns. If banks that have strong (weak) fundamentals that
15
investors have not completely impounded in stock price, then high (low) BSCORE firms should
earn higher (lower) ex-post returns. If on the other hand, the ratios constituting BSCORE are
already impounded in current price, we should see no relationship with future returns.
We analyze future returns using a oneyear horizon, with returns being compounded
beginning four months after the fiscal year end. Our measure of annual returns is labelled RET1,
calculated as buyandhold annual returns, with adjustments for delistings as in Shumway (1997).
In addition, we also calculate marketadjusted returns, RETM1, as the difference between RET1
and the compounded value-weighted market return over the same period (VWRETD from CRSP).
It is plausible that the association between BSCORE and returns could be driven by risk. We
will try to address this in a variety of ways, including examining the consistency of returns across
time, examining returns in a variety of partitions, and explicitly controlling for known risk factors. 6
We begin our sample construction using all banks with data available in the Bank
COMPUSTAT between 1993 and 2014. Panel A of Table 1 presents our sample selection process.
We restrict the sample to bankyears following 1993 due to limited data availability on Bank
COMPUSTAT in prior years. Accordingly, we begin our sample construction with 17,571 bank
year observations, corresponding to 2,074 unique banks. Application of further filters pertaining
to the data availability of the BSCORE components decreases the sample to 13,684 (1,775) bank
6
It is possible that some of the signals identified in this study especially those pertaining to credit risk constitute
systematic risk factors not already subsumed by extant risk factors.
16
year (banklevel) observations. As most banks have December fiscal year ends, we further restrict
the sample to firms that have their fiscal year ends in December, yielding 11,959 (1,466) bank-
year (bank-level) observations. This criterion ensures that the compounding periods for the returns
outliers and potential data errors relating to stock price, number of shares outstanding, and size
Panel B of Table 1 presents descriptive statistics for basic bank characteristics for our
sample as well as for the thirteen signals that construct the BSCORE index. Reflecting the fact that
our sample comprises banks that typically have large asset bases, the average (median) reported
total assets are $ 26.2 bill. ($1.2 bill.). The distribution in terms of size reveals a distinct skewness
towards the right, reflecting the presence of large universal banks in the sample. The distribution
of the other two size variables revenues and market capitalization reveals a similar right
skewness, with means that are considerably larger than the median.
The mean (median) ROE is 8.6% (10.3%). In contrast, the mean (median) ROA is 0.8%
(0.9%). The contrast in magnitudes of ROE and ROA is not surprising banks are in general
highly financially leveraged. Accordingly, their equity base is often very thin, resulting in a much
smaller denominator for ROE compared to ROA. The mean (median) spread is 5.4% (5.2%), with
a modest standard deviation of 1.6% this reflects the competitive nature of the traditional
banking industry with limited scope for excessive interest margins. The mean (median) operating
17
Mean (median) non-interest income of 21.5% (19.7%) shows that non-traditional banking
activities such as those that generate fees and trading commissions drive a substantial one-fifth of
total yearly revenues for an average bank. The mean (median) bank has 88% (89.8%) of its assets
classified as earning assets in that they represent investments in loans and securities as
opposed to idle cash balances and other assets such as PP&E. Loans to Deposits ratio exhibits a
mean (median) of 88% (87.5%), suggesting a substantially high proportion of funds raised through
traditional deposit raising activity are deployed into traditional banking assets loans.
In terms of credit quality metrics, mean (median) annual loan loss provision is 0.6%
(0.3%), while mean (median) non-performing loans are 1.8% (1.0%) of total year end loans
outstanding. Mean (median) allowance adequacy, which is loan loss allowance divided by non-
performing loans is 2.8 (1.34), implying that on average and across the years, outstanding
allowances were more than sufficient to cover expected near term loan losses. However, a closer
examination (untabulated) reveals this adequacy was severely stressed during the recent crisis,
Turning to growth, the average bank-year exhibits robust mean (median) revenue growth
of 12.9% (8.7%), and similar mean (median) loan growth of 13.5% (9.4%). Finally, average
trading assets as a percentage of total assets are quite low at 0.3% (0.0%), reflecting the limited
number of banks that are sophisticated and large enough to have active trading desks.
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4. Empirical Analyses
generating excess returns, we examine the relation between each of the thirteen signals (B1:B13)
and the one-year market adjusted returns (RETM1). Recall that each of the signals, takes on a value
of one for years in which the bank exhibits an improvement in that signal, and zero otherwise. In
particular, we compare the average one-year market adjusted returns for the sample of banks
exhibiting improvement in each of the signals (1) to the sample of banks with no improvement (0).
Table 2 presents the results. According to the last two columns on the right, the differences in
returns are positive and significant for 10 signals except for Spreadt (B3), Noninterest_Incomet
In terms of magnitude, returns for NPLt (B9) and Allowance_Adequacyt (B10) seem to
be the highest, indicating the valuation relevance of credit quality and the ability of a bank to
withstand shocks to credit quality. The insignificance of Spreadt (B3) could be partially explained
by the possibility that our measure of spread can increase either through an increase in net interest
income (a positive signal) or a decrease in assets (which could signal lower growth). The
greater reliance on non-traditional but risky banking activities. While engagement in these
activities could result in higher fees and trading income, it also increases the overall exposure of
the bank to market risk. Accordingly, our inability to observe significant returns using these
the fact that a few signals do not work at the univariate level, we include all thirteen signals in
BSCORE, as cherry-picking signals that appear to work ex-post would impose look-ahead bias.
Table 3 presents Pearson and Spearman correlations between BSCORE index, its thirteen
individual component signals (B1:B13), and one yearahead market adjusted returns (RETM1).
By construction, BSCORE is positively correlated with each of the thirteen constituent signals. A
closer inspection of the table reveals that BSCORE and its components, with few unremarkable
exceptions, are generally positively and significantly correlated among themselves. It is also
notable that generally, the strongest correlations are obtained when we look at signals related to
ratios within the same group i.e. profitability ratios, components of profitability, credit risk
and growth. Most of the individual BSCORE components also generally exhibit positive and
significant pairwise correlations with annual market adjusted returns. Most importantly, the
Pearson (Spearman) correlation between the BSCORE index and RETM1 at 0.15 (0.13) is positive
and significant at the 1% level. This correlation is also higher than that between the individual
signals and returns, suggesting that there may be a benefit to aggregating the individual signals.
Having established the efficacy of the individual signals in generating excess returns, we
now analyze the relationship between BSCORE and future returns. We sort banks into fourteen
portfolios based on their BSCORE levels from 0 to 13. Panel A of Table 4 reports the returns to
20
each of these fourteen portfolios, presenting one yearahead raw returns (RET1) and market
The mean and median returns for both RET1 and RETM1 show a monotonic increase as we
move from the BSCORE = 0 portfolio to BSCORE = 13. Specifically, for the BSCORE = 0
portfolio, the mean (median) RET1 is 9.1 % (43.7%), whereas the mean (median) RETM1 is
22.1 % (44.8%). For the BSCORE = 13 portfolio, the mean (median) RET1 is 22.5% (25.5%),
whereas the mean (median) RETM1 is 14% (4.9%). Examining the last two columns on the right
shows that the proportion of bankyears with positive returns also monotonically increases with
BSCORE. In particular, while only 33.3% of the observations have positive one yearahead raw
returns (RET1) in the lowest BSCORE portfolio, all the bank-year observations in the BSCORE =
13 portfolio show positive returns. This suggests the potential efficacy of a trading strategy that is
long on banks with the highest BSCORE and short on banks with the lowest BSCORE. The
monotonic increase in both RET1 and RETM1 across BSCORE portfolios also holds for the first
and third quartile of returns in each portfolio, suggesting that sorting on BSCORE helps to shift
However, there are very few observations in the extreme portfolios in Panel A. In order to
create an implementable strategy, we sort the sample into quintiles and create hedge portfolios
using the top and bottom quintiles (i.e., long on the top quintile, and short on the bottom quintile). 7
The results are presented in Panel B of Table 4. We observe mean RET1 (RETM1) of 6.4 % (7.4%),
and median RET1 (RETM1) of 5.1% (5.1%). Examining the last row of Panel B shows that the
7
As BSCORE is a discrete variable whose distribution varies across time, the exact cutoff to determine quintiles varies
from year to year, and the quintiles do not necessarily have identical number of observations.
21
differences between the mean and median returns on the long and short portfolios are statistically
significant.
In this section, we partition the sample along a number of dimensions to examine if the
results are robust in different subsets of the population. We consider three partitions firm size,
analyst following, and listing exchange. These partitions are related to both the information
environment and the implementability of the hedge strategy. The results are presented in Table 5.
Panel A of Table 5 presents the returns by partitions of firm size (market capitalization).
We do not observe any significant discernible pattern of differences in the distribution of hedge
returns across these three size groups. In particular, for small firms, the mean hedge returns RET1
(RETM1) are 5.77% (7.24%). For medium firms, the mean hedge returns RET1 (RETM1) are
5.84% (8.55%), while for large firms, the mean hedge returns RET1 (RETM1) are 7.82% (6.56%).
The last row shows that the return differences are statistically significant in each of the three size
categories. Hence, our results are robust across size partitions. Beyond documenting robustness,
our size partition results also provide comfort regarding the ease of implementation of the
BSCORE-based trading strategy the finding that results hold even with the small bank stock
partition suggests that transaction costs are unlikely to explain away the returns to BSCORE hedge
strategy.
Panel B of Table 5 presents the returns by partitions of analyst following. The BSCORE
strategy continues to generate positive and statistically significant hedge returns in both partitions.
22
In particular, for the subsample without analyst following, the mean hedge returns RET1 (RETM1)
are 7.00% (7.61%), and for the subsample with analyst following are 5.68% (7.09%). Therefore,
Panel C of Table 5 reports the returns by partitions of exchange listing status. Specifically,
we partition the sample into two subsamples of firms listed in NYSE/AMEX and NASDAQ/Other
shorting NYSE/AMEX stocks is easier than shorting NASDAQ stocks. The BSCORE strategy
generates positive and statistically significant hedge returns in both partitions. For the
NYSE/AMEX subsample, the mean hedge returns RET1 (RETM1) are 6.57% (5.35%), while for
the NASDAQ/Other subsample, the mean hedge returns RET1 (RETM1) are 6.33% (7.98%). Thus,
To ensure that the BSCORE results documented thus far are not attributable to extreme
return patterns at some points in time or to time clustering of observations, we examine the
performance of BSCOREbased trading strategy for each of the years in our sample period (1994
2013). In particular, we create long and short portfolios based on the top and bottom deciles of
BSCORE distribution each year. The results are presented in Table 6 and depicted in Figure 1-A.
Table 6 shows that long-short strategy based on BSCORE yields positive hedge returns
(HRET1) for all years during our 19942013 sample years except in 2002. Interestingly, hedge
returns reach a peak during the 20072009 years when the market was severely affected by the
23
effects of the financial crisis. The consistent performance of the BSCORE strategy over time,
including during the crisis period, seems to suggest that risk is unlikely to be a complete
explanation for our results. In fact, the sample period includes sharp turns in the business cycle
and materialization of tail risk events. Finally, a Sharpe ratio of 1.1 suggests that mean performance
The BSCORE strategy could potentially be correlated with common risk factors. In this
section, we examine whether the returns to a BSCORE trading strategy survive controls for
commonly used risk factors in asset pricing tests. Specifically, we run multifactor portfolio
regressions based on the Fama and French (1993) threefactor model (Table 7-A), Carhart (1997)
fourfactor model (Table 7-B), and Fama and French (2015) fivefactor model (Table 7-C). We
first create portfolios based on the top, middle 3 and bottom quintiles of BSCORE. We run
calendar-time portfolio regressions using monthly returns for the 12 months after portfolio
formation. The intercept () of the regression represents the monthly excess return for each
portfolio. We then consider the hedge return based on a strategy of going long in high BSCORE
firms and short in low BSCORE firms i.e. the difference in between the top and bottom
Panel A of Table 7 presents the results for the three-factor model. First, we note that the
three FamaFrench factors (RmRf, SMB, and HML) load positively and significantly across all
the BSCORE quintiles. Second, we observe a positive (negative) for the top (bottom). Lastly,
24
the hedge strategy based on top and bottom BSCORE quintiles has a positive of 0.607 (7.53%
Panel B of Table 7 presents the results for the fourfactor model. Momentum (UMD) loads
positively (0.131) and significantly (t = 4.61) for the hedge strategy, leading to a decline in to
0.505 (6.23% annualized), but still remaining statistically significant (t = 3.49). Lastly, Panel C
of Table 7 documents the results for the fivefactor model. Both the profitability factor (RMW)
and the investment factor (CMA) load significantly, which should not be surprising as the
components of BSCORE focus on both profitability and investment efficiency. The for the five-
factor model is lower at 0.450 (5.53% annualized), but still statistically significant (t = 2.90). In
summary, results from Table 7 suggest that the efficacy of BSCORE strategy persists after
4.7. Future Earnings Announcement Returns, Analyst Surprises, and Performance Delistings
The previous sections document that hedge returns to a longshort trading strategy created
using high and low BSCORE groups persist even after controlling for commonly employed risk
factors, and are consistent over time. To further cement this argument, we explore additional tests
to examine whether market participants are able to impound the future valuation implications
embedded within BSCORE signals immediately. For the mispricing story to hold, it must be the
case that market participants reaction to future resolution of uncertainty is positively correlated
with BSCORE. Prior research in accounting has used such tests to lend credence to mispricing
based explanations (e.g. Sloan 1996, Piotroski 2000 and Mohanram 2005). We examine analyst
25
forecast errors, stock market reaction to future earnings announcements, and the extent of
In Panel A of Table 8, the first column presents mean scaled annual forecast surprise for
the following fiscal year (SURP A1), using annual EPS forecasts obtained three months after prior
fiscal year end, scaled by year-end stock price. Analysts surprises are more negative for bottom
quintile banks and less negative for the top quintile banks, with the difference in forecast surprise
between the top and bottom BSCORE quintiles being a significant 0.94% (t = 3.03). 8 The next
four columns repeat the analyses using quarterly forecasts obtained two months after prior quarter
end and find similar results. The results are consistent with markets being more likely to be
negatively surprised by earnings realizations for low BSCORE firms, and to a lesser extent, with
markets being more likely to be positively surprised for firms with high BSCORE.
The last column of Panel A presents the stockmarket reaction around quarterly earnings
announcements in the first year. Quarterly buyandhold marketadjusted returns (EA_RET) are
computed for a threeday window (1 to +1) around earnings announcements, and then summed
across the four quarters. We observe that the quarterly announcement returns increases predictably
and monotonically from the bottom to top BSCORE quintile, and that the return difference
between the top and bottom quintile is 1.05% and statistically significant (t = 3.63). Hence, a high
proportion (1.05/7.40 = 14%) of the annual hedge returns are realized during the 12 trading days
8
The fact that the average forecast surprise is negative for all groups should not be surprising, given that prior research
has documented that analysts forecasts tend to be too optimistic.
26
surrounding the quarterly earnings announcements, consistent with the stock market reacting to
associated with poor performance in the year after BSCORE computation. Performance delistings
can be viewed as extreme negative return realization events. We predict and find that the
proportion of bank stocks delisted due to performance reasons is significantly higher in the bottom
BSCORE quintile (1.66%) compared with the top BSCORE quintile (0.33%). The difference in
The preceding analyses demonstrate that BSCORE can be used to effectively screen
between high and low quality bank stocks. However, future return performance is a function of
both future realized bank performance and its current valuation. This is especially likely to be
salient for many banks that are highly visible and followed by market participants for a variety of
political and regulatory reasons. Accordingly, we try to condition all of the preceding analyses on
current bank valuation. The expectation is that all of the previously documented strong results for
high BSCORE firms are especially pronounced for those banks that are in addition currently
undervalued (at time t). Conversely, we expect that the previously documented weak results for
low BSCORE firms will be especially pronounced for those banks that are currently over-valued.
This expectation also follows from the results in Li and Mohanram (2015), who show that
combining ratio analysis based methods of fundamental analysis with intrinsic value based
methodology in Frankel and Lee (1998) to calculate the Value to Price or V/P metric. We use the
cross-sectional forecasting approach from Li and Mohanram (2014) to ensure that we do not lose
observations for firms without analyst following. The details of the cross-sectional forecasting and
The results of this conditioning analysis are presented in Table 9 and depicted in Figure 1-
B. First, Panel A repeats the analysis in Table 4-B, except the long portfolio comprises of banks
within the topmost BSCORE quintile and above median V/P ratio (i.e., undervalued firms with
high fundamental quality), and the short portfolio comprises of the bottommost quintile and below
median V/P ratio (i.e., overvalued low fundamental quality firms). Table 9-A shows both the one
yearahead raw returns (RET1) and one year-ahead market adjusted returns (RETM1). The spread
in RET1 increases rather dramatically from 6.4% in Table 4B to 11.8% in Table 9-A. A similar
trend is observed for the spread in RETM1. It increases from 7.45% in Table 4-B to 12.2% in Table
9-A. 9
Panel B of Table 9 performs the same time partition analysis as in Table 6, except that the
long portfolio comprises of banks within the topmost BSCORE quintile and above median V/P
ratio, and the short portfolio comprises of the bottommost BSCORE quintile and below median
9
One concern might be that the stronger hedge returns shown here are merely an artefact of smaller sample size i.e.
the fact that we are focusing on more extreme high and low BSCORE firms. To test this conjecture, in untabulated
analyses, we examine hedge returns to deciles of BSCORE, so that the sample size for the long/short portfolios is
comparable to quintiles of BSCORE further conditioned by V/P. We find that the hedge returns increase modestly to
6.56% for RET1 and 8.03% for RETM1, far less than the hedge returns for the combination of BSCORE and V/P.
Finally, we also examine the average BSCORE for low and high V/P partitions. Among low BSCORE firms, the
average BSCORE for low V/P firms (3.57) is only marginally lower than the average BSCORE for high V/P firms
(3.78). Among high BSCORE firms, the average BSCORE for high V/P firms at 9.89 is actually lower than the average
BSCORE for low V/P firms at 9.97. This suggests that the V/P screen provides information orthogonal to BSCORE.
28
V/P ratio. Table 9-B also reveals a dramatic improvement in hedge returns over time compared to
Table 6. Specifically, we find that the hedge returns (HRET1) are positive in all of the years in our
sample. Furthermore, our previous finding in Table 5 that fundamental analysis gains importance
during years of macroeconomic uncertainty (20072009) is strengthened and now holds even for
the earlier recession in 2001. Finally, the Sharpe ratio improves from 1.1 to 1.4 using this strategy.
Lastly, Panel C of Table 9 repeats the risk factor analysis as in Table 7 after conditioning
the BSCORE portfolios on V/P. We find that the monthly for the FamaFrench (1993) three
factor, the Carhart (1997) four-factor, and the FamaFrench (2015) fivefactor models increases
from 0.607, 0.505, and 0.450 in Table 7 to 0.868, 0.767, and 0.790 in Table 9-C, respectively. The
from these tests corresponds to 10.93%, 9.60% and 9.90% in terms of annualized returns. All in
all, the results in Table 9 show that the efficacy of the BSCORE trading strategy can be enhanced
correlated with the signals associated with ROE (B1, correlation 0.67) or ROA (B2, correlation
0.70). Is it therefore likely that results similar to what we obtain with BSCORE could ostensibly
be obtained by using just these ratios? Indeed, ROE is very often used as a focal ratio in the analysis
of bank profitability. To test this, we run some additional (untabulated) tests focusing on portfolios
29
To ensure comparability with our BSCORE portfolios, we form quintiles based on the
change in ROE and ROA respectively. We then replicate the tests in Table 4, 6 and 7 using these
metrics. We find that while strategies based on ROE and ROA do generate positive hedge returns,
the performance of the strategies is inferior to that of the BSCORE strategy, with lower and more
inconsistent hedge returns. For instance, the ROE based strategy generates average annual hedge
returns of 4.82% (compared to 6.02% for BSCORE) with a Sharpe ratio of 0.67 (compared to 1.17
for BSCORE), with negative hedge returns in five years out of 20. An ROA based strategy
generates average hedge returns of 3.81% with a Sharpe ratio of 0.55, with negative returns in six
years out of 20. Hence, it is clear that the more comprehensive BSCORE strategy outperforms
strategies based on a single metric of performance such as ROE or ROA. This suggests that there
is merit in looking at bank ratios at a finer level, focusing on the drivers of profitability, risk and
growth.
5. Conclusion
This study examines returns to a fundamental analysis based trading strategy for U.S. bank
stocks. We exante identify thirteen bank fundamental signals related to profitability, risk and
growth to create an index of bank fundamental strength (BSCORE). We find that a long-short
strategy based on BSCORE yields positive market adjusted hedge returns of 7.4% during our
19942013 sample period. The results are consistent across partitions based on size, analyst
following and exchange listing status. Inconsistent with a risk-based explanation, positive hedge
returns are obtained for all but one year during the sample period. Hedge returns remain positive
across size partitions, and survive risk adjustment based on FamaFrench (1993) threefactor,
30
Carhart (1997) fourfactor, and FamaFrench (2015) fivefactor models. Further lending credence
BSCORE quintiles and analyst forecast surprises around earnings announcements. We also find
evidence that the pattern of excess returns around subsequent earnings announcements correlates
with BSCORE. Further corroborating these findings, we report a negative association between
BSCORE quintiles and extreme negative return realization events as measured by future
performance delistings. Finally, the returns to a BSCORE-based strategy are enhanced when we
combine this approach with ex-ante measures of under- or over-valuation based on intrinsic value.
as the accruals-based strategies seem to have diminished over time for non-financial firms, their
importance for banks remains intact and, in fact, peaked during the recent financial crisis. This is
consistent with the concept of adaptively efficient markets introduced by Grossman and Stiglitz
(1980) i.e. the notion that markets may have a blind spot but once this is pointed out, the markets
adapt and become efficient. Green et al. (2011) and Mohanram (2014) show that returns to the
accruals anomaly decline once investors and financial analysts respectively pay greater attention
to accruals. Given that banks have not been widely analyzed using an approach such as that
developed in this paper, it is not surprising to find continued strong returns to fundamental
This study adds to the recent regulatory policy debate on bank performance measurement
and valuation during the crisis, by showing that a simple approach using publicly available data
can be used to predict near term bank performance. Our results demonstrate that there are valuable
31
signals related to profitability, risk and growth embedded within past financial reports that can
serve as barometers of bank health. Our study demonstrates that fundamental analysis is especially
Finally, our results provide credence to observations by Admati (2011), and Moussu and
Petit-Romec (2013), among others, who have commented on the excessive fixation of bank
managers and analysts on ROE as the central performance metric. In particular, Moussu and Petit-
Romec (2013) document that ROE is often enhanced by leverage, and that precrisis ROE is
strongly correlated with value destruction during the financial crisis of the past decade. We
conjecture that this excessive focus on ROE could come at the expense of ignoring some other
fundamental performance signals that present a more nuanced picture of expected future
performance.
32
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34
Appendix A: Variable Definitions
Variable Definition
ROE Return on equity, calculated as net income divided by shareholders equity. B1 equals 1
(B1) when ROE increases (ROEt > 0), and 0 otherwise.
ROA Return on assets, calculated as net income divided by total assets. B2 equals 1 when
(B2) ROA increases (ROAt > 0), and 0 otherwise.
Spread Spread on the banks loan portfolio measured as the ratio of net interest income earned
(B3) during the year to average total loans. B3 equals 1 when spread increases (Spreadt >
0), and 0 otherwise.
Expense_Ratio Operating expense ratio, calculated as noninterest expense divided by total revenue. B4
(B4) equals 1 when expense ratio decreases (Expense_Ratiot < 0), and 0 otherwise.
Noninterest_Income Non-interest income, calculated as the ratio of noninterest income to total revenue. B5
(B5) equals 1 when noninterest income increases (Noninterest_Incomet > 0), and 0
otherwise.
Earning_Assets Earning assets, calculated as the ratio of earning assets to total assets. B6 equals 1 when
(B6) earning assets increases (Earning_Assetst > 0), and 0 otherwise.
Loans_Deposits Loans to deposits, calculated as the ratio of total loans to total deposits. B7 equals 1
(B7) when the ratio of loans to deposits increases (Loans_Depositst > 0), and 0 otherwise.
LLP Loan loss provision, calculated as the ratio of annual loan loss provision to total loans.
(B8) B8 equals 1 when the level of loan loss provisions decreases (LLPt < 0), and 0
otherwise.
NPL Nonperforming loans, calculated as the ratio of nonperforming loans to total loans.
(B9) B9 equals 1 when the level of nonperforming loans decreases (NPLt < 0), and 0
otherwise.
Allowance_Adequacy Allowance adequacy, calculated as the ratio of loan loss allowance to nonperforming
(B10) loans. B10 equals 1 when the ratio of loan loss allowance to non-performing loans
increases (Allowance_Adequacyt > 0), and 0 otherwise.
Revenues Total Revenue, calculated as the sum of net interest income (interest income interest
(B11) expense) and non-interest income. B11 equals 1 when the total revenue increases
(Revenuest > 0), and 0 otherwise.
Loans Loans is defined as the total loans of the bank. B12 equals 1 when the banks total loans
(B12) increases (Loanst > 0), and 0 otherwise.
Trading_Assets Trading assets, calculated as the ratio of trading assets to total assets or ratio of trading
(B13) income to total income. B13 equals 1 when the banks trading assets increases
(Trading_Asstest > 0), and 0 otherwise.
Buy-and-hold returns using a one-year horizon starting on Apr 1st, adjusted for
RET1 delisting returns consistent with Shumway (1997).
Buy-and-hold returns using a one-year horizon starting on Apr 1st, adjusted for
RETM1 delisting returns consistent with Shumway (1997),in excess of the buy-and-hold value
weighted market return.
35
Appendix B: Estimation of the V/P Ratio
From Li and Mohanram (2014), we forecast future earnings using the following model:
We implement this model using data from COMPUSTAT. Et is earnings per share before
special and extraordinary items ((ib-spi)/csho); NegEt is an indicator variable for loss firms; Bt is
book value of equity per share (ceq/csho); TACCt is total accrual per share calculated following
Richardson et al. (2005), i.e., (WC+ NCO+FIN)/csho, where WC is (act-che)-(lct-dlc); NCO
is (at-act-ivao)-(lt-lct-dltt); and FIN is (ivst+ivao)-(dltt+dlc+pstk).
We estimate this cross-sectional model using all available observations over the past ten
years. This ensures that the earnings forecasts are strictly out of sample. We estimate the model as
of June 30 of each year. To further reduce look-ahead bias, we assume that financial information
for firms with fiscal year ending (FYE) in April to June is not available on June 30. In other words,
only the financials of firms with FYE from April of year t-1 to March of year t are used for
estimation of year t. For each firm and each year t in our sample, we compute earnings forecasts
for year t+1 to year t+5 by multiplying the independent variables in year t with the pooled
regression coefficients estimated using the previous ten years of data. This method only requires a
firm have non-missing independent variables in year t to estimate its future earnings. As a result,
the survivorship bias is kept to a minimum.
Using the cross-sectional forecasts thus obtained, we estimate the intrinsic value of a firm
using the residual income valuation model:
[+ ( +1 )] [(+ )+1 ]
= + = +
(1 + ) (1 + )
=1 =1
where is the stocks fundamental value at time t, Bt is the book value of equity per share at time
t , Et[.] is expectation based on information available at time t; NIt+i is earnings before special and
extraordinary items per share for period t+i; re is the cost of equity capital, and ROEt+i is the after
tax return on book equity for period t+i.
36
To implement the model, we estimate the firms future earnings per share from t+1 to t+5
using the methodology discussed above. We compute book value of equity and return on equity in
each period assuming clean surplus accounting: Bt+I = Bt+i-1 + (1k) NIt+i and ROEt+i = NIt+I
/ Bt+i 1, where k is the estimated payout ratio. The payout ratio (k) is set to dividend divided by
net income (dvc/(ibspi)) in year t for firms with positive earnings, or dividend in t divided by 6%
of total assets (dvc/(6% at)) for firms with negative earnings. If k is greater (less) than one (zero),
we set it to one (zero).
We assume that abnormal earnings stay constant after the forecast horizon to estimate
terminal value. We use the risk-free rate (yield on the ten-year U.S. treasury) plus 5% as the cost
of equity capital (re), which is crosssectionally constant but varies across time.
37
Figure 1-A: Returns to BSCORE Strategy across Time
20.0%
15.0%
Hedge Returns (%)
10.0%
5.0%
0.0%
19941995199619971998199920002001200220032004200520062007200820092010201120122013
-5.0%
Year
Figure 1-B: Returns to BSCORE Strategy combined with V/P across Time
35%
30%
25%
Hedge Returns (%)
20%
15%
10%
5%
0%
19941995199619971998199920002001200220032004200520062007200820092010201120122013
Year
38
TABLE 1. Sample Selection and Descriptive Statistics
Panel A presents the sample selection procedure. Panel B presents descriptive statistics. Please see Appendix A for the definition
of the variables.
39
TABLE 2. Relation between Individual Signals and Future Returns
This table presents the mean one-year market adjusted returns (RETM1) for the two binary values of the individual signals for the
sample of banks. For definitions of B1:B13 as well as RETM1, please see the Appendix A. tstatistic for difference in means is
from a twosample ttest. */**/*** represent statistical significance using 2 tailed tests at 10%/ 5%/ 1% levels.
Category 4: Growth
B11: Revenuest > 0 1885 0.37% 7458 3.76% 4.13% 4.14***
B12: Loanst > 0 1721 1.23% 7622 3.31% 2.08% 2.00**
B13: Trading_Assetst > 0 8654 2.87% 689 3.65% 0.79% 0.51
40
TABLE 3. Correlations between Individual Signals, BSCORE, and Future Returns
This table presents correlations between the BSCORE index, the individual signal, and future stock returns for the sample of banks. BSCORE is the sum of the signals B1:B13. For definitions
of B1:B13 as well as RETM1, please see the Appendix A. Coefficients above the diagonal are Pearson and those below diagonal are Spearman rank-order correlations. */**/*** represent
statistical significance at 10%/ 5%/ 1% levels.
B1 0.70*** 0.04*** 0.64*** 0.01 0.15*** 0.16*** 0.12*** -0.01 0.04*** 0.19*** 0.00 0.18*** 0.66*** 0.09***
B2 0.70*** 0.03*** 0.71*** 0.01 0.14*** 0.24*** 0.12*** 0.00 0.06*** 0.20*** -0.03*** 0.19*** 0.68*** 0.08***
B3 0.04*** 0.03*** 0.03** 0.29*** 0.08*** -0.10*** 0.05*** -0.01 -0.07*** 0.05*** 0.12*** -0.01 0.30*** 0.03***
B4 0.64*** 0.71*** 0.03** 0.00 0.17*** 0.10*** 0.13*** -0.01 -0.02* 0.28*** 0.01 0.13*** 0.65*** 0.09***
B5 0.01 0.01 0.29*** 0.00 0.13*** -0.30*** 0.08*** -0.01 -0.07*** 0.05*** 0.36*** 0.06*** 0.31*** 0.07***
B6 0.15*** 0.14*** 0.08*** 0.17*** 0.13*** -0.08*** 0.79*** 0.01 -0.06*** 0.25*** 0.10*** 0.02* 0.55*** 0.12***
B7 0.16*** 0.24*** -0.10*** 0.10*** -0.30*** -0.08*** -0.01 0.00 -0.10*** -0.10*** -0.32*** 0.13*** 0.13***
B8 0.12*** 0.12*** 0.05*** 0.13*** 0.08*** 0.79*** -0.01 -0.01 -0.05*** 0.17*** 0.04*** 0.02 0.50*** 0.11***
B9 -0.01 0.00 -0.01 -0.01 -0.01 0.01 0.00 -0.01 -0.01 -0.01 -0.01 0.00 0.09*** 0.01
B10 0.04*** 0.06*** -0.07*** -0.02* -0.07*** -0.06*** -0.10*** -0.05*** -0.01 -0.05*** -0.06*** 0.14*** 0.15*** -0.01
*** *** *** *** *** *** *** *** *** *** *** ***
B11 0.19 0.20 0.05 0.28 0.05 0.25 -0.10 0.17 -0.01 -0.05 0.04 -0.05 0.41 0.07***
B12 0.00 -0.03*** 0.12*** 0.01 0.36*** 0.10*** -0.32*** 0.04*** -0.01 -0.06*** 0.04*** 0.29*** 0.26*** 0.02**
B13 0.18*** 0.19*** -0.01 0.13*** 0.06*** 0.02* 0.13*** 0.02 0.00 0.14*** -0.05*** 0.29*** 0.38*** 0.05***
BSCORE 0.67*** 0.70*** 0.29*** 0.66*** 0.30*** 0.54*** 0.13*** 0.50*** 0.09*** 0.14*** 0.41*** 0.23*** 0.35*** 0.15***
RETM1 0.09*** 0.08*** 0.03** 0.09*** 0.05*** 0.12*** -0.02* 0.10*** 0.00 -0.01 0.07*** 0.02 0.04*** 0.13***
41
TABLE 4. Returns to an Investment Strategy Based on BSCORE for Banks
This table presents the distribution of returns based on the level of BSCORE. BSCORE is the sum of the signals B1:B13. For definitions of B1:B13 as well as RET1 and RETM1, see the
Appendix A. In Panel B, in each year, the sample is divided into quintiles based on the level of BSCORE. As BSCORE is a discrete measure, the cutoff to determine quintiles varies by year,
and the quintiles may not equal exactly 20% of the sample. tstatistic for difference in means (zstatistic for differences in medians) is from a twosample ttest (Wilcoxon test). */**/***
represent statistical significance using 2 tailed tests at 10%/ 5%/ 1% levels.
44
TABLE 7. Comparison of Excess Returns after Controlling for Risk Factors
BSCORE is the sum of the signals B1:B13. For definitions of B1:B13 see the Appendix A. Calendar-time regression are run for
quintiles based on BSCORE for the twelve months starting on the April of the year after fiscal year end. We consider three portfolios
the top quintile, the three middle quintiles and the bottom quintile. The regression has 236 observations from April 1995 till
December of 2014. The average monthly return for each quintile portfolio is regressed on various combinations of the market
factor (Rm Rf), the size factor (SMB), the booktomarket factor (HML), the momentum factor (UMD), the profitability factor
(RMW), and the investment factor (CMA). In addition, we also run a hedge regression with the hedge return between the top and
bottom quintiles as the dependent variable. Figures in italics are tstatistics. */**/*** represent statistical significance using 2 tailed
tests at 10%/ 5%/ 1% levels.
BSCORE Quintile Rm Rf SMB HML UMD RMW CMA Adj. R2
Panel A: Fama French 3-Factor Model
Bottom Quintile 0.185 0.745 0.345 0.747 55.3%
*** *** ***
0.81 14.25 4.91 10.07
Middle Quintiles 0.198 0.691 0.286 0.731 64.2%
*** *** ***
1.11 17.09 5.26 12.75
Top Quintile 0.422 0.625 0.258 0.621 62.1%
*** *** *** ***
2.55 16.59 5.09 11.61
Top - Bottom 0.607 0.120 0.087 0.126 6.91%
*** *** * ***
4.07 3.53 1.91 2.62
Panel B: Carhart 4-Factor Model
Bottom Quintile 0.079 0.689 0.366 0.703 0.136 56.8%
*** *** *** ***
0.35 12.62 5.27 9.46 3.03
Middle Quintiles 0.242 0.667 0.294 0.713 0.057 64.4%
*** *** ***
1.35 15.60 5.41 12.23 1.61
Top Quintile 0.426 0.623 0.259 0.620 0.005 61.9%
** *** *** ***
2.54 15.53 5.07 11.34 0.16
Top - Bottom 0.505 0.066 0.107 0.084 0.131 14.26%
* ** *** ***
3.49*** 1.91 2.44 1.78 4.61
Panel C: Fama French 5-Factor Model
Bottom Quintile 0.186 0.744 0.379 0.778 0.068 0.113 55.1%
*** *** ***
0.76 12.25 4.64 7.24 0.56 0.74
Middle Quintiles 0.083 0.734 0.358 0.659 0.216 0.040 64.7%
*** *** *** **
0.44 15.78 5.72 8.01 2.34 0.34
Top Quintile 0.264 0.685 0.345 0.511 0.272 0.098 63.4%
*** *** *** ***
1.53 15.95 5.97 6.72 3.18 0.91
Top - Bottom 0.450 0.059 0.034 0.267 0.204 0.211 9.81%
*** *** *** **
2.90 1.53 0.66 3.90 2.65 2.18
45
TABLE 8. Relation between BSCORE and Future Forecast Surprises, Announcement Period
Returns and Delistings
BSCORE is the sum of the signals B1:B13. For definitions of B1:B13 see the Appendix A. The sample is partitioned each year
into quintiles based on BSCORE. We consider three portfolios the top quintile, the three middle quintiles and the bottom quintile.
EA_RET is the average marketadjusted return around earnings announcements, using the 12 trading days around the earnings
announcement dates (RDQ) in the following year, using the CRSP valueweighted index for market returns. SURP A1 is the annual
forecast surprise, measured as the difference between actual EPS and consensus mean annual EPS forecast issued three months
after fiscal year end. SURP Q1Q4 is the quarterly forecast surprise, measured as the difference between actual quarterly EPS and
consensus quarterly EPS, measured two months after prior quarter end. All surprise variables are scaled by stock price at the end
of the fiscal year. For Panel B, we use the classification in Shumway (1994) to identify delistings associated with poor performance
in the year after BSCORE computation.
46
TABLE 9. Returns to an Investment Strategy based on BSCORE Interacted with V/P
This tables repeats the analysis from prior tables, by further conditioning on the V/P ratio. For all firms in the sample, the V/P ratio
is calculated using the methodology described in Appendix B. Firms in the top quintile are included only if they have above median
V/P ratios, while firms in the bottom quintiles are only considered if they have below median V/P ratios. Please see headers to
Tables 4, 6 and 7 for details.
RET1 RET1
FYEAR NLONG NSHORT
(top BSCORE quintile) (bottom BSCORE quintile) HRET1
48