Valuing Financial Service Companies: Insights from Aswath Damodaran
Explore the challenges in valuing financial service companies, such as opaque cash flows and the importance of book value. Aswath Damodaran provides valuable insights on using the dividend discount model and understanding regulatory capital ratios.
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Aswath Damodaran 1 SESSION 27: VALUING FINANCIAL SERVICE COMPANIES #
Valuing Financial Service Companies 2 Aswath Damodaran 2
The Questions Aswath Damodaran 3 3
Lesson 1: Financial service companies are opaque The Faustian Bargain: Banks tell investors very little about the quality of their assets (loans, for a bank, for instance are not broken down by default risk status) but they accept that in return for assets being marked to market (by accountants who presumably have access to the information that we don t have) and regulatory oversight (to constrain risktaking) Cash Flows? In addition, estimating cash flows for a financial service firm is difficult to do. So, we trust financial service firms to pay out their cash flows as dividends. Hence, the use of the dividend discount model. Delusional Dividends: During times of crises or when you don t trust banks to pay out what they can afford to in dividends, using the dividend discount model may not give you a reliable value. Aswath Damodaran 6 6
Lesson 2: For financial service companies, book value matters The book value of assets and equity is mostly irrelevant when valuing non-financial service companies. After all, the book value of equity is a historical figure and can be nonsensical. (The book value of equity can be negative and is so for more than a 1000 publicly traded US companies) With financial service firms, book value of equity is relevant for two reasons: Since financial service firms mark to market, the book value is more likely to reflect what the firms own right now (rather than a historical value) The regulatory capital ratios are based on book equity. Thus, a bank with negative or even low book equity will be shut down by the regulators. From a valuation perspective, it therefore makes sense to pay heed to book value. In fact, you can argue that reinvestment for a bank is the amount that it needs to add to book equity to sustain its growth ambitions and safety requirements: FCFE = Net Income Reinvestment in regulatory capital (book equity) Aswath Damodaran 8 8
FCFE for a bank To estimate the FCFE for a bank, we redefine reinvestment as investment in regulatory capital. FCFEBank= Net Income Increase in Regulatory Capital (Book Equity) Think of this as potential dividend and if negative, new equity issues that will dilute your equity value per share. Deutsche Bank: FCFE Aswath Damodaran 9 9
Pricing Financing Service Companies 11 Stay equity focused: As with intrinsic valuation, pricing should be based on the equity in the financial service firm, rather than enterprise or operating asset value. Pay attention to book value: The book value for a bank is marked to market and has regulatory implications. Refine risk: Your risk measure should incorporate regulatory risk. 1. 2. 3. Aswath Damodaran 11
An Eyeballing Exercise with P/BV Ratios European Banks in 2010 Name PBV Ratio 0.80 1.09 1.23 1.66 1.72 1.86 1.96 1.98 2.04 2.09 2.15 2.23 2.30 2.46 2.53 2.59 2.94 3.33 2.05 2.07 Return on Equity -1.66% -6.72% 1.32% 1.56% 12.46% 11.06% 8.55% 11.17% 9.71% 20.22% 22.45% 21.16% 14.86% 17.74% 10.28% 20.18% 18.50% 32.84% 12.54% 11.82% Standard Deviation 49.06% 36.21% 35.79% 34.14% 31.03% 28.36% 26.64% 18.62% 22.55% 18.35% 21.95% 20.73% 13.79% 12.38% 21.91% 19.93% 19.66% 18.66% 24.99% 21.93% BAYERISCHE HYPO-UND VEREINSB COMMERZBANK AG DEUTSCHE BANK AG -REG BANCA INTESA SPA BNP PARIBAS BANCO SANTANDER CENTRAL HISP SANPAOLO IMI SPA BANCO BILBAO VIZCAYA ARGENTA SOCIETE GENERALE ROYAL BANK OF SCOTLAND GROUP HBOS PLC BARCLAYS PLC UNICREDITO ITALIANO SPA KREDIETBANK SA LUXEMBOURGEOI ERSTE BANK DER OESTER SPARK STANDARD CHARTERED PLC HSBC HOLDINGS PLC LLOYDS TSB GROUP PLC Average Median Aswath Damodaran 12 12
The median test We are looking for stocks that trade at low price to book ratios, while generating high returns on equity, with low risk. But what is a low price to book ratio? Or a high return on equity? Or a low risk One simple measure of what is par for the sector are the median values for each of the variables. A simplistic decision rule on under and over valued stocks would therefore be: Undervalued stocks: Trade at price to book ratios below the median for the sector,(2.07), generate returns on equity higher than the sector median (11.82%) and have standard deviations lower than the median (21.93%). Overvalued stocks: Trade at price to book ratios above the median for the sector and generate returns on equity lower than the sector median. Aswath Damodaran 13 13
How about this mechanism? We are looking for stocks that trade at low price to book ratios, while generating high returns on equity. But what is a low price to book ratio? Or a high return on equity? Taking the sample of 18 banks, we ran a regression of PBV against ROE and standard deviation in stock prices (as a proxy for risk). PBV = 2.27 + 3.63 ROE (5.56) (3.32) R squared of regression = 79% - 2.68 Std dev (2.33) Aswath Damodaran 14 14
And these predictions? Aswath Damodaran 15 15
