Valuation Framework for Banks Basic Information and Tutorials

The approach that is typically applied to decide whether a firm creates value is a variant of the traditional discounted cash flow (DCF) analysis of financial theory, with which the value of any asset can be determined.

This (shareholder value) approach estimates the value of the entire firm (therefore, it is also called “entity” approach) using a multi period framework.

It estimates a firm’s (free) cash flows, which are available for distribution to both shareholders and debt holders, and discounts them at the appropriate rate, which is the so-called weighted average costs of capital (WACC) and reflects both the riskiness and timing of the cash flows and the firm’s leverage.

The (market) value of the firm’s equity is then determined by subtracting the (market) value of the firm’s liabilities from the determined entity value.

As an exception to the rule, a different approach is often chosen for banks—even though the results are mathematically equivalent. This so-called “equity” approach estimates the bank’s (free) cash flows to its shareholders and then discounts these at the cost of equity capital39 to derive the value of the bank’s equity directly. Besides being easier to apply, this approach also has the following practical and conceptual advantages in the financial industry:

■ Determining the equity value by first determining the entity’s value and then subtracting the value of the liabilities is much more difficult for banks than for industrial companies, because a bank’s debt is, to a large extent, not traded in the capital markets. For instance, savings and current account deposits have either no interest rate or an interest rate far below their fair market return—and an unknown maturity.

Hence, it is very difficult to determine the fair overall market value of debt because of the simple practical inability to determine the appropriate cost of capital for these liabilities.

■ Additionally, the fact that taking in deposits may allow the bank to generate value (because it pays interest rates below their market opportunity costs) makes liability management a part of the bank’s business operations and not just a pure financing function.

This potential for value creation needs to be adequately reflected in the applied valuation methodology, which is not the case in the entity approach.

■ Given the narrow margins of the banking business, small errors in the estimation of the appropriate interest rates can lead to huge swings in the value of the equity when applying the entity approach.

Even though we will not discuss the details of the determination of (free) cash flows and the application of this framework at the business unit or even the transaction level  here, some authors43 and—by anecdotal evidence—many bank analysts point out that this valuation framework is notoriously difficult and cumbersome to apply to banks.

This observation is true for bank insiders, but especially for bank outsiders and is mostly due to the fact that banks are opaque institutions.  However, these informational problems may be only one reason for the scarce application of the valuation approach in banks. We will discuss potential other problems in the following section.