Valuing Banks

A New Corporate Finance Approach

Federico Beltrame, Daniele Previtali

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137561428
• Topic: Negocios y empresa
• Subtopic: Servicios financieros

This book aims to overcome the limitations the variations in bank-specifics impose by providing a bank-specific valuation theoretical framework and a new asset-side model. The book includes alsoa constructive comparison of equity and asset side methods.The authors present a novel framework entitled, the "Asset Mark-down Model". This method incorporates an Adjusted Present Value model, which allows practitioners to identify the main value creation sources of a particular bank: from asset-based cash flow and the mark-down on deposits, to tax benefits on bearing liabilities. Through the implementation of this framework, the authors offer a more accurate and more specific approach to valuing banks.

© The Editor(s) (if applicable) and The Author(s) 2016

Federico Beltrame and Daniele PrevitaliValuing BanksPalgrave Macmillan Studies in Banking and Financial Institutions10.1057/978-1-137-56142-8_1

Begin Abstract

1. Introduction

Federico Beltrame¹  and Daniele Previtali²

(1)

University of Udine, Udine, Italy

(2)

Luiss Guido Carli University, Rome, Italy

 

End Abstract

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.

If the financial crisis of 2007 has a “merit”, it is its having renewed the interest of the financial community and academics in the topic of bank valuation, leading to significant growth in the number of contributions to the literature since that time. Some of the authors explained the methods currently used in practice (among others Damodaran 2009, 2013; Koller et al. 2010; Massari et al. 2014), while others presented new valuation models (e.g. Calomiris and Nissim 2007; Dermine 2010), demonstrating the growing importance of the topic.

But why is the valuation of banks different from that of other industrial companies? The specifics of banks—such as the nature of the business process, the role of equity and debt capital, the pervasive regulation on the asset and liabilities side—have several implications with regard to valuation. In particular, it can be very difficult to obtain reliable estimates of many important variables—such as net working capital, capital expenditures, weighted average cost of capital (WACC)—and, above all, to provide a measure of free cash flow from operations. These limitations force the application of a simplified equity-side approach based on dividends. However, there is no clear view of the value creation process in terms of cash flows, because dividends represent a synthetic measure of cash. Therefore, the equity-side approach can be considered a flawed method, because it does not allow analysis of the cash generation created by the assets and liabilities. Specifically, we can neither appreciate the cash flows from assets, nor the contribution to value of mark-down and tax benefits. And all these aspects are of considerable relevance in practice, because a valuation should highlight where the value originates in relation to assets and liabilities. Such information is fundamental in several situations: strategy, business planning, shareholder value management, mergers and acquisitions, initial public offerings (IPOs), and so on.

In this book, after having reviewed the extant literature and valuation methods currently applied, in practice we try to overcome the problems we have just now recalled, providing a bank-specific valuation theoretical framework and a new asset-side model. The method used, which we called the Asset Mark-down Model (AMM), is an adjusted present value model that highlights the main value creation sources of a bank; in our model, these are the free cash flow from assets (FCFA), mark-down on deposits and tax benefits on bearing liabilities (deposits and non-deposit debt).

In particular, in Chap. 2, “Valuation in Banking: Issues and Models”, we discuss the problems in valuing banks that affect the application of the standard models of valuation used for industrial firms. In particular, we refer to the different role of debt and capital, the regulatory framework and the provisioning effect, and above all to the issues related to 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 Chap. 3, “Value, Capital Structure and Cost of Capital: A Theoretical Framework”, 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 through several empirical studies concerning the relation between capital requirements and the WACC and, consequently, bank value (e.g. Kashyap et al. 2010; Cosimano and Hakura 2011; Baker and Wurgler 2013; Miles et al. 2013). Moreover, in Chap. 3, we use such empirical evidence to highlight the problems related to the applicability of Modigliani–Miller propositions in regard to the banking industry. Specifically, the main concern of Chap. 3 is to propose a new corporate finance theoretical framework for bank valuation, exploring a new issue representing a relevant gap in the literature. Using such 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–Miller propositions using bank-specific adjustments. Additionally, we compare and reconcile the AMM to excess return models.

In Chap. 4, “Measuring the Cash Flows of Banks: The FCFA Asset-side Approach”, following the theoretical framework of the AMM, we discuss the free cash flow from asset measurement. In particular, we propose a valuation framework which splits a bank’s cash flows into those originating from assets and those from liabilities. In particular, 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 banks’ 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 reconstruction of the model is very important, as all the current literature has estimated direct cash flow to equity without reconciling it to cash flow from operations. Our model tries to close this gap in the literature. In addition, in Chap. 4, we propose a solution to the problems related to the net working capital and capital expenditure estimation of banks. After having discussed the free cash flow model in terms of theory, we propose the application of free cash flow from assets in relation to a real case.

In Chap. 5, “The Cost of Capital of Banks: Theories and Empirical Evidence”, we discuss the methodologies used for the estimation of the cost of capital in the banking industry. In particular, first, we discuss the generic treatment of the cost of equity calculation metrics that we divided into methods quantifying the systematic risk premium and methods measuring the total risk premium. The first aim of Chap. 5 is to modify the Hamada (1972) formula excluding value of deposits from a bank’s asset beta. According to this approach, we obtain a better measure with which to represent asset risks, which additionally is independent from bank leverage. The second aim is to discuss the equity pricing methods that enable the total risk (such as total beta and the implied cost of capital measures) to be quantified —in particular, adapting the Capital at Risk Model (CaRM) (Beltrame et al. 2014) to the banking industry. In order to better understand the applicability of the models, the chapter provides several numerical examples.

In Chap. 6, “Banks’ Asset-side Multiples: Profitability, Growth, Leverage and Deposits Effect”, the focus is on bank market multiples. In particular, we show the influence of firm growth on market multiples. Then, according to the theoretical framework we presented in Chap. 3, we propose alternative options of 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.

Finally, in Chap. 7 “A Comparison between Valuation Metrics in a Case Study“, we run a simulation on 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 us to better understand where the value of a bank lies and attributes greater value to the liabilities side than the traditional valuation approach. The asset-side model we present could represent a useful method to compare with the equity-side approach currently used in bank valuation.

References

Baker, M., & Wurgler, J. (2013). Do strict capital requirements raise the cost of capital? Banking regulation and the low risk anomaly (no. w19018). National Bureau of Economic Research.

Beltrame, F., Cappelletto, R., & Toniolo, G. (2014). Estimating SMEs cost of equity using a value at risk approach: The capital at risk model. London: Palgrave Macmillan.

Calomiris, C. W., & Nissim, D. (2007). Activity-based valuation of bank holding companies. NBER working paper no. 12918.

Cosimano T. F., & Hakura D. S. (2011). Bank behavior in response to Basel III: A cross-country analysis. IMF working paper 11/119.

Damodaran, A. (2009). Valuing financial service firms/A. Stern Business.

Damodaran, A. (2013). Valuing financial service firms. Journal of Financial Perspectives, 1, 1–16.

Dermine, J. (2010). Bank valuation with an application to the implicit duration of non-maturing deposits. International Journal of Banking, Accounting and Finance, 2, 1–30.CrossRef

Hamada, R. S. (1972). The effect of the firm’s capital structure on the systematic risk of common stocks. The Journal of Finance, 3(2), 435–452.CrossRef

Kashyap, A. K., Stein, J. C., & Hanson, S. (2010). An analysis of the impact of ‘substantially heightened’ capital requirements on large financial institutions. Mimeo: Booth School of Business, University of Chicago.

Koller, T. M., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and managing the value of companies (5th ed.). New York, NY: Wiley & Sons.

Massari, M., Gianfrate, G., & Zanetti, L. (2014). The valuation of financial companies. Chichester: Wiley & Sons.

Miles, D., Yang, J., & Marcheggiano, G. (2013). Optimal bank capital. The Economic Journal, 123(567), 1–37.CrossRef

© The Editor(s) (if applicable) and The Author(s) 2016

Federico Beltrame and Daniele PrevitaliValuing BanksPalgrave Macmillan Studies in Banking and Financial Institutions10.1057/978-1-137-56142-8_2

Begin Abstract

2. Valuation in Banking: Issues and Models

Federico Beltrame¹ and Daniele Previtali²

(1)

University of Udine, Udine, Italy

(2)

Luiss Guido Carli University, Rome, Italy

End Abstract

2.1 Introduction

Several specifics concerning the banking business make it difficult to apply the valuation methods commonly used for non-financial companies. The literature has universally acknowledged that pervasive regulation, the composition of assets and liabilities, the definition of debt and a completely different structure of business and product cycle represent some of the most relevant issues to deal with in bank valuation. Such limitations require several adjustments of standard valuation metrics in order to take into account of banks’ peculiarities. In the following sections, we first review such banks’ specifics in order to show how they affect the value generation process, and, second, we present the valuation methods commonly accepted by the literature and applied by practitioners in banking.

2.1.1 A Different Role for Equity: The Regulatory Constraints

Banks are subject to pervasive regulation and the power of enforcement ...