Untangling the Valuation of Banks: some useful hints

@Hunton & Williams

Valuation is undoubtedly one of the most fascinating and, at the same time, complex and problematic themes in Corporate Finance, bewildering students, researchers, financial advisors and investors. Bank’s valuation is undoubtedly one of the most relevant topics in modern economies, given their systemic importance and given the importance that valuation have in influencing their stock performances. Although as you may know the valuation of banks is based on the same principles as that of other more typical companies, there are undoubtedly different rules to apply.

The Fundamentals of Valuation

Every asset can be valued, the main differences are in the assumptions made in valuing it, depending on its peculiarities. On the contrary, valuation methodologies are based on common fundamental pillars, regardless of the asset type. In this perspective, I am intentionally ignoring the supporters of the so-called “bigger fool theory” which states that the proper value of an asset depends on the presence or not of somebody (the bigger fool) who is willing to buy the mentioned asset at a higher price.

In general, there are two main methodologies to follow when valuing companies and assets in general (this analysis is simplistic on purpose, how could I be able to synthetize the whole corporate finance theory in one article?!?!?):

  • Intrinsic Valuation
  • Relative Valuation

Intrinsic valuation comprises all the models based on valuing an asset estimating the present value of the cash flows that it generates. In general, under this perspective you need two things: you have to make assumptions on the future cash flows generation capacity and you have to understand how variable these cash flows can be, in order to identify the most suitable cost of capital to be used to estimate their present value.  This approach is defined as intrinsic since it is based on a company fundamentals and basically on your estimates, regardless of what other people (“the market”) are thinking. The most used present value models are based on the estimates of operating free cash flows or dividends to be discounted at the appropriate cost of capital (WACC or Ke, see Damodaran, Investment Valuation)

The second main pillar is Relative Valuation, which, on the contrary, totally depends on what happens around you. The value of an asset is estimated based on how similar assets are regularly priced or have been priced in some occasions, making prices comparable using variables such as earnings, revenues etc.  The main strong assumption here is that, on average, what is happening around you in the marketplace is somehow correct and rational.  In addition, here it is assumed that what you are valuing is comparable to what the market is valuing somewhere else or has valued in the past.

Banks Valuation

Is this true for banks? Absolutely. So you might be asking why I am writing about the peculiarities of their valuations if this rules do apply to them. The reality is that the framework is common, but many aspects do differ. Let’s try to understand them.

Knock Knock, anyone called EBITDA here?

No, no EBITDA here. The main peculiarities stem from bank financial statements.  Indeed, typical companies sell product or services and thus generate revenues. Revenues are counterbalanced by operating costs, making it possible to estimate operating profits and then, after some adjustments (Capex, Working Capital etc.), to define operating cash flows. Their balance sheets contain the assets that are used to carry on these operating activities, but the main driver is undoubtedly the P&L. This could not be more different for banks. Main drivers in their activities are indeed assets, loans and deposits in particular. They get resources from customers (deposits), pay a defined interest rate on it and they lend them at a higher interest rate. The main component of their income is thus defined as Net Interest Margin, given by the spread between the interest at which they lend money and the one at which they borrow it. The second most important source of income (much more relevant in the current low-interest rates environment) are fees deriving from services to clients (both retail and corporate).

Thus, what are the main implications?

  • The separation between operating and financial activities is not only impossible, but also wrong. Interest income and expenses are the real core elements of banks ‘operations.
  • Debt is not a real liability to be raised to finance their activity, but on the contrary, is part of the operating activity itself, since it generates operating expenses.

What Intrinsic Valuation?

Since debt is irrelevant, is it meaningful to speak about enterprise value (EV= Equity Value + Net Financial Debt)? No, not at all, thus the only cash flows that can be estimated are equity-related, thus here comes the old Dividend Discount Model as main cash flow model.

What Relative Valuation?

Having said that EV is not relevant, the only multiples that should be used are equity ones. Price / Earnings (typically forward + 1 or + 2), Price / BV or TBV are the most commonly used.

Based on the two main pillars here defined, it is also possible to identify other more elaborated methodologies to value banks, such as the regression analysis

Regressions analysis can be used to position a bank to a certain P / TBV level, analysing its Return on Equity (ROE) or Return on Tangible Equity (ROTE). Regressions allow thus to value a private bank or to analyse if a listed one is currently undervalued or overvalued compared to listed peers.

Is it all clear?

Of course not, this topic is extremely variegated, but at least, this framework might be useful as a first approach to financial institutions valuations. What however is to essential to incorporate into this methodologies is the role of regulations. Unlike regular sectors, financial systems are regulated and are thus not completely market-ruled. Capital adequacy, leverage and liquidity ratios are only few examples of all the many constraints banks should comply with and are inevitably bound to affect their valuation. But this will be treated in my next article. Stay tuned bankers!

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