Valuation of Banks


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Valuation of Banks

  1. 1. Valuation Of BanksGarima,Jeetesh,Laxmi,Nilanjana
  2. 2. 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
  3. 3. 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
  4. 4. 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
  5. 5. Income Method Basic Dividend Discount Method Gordon Growth Model FCF Method Enterprise Value Method
  6. 6. 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.
  7. 7. 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
  8. 8. 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
  9. 9. 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 yearshg = high growth periodst = stable growth period Source – Valuation of Banks By Aswath Damodaran
  10. 10. 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
  11. 11. 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
  12. 12. 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
  13. 13. Enterprise Valuation Model ENTERPRISE VALUATION MODEL The balance sheet is rewritten by moving the ORIGINAL BALANCE SHEET current liabilities from the liabilities/equity side to the asset side of the balance sheet: Assets Liabilities Cash and marketable Operating current liabilities Thus to value a company, securities Market value = Initial cash balances FCF + SUM Operating current assets Debt (FCF)/ (1+WACC) ^ t Net fixed assets Equity If we are valuing the equity of the firm, we subtract the value of the debt. Goodwill Total assets Total liabilities and equity Equity value = market value – debt THE ENTERPRISE VALUATION "BALANCE SHEET" Applying this to banks Assets Liabilities Cash and marketable Most marketable securities (and some of the cash) is an operating current asset. securities Debt = Long-term debt + Notes payable + Current Operating current assets Debt portion of LTD +... - Operating current liabilities For a bank, most short-term debt items are = Net working capital operating current liabilities and are therefore part of the bank’s working capital Net fixed assets Equity Goodwill Market value Market value 13 Source : Benninga/Sarig, Valuing financial institutions
  14. 14. Free Cash Flow Model Free Cash Flow calculation for a Financial Company Item ExplanationProfit after taxes Depreciation is usually not a very significant itemAdd back depreciation This leaves the net interest income on the bank’s productive activities—its financial intermediationAdd back after-tax Since we define the NWC to include deposits, etc.,interest on permanent this effectively subtracts the self-funded part of thedebt items (typically Long-Term debt) banks operations from the FCFSubtract out increases inoperating NWCSubtract increases in Note that Fixed Assets for banks are typically smallFixed Assets at Cost relative to total assets=Free Cash Flow14 Source : Benninga/Sarig, Valuing financial institutions
  15. 15. 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 164280Following Assumptions for growth were taken and beta = .9. 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 15 Source : Benninga/Sarig, Valuing financial institutions
  16. 16. 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 capital 16
  17. 17. Calculation Treatment Capitalize 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.17 Source : Benninga/Sarig, Valuing financial institutions
  18. 18. 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
  19. 19. 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
  20. 20. Relative Valuation Method Price to Earning Ratio Price to Book Value Ratio
  21. 21. 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
  22. 22. Ratio comparisonBank Ratio 2012 2011SBI PE 10.86 13.54SBI Price to BV 1.51 1.54HDFC PE 23.1 30.3HDCF Price to BV 4.66 4.1
  23. 23. 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
  24. 24. Asset Based MethodAdvantages Disadvantages Simple for  The most simplified understanding and valuation model practical usage  Requires access to all Does not require of the bank’s internal guesswork and data assumptions  Does not consider the long-term development perspectives
  25. 25. Relative Valuation MethodAdvantages Disadvantages Uses actual data  Most of the important Simple application assumptions are (derives estimates of  Hidden value from relatively  No good guideline simple financial ratios) companies exist Does not rely on explicit  Laborious and time- consuming forecasts  Based on the present situation, resulting in losing long-term trends
  26. 26. Income ApproachAdvantages Disadvantages Flexible for changes  Controversial results Considers future  Requires estimates of expectations appropriate discount Considers market rates Partially based on performance (through probabilities and excess return on expertise market)  Problems with application in the emerging markets  The valuation results can be easily
  27. 27. 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 rateThe original formula for calculating the theoretical option price (OP) is as follows: S = stock priceWhere, 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
  28. 28. 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
  29. 29. 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
  30. 30. 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