Finfirm - 1 VALUING FINANCIAL SERVICE FIRMS Banks insurance companies and other financial service firms pose a particular challenge for an analyst

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1 VALUING FINANCIAL SERVICE FIRMS Banks, insurance companies and other financial service firms pose a particular challenge for an analyst attempting to value them for two reasons. The first is the nature of their businesses makes it difficult to define both debt and reinvestments, making the estimation of cash flows much more difficult. The other is that they tend to be heavily regulated, and the effects of regulatory requirements on value have to be considered. In this chapter, we begin by considering what makes financial service firms unique and ways of dealing with the differences. We then look at how best we can adapt discounted cash flow models to value financial service firms, and look at three alternatives – a traditional dividend discount model, a cash flow to equity discount model and an excess return model. With each, we look at a variety of examples from the financial services arena. We move on to look at how relative valuation works with financial service firms, and what multiples may work best with these firms. In the last part of the chapter, we examine a series of issues that, if not specific to, are accentuated in financial service firms ranging from the effect of changes in regulatory requirements on risk and value to how best to consider the quality of loan portfolios at banks. Categories of financial service firms Any firm that provides financial products and services to individuals or other firms can be categorized as a financial service firm. We would categorize financial service businesses into four groups from the perspective of how they make their money. A bank makes money on the spread between the interest it pays to those from who it raises funds and the interest it charges those who borrow from it, and from other services it offers it 1 For purposes of simplicity, it has been assumed that the cash flow is the same in each year. This can be generalized to allow cash flows to grow over time.
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2 depositors and its lenders. Insurance companies make their income in two ways. One is through the premiums they receive from those who buy claims from them and the other is income from the investment portfolios that they maintain to service these claims. An investment bank provides advice and supporting products for non-financial service 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. With the consolidation in the financial services sector, an increasing number of firms operate in more than one of these businesses. For example, Citigroup, created by the merger of Travelers and Citicorp operates in all four businesses. At the same time, however, there remain a large number of small banks, boutique investment banks and specialized insurance firms that still derive the bulk of their income from one source. How big is the financial services sector in the United States? Figure 21.1
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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Finfirm - 1 VALUING FINANCIAL SERVICE FIRMS Banks insurance companies and other financial service firms pose a particular challenge for an analyst

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