The Difficulty with Valuing Banks

Valuing banks is conceptually difficult. For an outsider, determining the quality of the loan portfolio, measuring the amount of current accounting profits attributable to interest-rate mismatch (for example, the difference between what is earned on loans with long-term rates and deposits compensated by short-term rates), and understanding which business units are driving the bank's profit potential are all hard to do.

For an insider attempting to value a bank, the major issue is transfer pricing. As illustrated in Exhibit 21.1, most banks can be separated into three basic business units (although most have dozens of distinct businesses): a retail bank that may have only 20 cents in loans for each dollar in deposits, a

Exhibit 21.1 Business Unit Structure of Banks

wholesale bank with only 20 cents in deposits for each dollar in loans, and a treasury that stands between them and carries on activities of its own such as securities trading. The excess funds generated by the retail bank can be loaned to the marketplace or to the wholesale bank. If loaned internally, the rate credited to the retail bank and the rate paid by the wholesale bank are crucial transfer prices. If the price credited to the retail bank is set too high, it will appear to be more profitable, and vice versa. It is critical to establish the correct transfer price in order to determine where the bank should allocate its marginal resources—to the retail bank or to the wholesale bank.

This chapter does not present all the answers to bank valuation, but focuses mainly on the issue of how to value banks. First, we discuss the practical reasons why it is easier to use an equity approach than an enterprise approach to valuing banks. Second, we cover the issues involved in an outsider's approach. Finally, we turn to the problems of an insider's approach.

The Equity Approach to Valuing Banks

Throughout the book we have recommended and used the enterprise DCF approach to valuing companies. (The enterprise approach discounts the aftertax free cash flow from operations at the weighted average cost of capital to first obtain the estimated enterprise value, then subtracts the market value of debt to estimate the equity value.) Although the equity and enterprise approaches are mathematically equivalent, the equity approach to valuing banks is easier to use and reflects the fact that banks can create value from the liability side of the balance sheet. So, we recommend that for banks you forecast free cash flow to equity holders and discount it at the cost of equity.

The enterprise method is more difficult to use for banks because a main source of financing is non-interest-bearing customer deposits raised through the retail bank, not borrowing in capital markets. The cost of capital for these deposits can be difficult to estimate. Furthermore, the retail bank is legitimately a separate business in its own right, unlike the treasury function of most corporations. These facts make it difficult, if not impossible, to value the bank's equity by first valuing its assets (that is, its lending function) by discounting interest income less administrative expenses at the weighted average cost of capital, then subtracting the present value of its deposit business (interest expenses plus consumer bank administrative costs, discounted at the cost of debt). Still another problem with the enterprise approach for banks is that the spread between the interest received on loans and the cost of capital is so low that small errors in estimating the cost of capital can result in huge swings in the value of the bank.

In addition to being easier to use, there is a conceptual reason for using the equity approach for valuing banks. The deposit franchise given by the government to the bank potentially allows the bank to create value on the liabilities side of its balance sheet. If the cost of issuing deposits (e.g., interest expense, check clearing, and tellers) is less than the cost of raising an equivalent amount of funds with equal risk in the open market, then a positive spread is created that creates value for shareholders. Thus, liabilities management is part of the business operations of the bank and is not purely financing. If it were pure financing, there would be no spread. The bank would be paying market rates for funds received and no value would be created for shareholders (aside from the tax shield of interest expense).

To apply the equity DCF method to banks, you need to know how to define free cash flow to shareholders and how to use the ''spread" or the "income" model.

Defining Free Cash Flow to Shareholders

Free cash flow to shareholders is net income plus noncash charges less cash flow needed to grow the balance sheet. The value of equity is not simply net income discounted at the cost of equity, because not all of net income can be paid to shareholders. Only dividends can be paid to shareholders.

Exhibit 21.2 shows the definition of free cash flow to shareholders of a bank. The best way to think about it is to keep your eye on actual cash in and cash out. Cash flow from the income statement is reasonably straightforward except for the fact that depreciation and provisions for credit losses are not cash flow. Their only effect is to reduce taxes. We find it easier to treat loan-loss provisions as though they are an actual cash flow. We have little choice in the matter because actual cash flows regarding the nonpayment of loans are not a matter of public record. Balance sheet cash flow starts with cash in as loans are repaid. Actual cash received is gross loans due less provisions (and unearned income) resulting in net loans paid. To this number we must add increases in deposits and external debt, and sale of new equity, all sources of funds. On the uses side, new loans, increases in cash reserves, and securities held represent the main cash outflows.

Exhibit 21.2 Free Cash Flow to Bank Shareholders

Income -statement

Interest income

+ Fee income

- Interest expense

- Provision tor credit losses +Non-interest revenue

- Non interest expenses1 + FX income

-Taxes = Net income + Extraordinary items + Depreciation

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