Must-know: Determining a bank’s value

A bank’s value

Banking valuation is quite different from the valuation of other sectors. It also poses its own set of challenges. The first challenge is that banks are highly regulated and any change in regulations has a huge impact on the valuation of a bank. The second challenge is that it’s difficult to determine cash flow for a bank because both debt and reinvestment are difficult to calculate.

Generally three main approaches are used to value banks. These three approaches are:

Cash flow based approach

This approach treats the value of a bank as the sum of all its future earnings discounted by an appropriate factor to present. There are two main methods in this approach. First, is to discount all the projected free cash flow to equity (or FCFE) by cost of equity to get a valuation. Second, is to treat all income to accrue from dividends and discount all current and future dividends by cost of equity to get a valuation.

Relative valuation approach

This approach is the simplest way to value a bank. This is based on an assumption that similar sized companies operating in similar business should trade at similar valuation multiples. The most used metric to compare banks while using this approach is the price/book value ratio. As a result, a valuation is generally obtained by taking an average of peer set price/book value ratio and then multiplying it with the book value of the bank. Similar sets of banks like Goldman Sachs (GS) and Morgan Stanley (MS) or U.S. Bancorp (USB) and PNC Financial Services (PNC) or companies in an exchange-traded fund (or ETF) which is comprised of similar companies—like the iShares U.S. Regional Banks ETF (IAT)—can be valued using relative valuation approach.

Asset based approach

This approach entails valuing the market value of assets, or loans, of a bank and then subtracting it by the outstanding debt of the bank. This is generally used when a bank is being liquidated because markets will generally assign a premium to productive assets, loans, of a bank. This approach is difficult to use when a bank operates in multiple business domains and geographies.