Valuing Financial Service Companies

In this chapter, we will focus on financial service companies and what makes them unique when it comes to valuation. Financial service companies include traditional banks, insurance companies, investment banks, and traditional investment firms, and each has a different business model for making money.

Business Models of Financial Service Companies

• Traditional Banks: Traditional banks make money through the spread, which is the difference between the interest they pay on deposits and the interest they earn from lending out those deposits.
• Insurance Companies: Insurance companies collect premiums to manage risk and pay out claims when necessary. Their premiums must exceed the claims made on them.
• Investment Banks: These firms provide advice and support products, as well as earn fees from deal-making for their clients.
• Traditional Investment Firms: These firms manage other people's money and are paid based on assets under management or by charging direct fees.

Commonalities and Valuation Issues

Financial service companies share commonalities, such as regulation, constraints on their investments, and strong regulatory overlay. Valuation issues arise when traditional methods like cost of capital and free cash flow computations may not fully apply to financial service companies.

Unique Valuation Issues for Financial Service Companies

1. Cost of Capital: Debt is considered raw material for banks, and their cost of equity must be considered. The old method of using a sector average beta may need to be adjusted for how capitalized the bank is and the risk associated with its growth.
2. Estimating Cash Flows: Estimating cash flows to equity is difficult for banks due to the nature of their investments and regulatory requirements, making traditional free cash flow computations challenging to apply.
3. Dividend Discount Model: The traditional approach to valuing banks, the dividend discount model, remains in place due to the challenge of estimating free cash flow for banks.

Valuing a Bank

When valuing a bank, using the dividend discount model is one approach, but it inherently assumes that the bank is paying out what it can afford to in dividends. The free cash flow to equity model considers reinvestment as investment in regulatory capital, providing a more realistic value of equity for a bank.

Excess Return Model

The excess return model accounts for the return on equity and the cost of equity to determine the market value of the bank. If a bank is expected to earn below its cost of equity, its market value will be lower than its book value.

Pricing Banks

When pricing banks, it is essential to consider variables such as growth, return on equity, and regulatory capital ratios, as these factors can significantly impact the price-to-book ratio. Comparing price-to-book ratios across banks allows investors to gauge the relative value of banks, but it is crucial to consider other factors such as growth and regulatory capital.

Conclusion

Valuing financial service companies, especially banks, requires a unique approach due to their distinct business models and regulatory constraints. While traditional valuation methods may not fully apply, alternative models such as the dividend discount model, free cash flow to equity, and excess return model provide more realistic and accurate valuations for financial service companies. Understanding the specific nuances of these companies is essential for making informed investment decisions.