Valuing Banks

There are four complications in the valuation of banks:

1. the latitude managers have with respect to accounting decisions,
2. lack of transparency,
3. the level of leverage, and 
4. the fact that banks are multibusiness companies.

Those businesses include

1. borrowing and lending,
2. underwriting and placement of securities,
3. payment services, 
4. asset management, 
5. proprietary trading, and 
6. brokerage.

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:

Current Value at time t = Net Income at time t+1  *  [1 - (g/RONE)] / ke - g

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.