Valuing Financial Service Firms – Lessons learned from Damondaran’s Investment Valuation (2rd ed) – calculate PBV of BAC and AIG, also factor in all important factors
My action – calculate PBV of BAC and AIG, also factor in all important factors
Valuation methods:
- Dividend discount model
- Cash flow to equity model
- Asset-based valuation
- Relative valuation: PE, PBV (ROE) – this is the key method
Categories of financial service firms:
- bank – makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it, and from other services it offers it depositors and its lenders.
- insurance companies – make their income in two ways. One is through the premiums they receive from those who buy insurance protection from them and the other is income from the investment portfolios that they maintain to service the claims.
- investment bank – provides advice and supporting products for other firms
to raise capital from financial markets or to consummate deals such as acquisitions or
divestitures. - Investment firms – provide investment advice or manage portfolios for clients. Their income comes from advisory fees for the advice and management and sales fees for investment portfolios.
- Thrift banks – financial institutions that have a primary focus on taking deposits and originating home mortgages. One major factor that differentiates thrift banks from larger commercial banks such as Wells Fargo & Company or Bank of America Corporation is that thrifts generally have access to low-cost funding from Federal Home Loan Banks, which enables them to offer customers higher savings account yields. Thrifts also have greater liquidity for making home mortgage loans. Read more: Thrift Bank Definition | Investopedia http://www.investopedia.com/terms/t/thriftbank.asp#ixzz4FHnN36B9
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What is unique about financial service firms?
- Debt: Raw Material or Source of Capital
- The first is that debt, for a financial service firm, is difficult to define and measure, making it difficult to estimate firm value or costs of capital. Consequently, it is far easier to value the equity directly in a financial service firm, by discounting cash flows to equity at the cost of equity. The second is that capital expenditures and working capital, which are required inputs to estimating cash flows, are often not easily estimated at financial service firms.
- The Regulatory Overlay: First, banks and insurance companies are required to maintain capital ratios to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are often constrained in terms of where they can invest their funds. For instance, until recently, the Glass-Steagall act in the United States restricted commercial banks from investment banking activities and from taking active equity positions in manufacturing firms. Third, entry of new firms into the business is often restricted by the regulatory authorities, as are mergers between existing firms. Why does this matter? From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints. There might also be implications for how we measure risk at financial service firms. If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, which can have an effect on value.
- Reinvestment at Financial Service Firms: Note that in Chapter 10, we consider two items in reinvestment – net capital expenditures and working capital. Unfortunately, measuring either of these items at a financial service firm can be problematic.
General Framework for Valuation
- Dividend Discount Model
If the return on equity is not expected to change over time,
Expected Growth in EPS = Retention ratio * Return on equity
If the return on equity is expected to change over time, the expected
growth rate in earnings per share can be written as:
Expected GrowthEPS = (Retation Ratio) (ROE t+1)+ (ROE t+1 – ROEt)/ROEt
In both formulations, the expected growth rate is a function of the retention ratio,
which measures the quantity of reinvestment, and the return on equity, which
measures their quality.
Valuing a Non-dividend Paying Financial Service Firm
- Cash Flow to Equity model
Defining Cashflow to Equity: With financial service firms, the reinvestment generally does not take the form of plant, equipment or other fixed assets. Instead, the investment is in human capital and regulatory capital; the latter is the capital as defined by the regulatory authorities, which, in turn, determines the limits on future growth. There are ways in which we could incorporate both of these items into the reinvestment.
- Excess Return Models
The third approach to valuing financial service firms is to use an excess return model. In such a model, the value of a firm can be written as the sum of capital invested currently in the firm and the present value of dollar excess returns that the firm expects to make in the future.
- Asset Based Valuation
In asset based valuation, we value the existing assets of a financial service firm, net
out debt and other outstanding claims and report the difference as the value of equity.
- Relative Valuation – Key method
Choices in Multiples
Firm value multiples such as Value to EBITDA or Value to EBIT cannot be easily
adapted to value financial service firms, because neither value nor operating income can be easily estimated for banks or insurance companies. In keeping with our emphasis on
equity valuation for financial service firms, the multiples that we will work with to
analyze financial service firms are equity multiples. The three most widely used equity
multiples are price earnings ratios, price to book value ratios and price to sales ratios.
Since sales or revenues are not really measurable for financial service firms, price to sales
ratios cannot be estimated or used for these firms. We will look, in this section, at the use
of price earnings and price to book value ratios for valuing financial service firms.
Price Earnings Ratios
The price earnings ratio for a bank or insurance companies is measured much the
same as it is for any other firm. The price earnings ratio is a function of three variables – the expected growth rate in earnings, the payout ratio and the cost of equity.
An issue that is specific to financial service firms is the use of provisions for
expected expenses.
Another consideration in the use of earnings multiples is the diversification of
financial service firms into multiple businesses. The multiple that an investor is willing to
pay for a dollar in earnings from commercial lending should be very different than the
multiple that the same investor is will to pay for a dollar in earnings from trading. When a
firm is in multiple businesses with different risk, growth and return characteristics, it is
very difficult to find truly comparable firms and to compare the multiples of earnings
paid across firms. In such a case, it makes far more sense to break the firm’s earnings
down by business and assess the value of each business separately.
Price to Book Value Ratios
The price to book value ratio for a financial service firm is the ratio of the price
per share to the book value of equity per share.
PBV is determined by the variables – the expected growth rate in earnings per share, the dividend payout ratio, the cost of equity and the return on equity. Other thing remaining equal, higher growth rates in earnings, higher payout ratios, lower costs of equity and higher returns on equity should all result in higher price to book ratios. Of these four variable, the return on equity has the biggest impact on the price to book ratio, leading us to identify it as the companion variable for the ratio.
How to determine the ROE: page 283 ~P288 (leverage will affect ROE)
Issues in Valuing Financial Service Firms
- Provisions for Losses
Banks and insurance companies often set aside provisions to meet future losses.
These provisions reduce net income in the current period but are used to meet expected losses in future periods. - Regulatory Risk and Value
As we have noted in this chapter, financial service firms are much more likely to
be regulated. This regulation can affect the perceived risk of investing in these firms as
well as the expected cash flows. - Financing Mix and Value
When analyzing manufacturing firms, we looked at the effect of changing the mix
of debt and equity used by the firm for funding on value. With financial service firms, we generally do not examine the financing mix question for two reasons. One is the aforementioned difficulty of defining and measuring debt. The other is that financial service firms tend to use as much debt as they can afford to carry, making it very unlikely that they will be significantly underlevered or overlevered. - Subsidies and Constraints
In many markets, banks and insurance companies operate under systems where
they derive special benefits because of subsidies and exclusive rights that they are granted, while at the same time being forced to make investments at below-market rates in what are viewed as socially desirable investments. Both subsidies and social investments affect value and can be incorporated into cash flows.
