Valuing Banks

Bank valuation is one of the most difficult topics to address in corporate finance. This is because banks are characterized by business peculiarities that make them a special case for valuation compared with other industrial firms. Although they represent only a small part of the full range of industries, they constitute the cornerstone of economic and financial systems, and a considerable proportion of the index market capitalization of the major developed countries.

We discuss the problems in valuing banks affecting the application of the standard models of valuation used for industrial firms. In particular, we refer to the different roles of debt and capital, the regulatory framework, the provisioning effect and to the issues related to the cash flow measurement (net working capital and capital expenditure determination). In the second part of Chap. 2, we discuss the equity- and asset-side valuation metrics which academic literature and professionals consider the most suitable for banks. For each method, we highlight the main characteristics, the formalization and the advantages or disadvantages in their application.

In this chapter, we discuss the implementation of an asset-side approach in order to overcome the problems of the equity-side models. Unlike non-financial firms, bank deposits generate value. Such an effect is explored by several empirical studies concerning the relation between capital requirements and the weighted average cost of capital (WACC) and, consequently, on a bank’s value. Moreover, in this chapter, we use such empirical evidence to highlight the problems related to the applicability of Modigliani and Miller propositions to the banking industry. Specifically, the main concern of this chapter is to build a new corporate finance theoretical framework for bank valuation, exploring a new issue that represents a relevant gap in the literature. Using the theoretical framework, we elaborate the AMM to highlight the value generated from the unlevered assets, deposits and tax-shields. To do this, we formalize the link between the cost of assets and the WACC, and propose a restatement of the Modigliani and Miller propositions using bank-specific adjustments. Additionally, we compare and reconcile the AMM to excess returns models.

According to the theoretical framework of the AMM, we consider the free cash flow from asset measurement. In particular, we propose a valuation framework which splits bank cash flows into those originating from assets and those from liabilities. Specifically, the most important assumption is that bank debt is considered as a financial liability. This has several implications for the balance sheet, income statement and cash flow reclassifications. For those reasons, we develop a new model for reclassifying a bank’s financial statements in order to obtain a measure of free cash flow from assets. In addition, we reconcile the latter to the free cash flow to equity, taking into account the overall debt financial operations. Such a model reconstruction is very important, as all the current literature directly estimates a cash flow to equity without reconciling it to a cash flow from operations. Our model tries to close this gap in the literature. Besides, in Chap. 3 we proposed a solution to the problems related to the net working capital and capital expenditures estimation of banks. After having discussed the free cash flow model in theory, we propose the application of the free cash flow from assets to a real case.

In this chapter, we discuss the methodologies used for cost of capital estimation in the banking industry. In particular, we first consider the generic treatment of the cost of equity calculation techniques that we divided into those methods quantifying the systematic risk premium and those measuring the total risk premium. The first aim of this chapter is to modify the Hamada (1972) formula excluding deposits value from a banks’ asset beta. Following this approach, we obtain a better measure with which to represent asset risk that is, additionally, independent from bank leverage. The second aim is to discuss the equity pricing methods that enable the quantification of the total risk (such as total beta and the implied cost of capital measures), in particular, adapting the CaRM to the banking industry. In order to better understand the applicability of the models, the chapter provides examples on listed and non-listed banks.

The focus in this chapter is on banks’ market multiples. In particular, we first show the influence of firm growth on market multiples. Moreover, according to the theoretical framework we presented in Chap. 3, we propose alternative options for asset-side multiples that can be used in the relative valuation of banks. In addition, we implement a new approach that mixes the use of asset-side multiples with a separate evaluation of deposits and tax-shields.

We run a simulation of a real case of a bank valuation with the application of the AMM and its derived market multiples, and we compare this with the traditional metrics currently used in banking. Results show that the AMM allows a better understanding of where the value of a bank lies and appoints greater value to the liabilities side than the traditional valuation approach. The asset-side model we present could represent a useful method with which to compare the equity-side approach currently used in bank valuation.