Abstract
In common with other financial institutions, banks exhibit some specific features relative to industrial companies. This has led the analyst community to opt for certain valuation methods rather than others, over the years. In this chapter, we investigate the most common methodologies used by analysts in valuing Banks in going concern status. The warranted equity value (WEV) method, an adaptation of the EVA approach, is used to value both the entity as a whole or individual business areas in a sum-of-the-parts. It responds to the need to take a bank’s capital absorption and capital position into account. The DDM is a universal method which suits banks as well as industrials. And so is the free cash flow to equity (FCFE), in a sense an expansion of the DDM in that it adds potential dividends to actual dividends.
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Notes
- 1.
A. Damodaran, Investment valuation, Chap. 21, where the author states that some banks see debt as “raw material” to be transformed into high value-added financial products to be sold to clients. Indeed, we notice the statement made by a UK bank’s head of mortgages in the wake of the turmoil in the mortgage market of September 2022, as reported by the Financial Times: “we were taken aback by how quickly some people withdrew their products”. “if you are a supplier of any product and relying on raw materials, you have a period of time in which you should be planning. You shouldn’t need to act in a knee-jerk way”.
- 2.
A. Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of any Asset, University Edition, Wiley, Chap. 14 (free cash flow to equity discount models) and Chap. 15 (free cash flow to the firm), Wiley Finance Series, April 2012. And, by the same author: https://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/fcff.pdf
- 3.
Damodaran: Investment valuation, Wiley finance, University edition, Chap. 21 (Valuing financial services firms). According to the author, many banks see financial debt as a sort of “raw material”, to be moulded into higher value financial products.
- 4.
A. Damodaran: Investment valuation, Wiley finance, University edition, Chap. 21 (Valuing financial services firms), Chap. 12 (estimating terminal value), and Chap. 13 (Dividend discount models). Also, See Koller, Tim, Goedhart, Marc, Wessels, David (McKinsey & co.): Valuation: measuring and managing the value of companies, Chap. 14 (estimating continuing value).
- 5.
A Damodaran: Investment valuation, Chap. 14 (Free cash flow to equity discount models)
- 6.
Market price divided by earnings per share. These can be estimates of future years’ earnings, in which case we will have a forward PE, or data from the past, in which case we have a trailing PE. PE ratios along with P/TE are arguably the most popular ratios to compare banks’ market valuation.
- 7.
A. Damodaran, Investment valuation, Chap. 14. FCFE Valuation versus Dividend Discount Model Valuation.
- 8.
Forward and trailing PE—see Glossary for definitions.
- 9.
BIS: LCR is designed to ensure that banks hold a sufficient reserve of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days. HQLA are cash or assets that can be converted into cash quickly through sales (or by being pledged as collateral) with no significant loss of value.
- 10.
BIS: NSFR is defined as the amount of available stable funding relative to the amount of required stable funding. This ratio should be equal to at least 100% on an ongoing basis.
- 11.
J. A. Soler Martin, S. Carbo Valverde: market value of banks, an international comparison, Madrid, April 2020. https://biblioteca.cunef.edu/files/documentos/TFG_Jose_Antonio_Soler_Martin.pdf
- 12.
See T. Koller, M. Goodhart, D. Wessels (Mc Kinsey & co.): Valuation: measuring and managing the value of companies, Chap. 26 (inflation).
- 13.
ECB working paper series (September 2018): Who bears interest rate risk?
- 14.
HSBC Global Research, Greek banks, July 2020
- 15.
For Economic Value added, see: A. Damodaran, Investment valuation, Chap. 32; And T. Koller, M. Goedhart, D. Wessels (McKinsey): Valuation (1990), Chap. 38. The authors define value added in the banking sector in an interesting way: value added on loans, for instance, is defined as (a) net interest margin less (b) MOR (matched opportunity rate), i.e. the return that the bank could have earned on investments with a similar duration and risk profile less (c) a tax penalty on required equity capital and on the portion of loans funded by equity.
- 16.
see: A. Damodaran, Investment valuation, Chap. 21; excess return models.
- 17.
- 18.
- 19.
See T. Koller, M. Goedhart, D. Wessels (McKinsey & co.): Valuation: measuring and managing the value of companies, appendix A (discounted economic profit equals discounted free cash flow)
- 20.
It should be borne in mind that the analyst should use perspective betas for valuation. Historical betas should be seen as a useful starting point but not necessarily accepted and used as God’s immutable will, as some analysts seem want to do.
- 21.
See T. Koller, M. Goedhart, D. Wessels (McKinsey & co.): Valuation: measuring and managing the value of companies, Appendix G, where the (historical)global risk premium is calculated to be 4.5% for the years 1967–2016 and 4.2% for 1900–2016. T bills are used as the risk-free asset.
On the cost of equity, see also: A Damodaran, Investment valuation, Chap. 4 (estimating risk parameters and cost of financing), Chap. 7 (riskless rates and risk premiums), & Chap. 8 (the cost of equity and capital).
Reference
Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and managing the value of companies. McKinsey & Co..
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Santoni, A., Salerno, F. (2023). Valuing a Bank in Going Concern. In: How to Value a Bank. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-031-43872-1_3
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