What it means
Shareholders' equity is the difference between a company's assets and its liabilities. Two adjustments are made to find tangible common equity.
First, preferred shares are removed because their holders rank ahead of common shareholders. Second, goodwill and other intangible assets are removed because they may not be worth anything in a crisis.
The measure is popular for banks because their balance sheets contain large amounts of goodwill from past acquisitions. Goodwill cannot absorb a loan loss or be sold to repay depositors.
Tangible common equity strips it away and shows the cushion that is actually available. Analysts use it to compare banks fairly, since two banks with similar reported equity can have very different tangible equity.
A bank that has grown by buying other banks may carry a lot of goodwill and so have a thinner cushion than it appears. Investors then ask whether the share price is justified by that tangible cushion, since the market will usually pay more than the cushion only when it expects good profits.
Regulators use their own formal capital measures, so tangible common equity is an analyst's tool and not a legal requirement. For a non-specialist, the simplest way to read the figure is as the hard cushion under the common shareholders.
If losses exceed it, the shareholders' stake is gone, and attention turns to the preferred holders, lenders and depositors. A thicker cushion means the bank can absorb more bad news before anyone else is hurt, and the figure often moves in step with the formal regulatory measures.
Dividing it by the number of shares gives tangible book value per share, a conservative measure widely used to value banks.
In practice
Real-world examples.
Example
An analyst compares two regional banks that each report $2,000,000,000 of equity. One carries $600,000,000 of goodwill and the other carries $100,000,000. On a tangible basis, the second bank has a much stronger cushion.
Example
An investor sees that a bank's shares trade at $9.00 while its tangible book value per share is $7.00. She calculates that she is paying 1.29 times tangible book value, or 9 / 7. She compares that with the bank's earnings and its return on tangible equity to decide whether the premium to tangible book value is fair.
Example
A bank's chief financial officer reviews a planned acquisition that would add $400,000,000 of goodwill. She calculates that tangible common equity would fall by the same amount unless new shares are issued. The board decides to fund part of the deal with new equity so that the bank's cushion stays at the level its investors and regulators expect.
Formula
Calculation
Tangible common equity = total shareholders' equity - preferred equity - goodwill and other intangible assets
Tangible book value per share = tangible common equity / number of common shares
A bank reports total shareholders' equity of $1,200,000,000, including $200,000,000 of preferred shares. It also has $300,000,000 of goodwill and other intangible assets. Tangible common equity = 1,200,000,000 - 200,000,000 - 300,000,000 = $700,000,000. With 100,000,000 common shares in issue, tangible book value per share = 700,000,000 / 100,000,000 = $7.00.Case study
Seen in the real world.
Westmere Bancorp is an illustrative, fictional bank that reported shareholders' equity of $900,000,000 after a series of acquisitions. Of this, $150,000,000 was preferred equity and $350,000,000 was goodwill.
Its tangible common equity was therefore 900,000,000 - 150,000,000 - 350,000,000 = $400,000,000, less than half of the headline equity. When loan losses rose, investors focused on the tangible figure and marked the bank's shares down.
The illustrative bank responded by selling $100,000,000 of new common shares, lifting tangible common equity to $500,000,000. The change reassured investors, although the bank had to accept a lower earnings per share because there were more shares in issue. The finance team now reports tangible common equity alongside the regulatory ratios in every quarterly update.
Watch out
Common mistakes.
- Using total equity to judge a bank's strength, when goodwill and preferred shares may account for a large part of it.
- Forgetting to deduct preferred equity, which belongs to a different class of shareholder.
- Treating tangible common equity as a regulatory capital ratio, when it is an analyst's measure that regulators do not use as their formal test of capital adequacy.
Questions
People also ask.
Why is goodwill removed?
Because it represents the premium paid in past acquisitions and cannot be sold separately to repay depositors or absorb losses, so counting it would overstate the real cushion.
What is tangible book value per share?
It is tangible common equity divided by the number of common shares, a conservative measure of value per share.
Does a higher tangible common equity mean a safer bank?
Generally yes, because it shows a thicker cushion against losses, but it should be viewed alongside the quality of the bank's loans and its liquidity.
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