- the latitude managers have with respect to accounting decisions,
- lack of transparency,
- the level of leverage, and
- the fact that banks are multibusiness companies.
Those businesses include
- borrowing and lending,
- underwriting and placement of securities,
- payment services,
- asset management,
- proprietary trading, and
DCF on operations approach is not appropriate
In valuing a bank, a discounted cash flow (DCF) on operations approach is not appropriate because interest rates revenue, and costs, are part of operating income.
Equity DCF method is more appropriate
The equity DCF method is more appropriate, and the analyst should triangulate the results with a multiples-based valuation.
The equity approach uses a modified version of the value driver formula in which
- return on equity (ROE) and return on new equity (RONE) replace ROIC and RONIC, and
- net income replaces NOPLAT:
ke = cost of equity
Problems and complications in bank valuations
Problems associated with applying the equity DCF valuation method include
- determining the source of value,
- the effect of leverage, and
- the cost of holding equity capital.
Economic spread analysis can help determine the sources of value creation.
Other complications in bank valuations are
- monitoring the yield curve and forward rates,
- estimating loan loss provisions,
- approximating the bank's equity risk capital needs, and
- constructing separate statements for each of the bank's activities.