Valuation Of Banks

Garima,Jeetesh,Laxmi,Nilanjana

Introduction

The valuation of a bank is an estimation of its market

value in terms of money on a certain date, taking into

account the factors of aggregate risk, time and

income expectations.

Therefore, it requires specific expertise in two

special subjects:

an in-depth knowledge of valuation techniques

understanding of the banking industry and the bank-

specific characteristics of valuation.

2

Challenges

Banks, insurance companies and other financial service firms pose particular challenges for an analyst attempting to value them for two reasons.

The nature of their businesses makes it difficult to define both debt and reinvestment, making the estimation of cash flows much more difficult.

Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material.

They tend to be heavily regulated and the effects of regulatory requirements on value have to be considered.

Maintain capital ratios

Constrained in terms of where they can invest their funds

Entry of new firms into the business is often restricted 3

GENERAL FRAMEWORK FOR VALUATION

More practical to value equity directly at Banks, rather than the entire firm most of the times, as free cash flow calculation is difficult.

Equity Value is estimated by discounting cash flows to equity investors at the cost of equity.

Either need a measure of cash flow that does not require estimation of reinvestment needs or redefine reinvestment to make it more meaningful for a financial service firm like a bank.

When valuing or analysing a bank, distinction between the bank’s borrowing for the purpose of making loans and the bank’s permanent debt, which may not be always possible.

4

Income Method

Basic Dividend Discount Method

Gordon Growth Model

FCF Method

Enterprise Value Method

Dividend Discount Model

Used to value only the equity part instead of valuing

entire firm

Dividend discount model defines cash flows as

dividends

Model accounts for reinvested earnings when it

takes all future dividends into account.

Less sensitive to short-run fluctuations in underlying

value than alternative DCF models.

The Basic Model

Value per share of equity -

where,

= Expected dividend per share in period t

= Cost of equity

Source – Valuation of Banks By Aswath Damodaran

Gorgon Growth Dividend Discount Model

If expected growth rate in dividends is constant

forever, then,

Value per share of equity in stable growth =

where,

DPS1 = expected dividend in next year

g = expected growth rate in perpetuity

Gordon Growth Model

If dividends are growing at a rate which is not

expected to be sustainable or constant forever then,

Value per share of equity in extraordinary growth =

+

where,

gn = expected growth rate after n years

hg = high growth period

st = stable growth period

Source – Valuation of Banks By Aswath Damodaran

Estimation Notes in Valuation of Banks

Use bottom-up betas

Do not adjust for financial leverage

Adjust for regulatory and business risk

Consider the relationship between risk and growth

Source – Valuation of Banks By Aswath Damodaran

Stable Growth Dividend Discount Model

– Citigroup (2000)

Modified Payout Ratio = 56.4%

Earnings estimate (2000) = $13.9 billion

Sustainable Growth Rate Estimate = 5%

Beta = 1

Risk Free Rate = 5.1%

Risk Premium = 4%

Source – Valuation of Banks By Aswath Damodaran

Stable Growth Dividend Discount Model

– Citigroup (2000)

Cost of equity for Citigroup = 5.1% + 1.00 (4%) =

9.1%

Value of Citigroup’s equity=

= $13.993 (1.05) (0.564)/(0.091-0.05)

= $202.113 billion

Enterprise Valuation Model

Source : Benninga/Sarig, Valuing financial

institutions

13

The balance sheet is rewritten by moving the current liabilities from the liabilities/equity side to the asset side of the balance sheet:

Thus to value a company,

Market value = Initial cash balances FCF + SUM (FCF)/ (1+WACC) ^ t

If we are valuing the equity of the firm, we subtract the value of the debt.

Equity value = market value – debt

Applying this to banks

Most marketable securities (and some of the cash) is an operating current asset.

Debt = Long-term debt + Notes payable + Current portion of LTD +...

For a bank, most short-term debt items are operating current liabilities and are therefore part of the bank’s working capital

ENTERPRISE VALUATION MODEL

ORIGINAL BALANCE SHEET

Assets Liabilities

Cash and marketable

securities

Operating current liabilities

Operating current assets Debt

Net fixed assets Equity

Goodwill

Total assets Total liabilities and equity

THE ENTERPRISE VALUATION "BALANCE SHEET"

Assets Liabilities

Cash and marketable

securities

Operating current assets Debt

- Operating current

liabilities

= Net working capital

Net fixed assets Equity

Goodwill

Market value Market value

Free Cash Flow Model

Free Cash Flow calculation for a Financial Company

Item Explanation

Profit after taxes Depreciation is usually not a very significant item

Add back depreciation This leaves the net interest income on the bank’s

productive activities—its financial intermediation

Add back after-tax

interest on permanent

debt items (typically Long-Term debt)

Subtract out increases in

operating NWC

Since we define the NWC to include deposits, etc.,

this effectively subtracts the self-funded part of the

banks operations from the FCF

Subtract increases in

Fixed Assets at Cost

Note that Fixed Assets for banks are typically small

relative to total assets

=Free Cash Flow

Source : Benninga/Sarig, Valuing financial

institutions

14

Example Valuation of a bank

Year -1 Year -2 Year -2

Profit after taxes 172138 178050 185165

Add back depreciation 35673 39636 44040

Add back after-tax interest on permanent debt 117

Changes in operating Net Working Capital

Subtract increases in Cash 13210 20002 21002

Subtract increases in Fixed Assets at Cost 73772 39636 44040

Free cash flow 120947 158165 164280

Risk-free rate 6.19%

Market risk premium 10.57%

Discount rate 13.53%

Projected FCF growth 10.57%

Terminal growth rate of FCF 5.00%

Year - 1 Year -2 Year -3

Free Cash Flow 120947 158165 164280

Terminal value 22,24,259

Value of Bank 17,20,203

Long-term debt 2,826

Other liabilities 1,26,126

Implied equity value 15,91,251

Number of Small Bank shares 3,24,06,000

Imputed per-share value of Small Bank 49.1

Following Assumptions for growth were taken and beta = .9.

Source : Benninga/Sarig, Valuing financial

institutions

15

Cash flow to Equity Model

The difficulty in estimating cash flows when net capital expenditures and non-cash working capital cannot be easily identified. It is possible, however, to estimate cash flows to equity even

for financial service firms if we define reinvestment differently.

The cash flow to equity is the cash flow left over for equity investors after debt payments have been made and reinvestment needs met.

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 capital16

Calculation TreatmentCapitalize Training and Employee Development Expenses

• Identify the amortizable life for the asset

• Collect information on employee expenses in prior years

• Compute the current year’s amortization expense

• Adjust the net income for the firm

- Adjusted Net Income = Reported Net income + Employee development expense in the current year – Amortization of the employee expenses (from step 3)

• Compute the value of the human capital

Investments in Regulatory Capital

• For a financial service firm that is regulated based upon capital ratios, equity earnings that are not paid out increase the equity capital of the firm and allow it to expand its activities

For instance, a bank that has a 5% equity capital ratio can make $100 in loans for every $5 in equity capital. When this bank reports net income of $15 million and pays out only $5 million, it is increasing its equity capital by $10 million. This, in turn, will allow it to make $200 million in additional loans and presumably increase its growth rate in future periods

• Look at the equity capital ratios of the firm over time and compare them to the regulatory constraints.

Source : Benninga/Sarig, Valuing financial

institutions

17

Asset Based Valuation

Equity Value of a Bank = Value of the Loan Portfolio

(assets of the bank) – Market Value of Debt & other

outstanding claims.

Value of the loan portfolio = Price at which the loan

portfolio can be sold to other financial firm OR

Value of loan portfolio = Present value of expected

future cash flows.

Source – Valuation of Banks By Aswath Damodaran

Example

Loan Portfolio = $1 billion

Weighted average maturity = 8 years

Interest Income per year = $70 million

Fair market interest rates (considering default rates)

= 6.50%

Value of loans= $70 million (PV of annuity, 8

years, 6.5%) + PV of $1 billion (at 6.5%, 8years) =

$1030 million.

Source – Valuation of Banks By Aswath Damodaran

Relative Valuation Method

Price to Earning Ratio

Price to Book Value Ratio

Price to Earnings Ratio

PE ratio is a function of expected growth rate of

earnings, pay out and cost of equity

Depend on the conservatism of bank in classification

of NPA

Effects on Net Income lead to variation in PE ratio

Ratio comparison

Bank Ratio 2012 2011

SBI PE 10.86 13.54

SBI Price to BV 1.51 1.54

HDFC PE 23.1 30.3

HDCF Price to BV 4.66 4.1

http://www.business-standard.com/content/research_pdf/hdfcbank_200711_01.pdf

Price to Book Value Ratio

Price to Book Value depend on

growth rates in earnings

payout ratios

costs of equity

returns on equity

Strength of the relationship between price to book

ratios and ROE should be stronger for financial

service

ROE is less likely to be affected by accounting

decisions

Asset Based Method

Advantages

Simple for

understanding and

practical usage

Does not require

guesswork and

assumptions

Disadvantages

The most simplified

valuation model

Requires access to all

of the bank’s internal

data

Does not consider the

long-term development

perspectives

Relative Valuation Method

Advantages

Uses actual data

Simple application

(derives estimates of

value from relatively

simple financial ratios)

Does not rely on explicit

forecasts

Disadvantages

Most of the important assumptions are

Hidden

No good guideline companies exist

Laborious and time-consuming

Based on the present situation, resulting in losing long-term trends

Income Approach

Advantages

Flexible for changes

Considers future

expectations

Considers market

performance (through

excess return on

market)

Disadvantages

Controversial results

Requires estimates of

appropriate discount

rates Partially based on

probabilities and

expertise

Problems with

application in the

emerging markets

The valuation results

can be easily

manipulated

The Black-Scholes ModelTo calculate a theoretical call price

- Using determinants like:

Stock price

Strike price

Volatility

Time to expiration

Short term(risk free) interest rate

The original formula for calculating the theoretical option price (OP) is as follows:

Where, S = stock price

X = strike price

t = time remaining until expiration, expressed as a

percent of a year

r = current continuously compounded risk-free

interest rate

v = annual volatility of stock price (the standard

deviation of the short-term returns over one year).

N(x) = standard normal cumulative distribution

function

The binomial model

Breaks down the time to expiration into potentially a very

large number of time intervals

At each step it is assumed that the stock price will move

up or down by an amount calculated using volatility and

time to expiration which produces a binomial distribution

or recombining tree of underlying stock prices

Next the option prices at each step of the tree are

calculated working back from expiration to the present

Excess return model

In the present value of excess returns that the firm

expects to make in the future

Value of Equity = Equity Capital invested currently +

Present Value of Expected Excess Returns to Equity

investors

Two inputs needed for this model:

- Measure of equity capital currently invested in the firm.

- Expected excess returns to equity investors in future

periods

is model, the value of a firm can be written as the sum of

capital invested currently in the firm and the

Regulatory Overlay

Banks required to maintain regulatory capital ratios

Ratios are computed based upon the book value of

equity and their operations

They are to ensure that they do not go beyond their

means

RBI has set guidelines for investment activities for a

bank