Topic 3 - Bank Valuations _Final_.pdf - TOPICS IN BANKING AND TREASURY MANAGEMENT TOPIC 3 – BANK VALUATIONS Principles of Valuation • Cannot usually

Topic 3 - Bank Valuations _Final_.pdf - TOPICS IN BANKING...

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TOPICS IN BANKING AND TREASURY MANAGEMENT TOPIC 3 BANK VALUATIONS
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Principles of Valuation Cannot usually apply basic principles of valuation as easily to financial services firms because: EBITDA loses its meaning as interest is a contributor to both revenue and expenses. The balance sheet drives value – banks’ growth is driven by loans (interest -earning) and deposits (interest-bearing) rather than sales (income statement driven). Differentiating between operating and financing activities is complicated because interest and debt are related to the company’s operations (i.e. they’re not purely financing activities). This means “working capital” and “free cash flow” are no longer applicable. Because of the issues around debt, Equity Value is more meaningful than Enterprise Value (Debt + Equity). FI firms mark-to-market daily this has implications for things like book value. Regulatory requirements mean banks must maintain minimum amounts of capital at all times and this creates constraints when forecasting within the valuation model.
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The Challenges: Accounting Rules Assets of financial services firms tend to be financial instruments which trade daily; as a consequence, they tend to mark to market more than other firms. This makes it difficult to compare ratios such as book-to-market ratio and ROE between financial firms and nonfinancial firms who work with historical figures. Financial services firms also tend to have long periods of profitability followed by short periods of large losses (this is the nature of the market). Banks smooth their earnings by making provisions for losses on their loan advances this gives banks a lot more control over their bottom line than other firms. Source: Damodaran, 2013
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The Challenges: Debt and Equity Only two ways to raise funds for a firm debt or equity. For banks, debt is really a raw material, a tool to generate profit (as it finances their loans) Defining debt is also harder for banks; e.g. are deposits by customers into their cheque accounts debt? If so, the operating cash flows of the bank should be measured prior to the interest paid on these accounts as per FCF valuation methods; but this interest expense is usually the single biggest expense item for a bank (i.e. you would be overstating your cash flows using FCF). Banks tend to have more debt by nature than normal firms and therefore significantly higher leverage; this means that small changes in assets can have much bigger impacts on equity. Source: Damodaran, 2013
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The Challenges: Estimating Cash Flows Reinvestment ( Capex ) and working capital investment are two key aspects of free cash flow valuation. While banks do have PPE, their primary operating investments are in intangible assets such as brand name and human capital; they therefore tend to have minimal capex and depreciation .
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