ACF5130 Financial statement analysis and business valuation
Seminar 12: Special Topics in Valuation
Valuing Financial Institutions
Importance of Financial Institutions
• Backbone of the global economy
• Intermediaries in financial markets facilitating everything from daily transactions to long-term financing for growth projects
• Economic impact
• Play a critical role in mobilising savings, allocating capital, maintaining liquidity, and stabilising the financial system.
• Integral to the implementation of monetary policy, influencing interest rates and credit availability.
• Regulatory Focus
• Subject to stringent regulatory oversight to ensure stability and protect depositors
• Individual Project Forum and weekly forums
Data: Morningstar DatAnalysis Premium
Unique Characteristics of Financial Institutions
• Regulatory Environment: Heavily regulated, impacts operational and business decisions.
• Capital Structure: High leverage, primarily funded through customer deposits
• Is debt a source of capital or something like “raw materials”
• Asset Composition: Major assets are loans and securities, which carry different risk profiles and liquidity characteristics compared to other sectors.
• Income Structure: Interest-based revenue from loans, fees from services, which are influenced by economic cycles and interest rate changes.
Valuation Challenges
• Operating vs. Investing Cash Flows: Difficulty in distinguishing cash flows related to core banking operations from those generated through investment and financing activities
• Difficult to estimate Free Cash Flows
• Difficult to measure capital expenditure
• Significant expenditure in intangible assets
• Expensed in the financial statements
• Highly volatile working capital
• Regulation
• Assumptions about growth are linked to assumptions about reinvestment
• These assumptions must pass regulatory scrutiny
• Additional risk owing to (changing) regulatory restrictions
Valuation Techniques for Financial Institutions
• DCF Valuation Approaches:
• Dividend Discount Model (DDM): Suitable for banks as they typically pay regular dividends. Focuses on the present value of projected dividends.
• Relative Valuation:
• Price to Earnings (P/E) Ratio: Comparing market value per share to earnings per share. Useful for comparing banks in stable economic conditions.
• Price to Book (P/B) Ratio: Reflects the net asset value per share, frequently used due to its relevance in reflecting the liquidation value.