Valuing Financial Service Firms by Aswath Damodaran
April 2009 Valuing banks, insurance companies and investment banks has always been difficult, but the market crisis of 2008 has elevated the concern to the top of the list of valuation issues. The problems with valuing financial service firm stem from two key characteristics. The first is that the cash flows to a financial service firm cannot be easily estimated, since items like capital expenditures, working capital and debt are not clearly defined. The second is that most financial service firms operate under a regulatory framework that governs how they are capitalized, where they invest and how fast they can grow. Changes in the regulatory environment can create large shifts in value. In this paper, we confront both factors. We argue that financial service firms are best valued using equity valuation models, rather than enterprise valuation models, and with actual or potential dividends, rather than free cash flow to equity. The two key numbers that drive value are the cost of equity, which will be a function of the risk that emanates from the firm’s investments, and the return on equity, which is determined both by the company’s business choices as well as regulatory restrictions. We also look at how relative valuation can be adapted, when used to value financial service firms. Banks, insurance companies and other financial service firms pose special challenges for an analyst attempting to value them, for three reasons. The first is the nature of their businesses makes it difficult to define both debt and reinvestment, making the estimation of cash flows much more difficult. The second is that they tend to be heavily regulated and changes in regulatory requirements can have significant effect on value. The third is that the accounting rules that govern bank accounting have historically been very different from the accounting rules for other firms, with assets being marked to market more frequently for financial service firms. In this paper, we begin by considering what makes financial service firms unique and ways of dealing with the differences. We move on to look at how the dark side of valuation manifests itself in the valuation of financial service firms in the form of an unhealthy dependence on book values, earnings and dividends. We then look at how best we can adapt discounted cash flow models to value financial service firms by looking at three alternatives – a traditional dividend discount model, a cash flow to equity discount model and an excess return model. With each, we look at examples from the financial services arena. We move on to look at how relative valuation works with financial service firms and what multiples may work best with these firms.
Financial Service firms – The Big Picture
Any firm that provides financial products and services to individuals or other firms can be categorized as a financial service firm. We would categorize financial service businesses into four groups from the perspective of how they make their money. A bank makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it, and from other services it offers it depositors and its lenders. Insurance companies make their income in two ways. One is through the premiums they receive from those who buy insurance protection from them and the other is income from the investment portfolios that they maintain to service the claims. An investment bank provides advice and supporting products for other firms to raise capital from financial markets or to consummate deals such as acquisitions or divestitures. Investment firms provide investment advice or manage portfolios for clients. Their income comes from advisory fees for the advice and management and sales fees for investment portfolios. With the consolidation in the financial services sector, an increasing number of firms operate in more than one of these businesses. For example, Citigroup, created by the merger of Travelers and Citicorp operates in all four businesses. At the same time, however, there remain a large number of small banks, boutique investment banks and specialized insurance firms that still derive the bulk of their income from one source. How big is the financial services sector in the United States? We would not be exaggerating if we said that the development of the economy in the US would not have occurred without banks providing much of the capital for growth, and that insurance companies predate both equity and bond markets as pioneers in risk sharing. Financial service firms have been the foundation of the US economy for decades and the results can be seen in many measures. Table 14.1 summarizes the market capitalization of publicly traded banks, insurance companies, brokerage houses, investment firms and thrifts in the United States at the end of 2007 and the proportion of the overall equity market that they represented at the time. See full Valuing Financial Service Firms in PDF format here via people.stern.nyu.edu/
