Putting a value on banks
A pure DCF model cannot be used directly in valuing a bank, for which notions of capital employed and debt are irrelevant. Valuation of equity can therefore only be done directly (either through discounted cash flow to equity or by a multiple). The main valuation models are as follows:
- Discounting models are generally based on net profit
after rebuilding of a minimum solvency ratio.
A bank is required to set aside a certain amount of capital to mitigate the risk it takes when lending money. The so-called "Tier 1" ratio is approximately equivalent to capital / risk-weighted assets (i.e. the banks' outstanding loans weighted by the risk presented by each client; e.g. from 0% for the French state to 100% for a company). Over and above the regulatory requirements, banks maintain a reasonable Tier 1 ratio to be able to obtain funding on decent terms (a bank's rating and thus its cost of funding, depends mostly on its Tier 1 ratio).
The valuation model is thus tantamount to: 1) projecting the bank's net profit (particularly in projecting the loans it will make and the margin it will make on these loans, but also its personnel costs, etc.); and 2) to estimating the bank's minimum capital requirement at the end of each year (having first estimated the bank's risk-weighted assets and thus its Tier 1 ratio target). It is then assumed that the bank will then set aside what it needs for its minimum capital requirement and will distribute the rest. Discounting this "distributable" income results in an equity valuation.
- Transaction multiples (generally P/Es or PBR) to
estimate the value of control.
- Listed comparables, in which case the most reliable
method is a regression (ROE vs. PBR). Then, based on the return on equity
of the bank to be valued, it is possible to deduce a bank's book value multiple
and thus its value from the point of view of a marginal transaction.
- Net asset value is also used very often, given the importance of assets in banking. It is then equal to the sum of its parts.