1. Valuation Of Banks
Garima,Jeetesh,Laxmi,Nilanjana

2. Introduction
 The valuation of a bank is an estimation of its market
value in terms of money on a certain date, taking into
account the factors of aggregate risk, time and
income expectations.
 Therefore, it requires specific expertise in two
special subjects:
 an in-depth knowledge of valuation techniques
 understanding of the banking industry and the bank-
specific characteristics of valuation.
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3. Challenges
 Banks, insurance companies and other financial service
firms pose particular challenges for an analyst attempting
to value them for two reasons.
 The nature of their businesses makes it difficult to define both
debt and reinvestment, making the estimation of cash flows
much more difficult.
 Rather than view debt as a source of capital, most financial service
firms seem to view it as a raw material.
 They tend to be heavily regulated and the effects of regulatory
requirements on value have to be considered.
 Maintain capital ratios
 Constrained in terms of where they can invest their funds
 Entry of new firms into the business is often restricted
3

4. GENERAL FRAMEWORK FOR VALUATION
 More practical to value equity directly at Banks, rather than the
entire firm most of the times, as free cash flow calculation is
difficult.
 Equity Value is estimated by discounting cash flows to equity
investors at the cost of equity.
 Either need a measure of cash flow that does not require
estimation of reinvestment needs or redefine reinvestment to
make it more meaningful for a financial service firm like a bank.
When valuing or analysing a bank, distinction between the
bank’s borrowing for the purpose of making loans and the
bank’s permanent debt, which may not be always possible.
4

5. Income Method
 Basic Dividend Discount Method
 Gordon Growth Model
 FCF Method
 Enterprise Value Method

6. Dividend Discount Model
 Used to value only the equity part instead of valuing
entire firm
 Dividend discount model defines cash flows as
dividends
 Model accounts for reinvested earnings when it
takes all future dividends into account.
 Less sensitive to short-run fluctuations in underlying
value than alternative DCF models.

7. The Basic Model
 Value per share of equity -
where,
= Expected dividend per share in period t
= Cost of equity
Source – Valuation of Banks By Aswath Damodaran

8. Gorgon Growth Dividend Discount Model
 If expected growth rate in dividends is constant
forever, then,
Value per share of equity in stable growth =
where,
DPS1 = expected dividend in next year
g = expected growth rate in perpetuity

9. Gordon Growth Model
 If dividends are growing at a rate which is not
expected to be sustainable or constant forever then,
Value per share of equity in extraordinary growth =
+
where,
gn = expected growth rate after n years
hg = high growth period
st = stable growth period
Source – Valuation of Banks By Aswath Damodaran

10. Estimation Notes in Valuation of Banks
 Use bottom-up betas
 Do not adjust for financial leverage
 Adjust for regulatory and business risk
 Consider the relationship between risk and growth
Source – Valuation of Banks By Aswath Damodaran

11. Stable Growth Dividend Discount Model
– Citigroup (2000)
 Modified Payout Ratio = 56.4%
 Earnings estimate (2000) = $13.9 billion
 Sustainable Growth Rate Estimate = 5%
 Beta = 1
 Risk Free Rate = 5.1%
 Risk Premium = 4%
Source – Valuation of Banks By Aswath Damodaran

12. Stable Growth Dividend Discount Model
– Citigroup (2000)
 Cost of equity for Citigroup = 5.1% + 1.00 (4%) =
9.1%
 Value of Citigroup’s equity=
= $13.993 (1.05) (0.564)/(0.091-0.05)
= $202.113 billion

13. Enterprise Valuation Model
ENTERPRISE VALUATION MODEL
 The balance sheet is rewritten by moving the ORIGINAL BALANCE SHEET
current liabilities from the liabilities/equity
side to the asset side of the balance sheet: Assets Liabilities
Cash and marketable Operating current liabilities
 Thus to value a company, securities
 Market value = Initial cash balances FCF + SUM Operating current assets Debt
(FCF)/ (1+WACC) ^ t Net fixed assets Equity
 If we are valuing the equity of the firm, we
subtract the value of the debt. Goodwill
 Total assets Total liabilities and equity
 Equity value = market value – debt
THE ENTERPRISE VALUATION "BALANCE SHEET"
 Applying this to banks
Assets Liabilities
Cash and marketable
 Most marketable securities (and some of the
cash) is an operating current asset. securities
 Debt = Long-term debt + Notes payable + Current Operating current assets Debt
portion of LTD +... - Operating current
liabilities
 For a bank, most short-term debt items are = Net working capital
operating current liabilities and are therefore part
of the bank’s working capital Net fixed assets Equity
Goodwill
Market value Market value
13 Source : Benninga/Sarig, Valuing financial
institutions

14. Free Cash Flow Model
Free Cash Flow calculation for a Financial Company
Item Explanation
Profit after taxes Depreciation is usually not a very significant item
Add back depreciation This leaves the net interest income on the bank’s
productive activities—its financial intermediation
Add back after-tax Since we define the NWC to include deposits, etc.,
interest on permanent this effectively subtracts the self-funded part of the
debt items (typically Long-Term debt) banks operations from the FCF
Subtract out increases in
operating NWC
Subtract increases in Note that Fixed Assets for banks are typically small
Fixed Assets at Cost relative to total assets
=Free Cash Flow
14 Source : Benninga/Sarig, Valuing financial
institutions

15. Example Valuation of a bank
Year -1 Year -2 Year -2
Profit after taxes 172138 178050 185165
Add back depreciation 35673 39636 44040
Add back after-tax interest on permanent debt 117
Changes in operating Net Working Capital
Subtract increases in Cash 13210 20002 21002
Subtract increases in Fixed Assets at Cost 73772 39636 44040
Free cash flow 120947 158165 164280
Following Assumptions for growth were taken and beta = .9.
Risk-free rate 6.19%
Market risk premium 10.57%
Discount rate 13.53%
Projected FCF growth 10.57%
Terminal growth rate of FCF 5.00%
Year - 1 Year -2 Year -3
Free Cash Flow 120947 158165 164280
Terminal value 22,24,259
Value of Bank 17,20,203
Long-term debt 2,826
Other liabilities 1,26,126
Implied equity value 15,91,251
Number of Small Bank shares 3,24,06,000
Imputed per-share value of Small Bank 49.1
15 Source : Benninga/Sarig, Valuing financial
institutions

16. Cash flow to Equity Model
 The difficulty in estimating cash flows when net capital
expenditures and non-cash working capital cannot be
easily identified.
 It is possible, however, to estimate cash flows to equity even
for financial service firms if we define reinvestment differently.
 The cash flow to equity is the cash flow left over for
equity investors after debt payments have been made
and reinvestment needs met.
 With financial service firms, the reinvestment generally
does not take the form of plant, equipment or other fixed
assets.
 Instead, the investment is in human capital and
 Regulatory capital
16

17. Calculation Treatment
Capitalize Training and Employee Development Expenses
• Identify the amortizable life for the asset
• Collect information on employee expenses in prior years
• Compute the current year’s amortization expense
• Adjust the net income for the firm
- Adjusted Net Income = Reported Net income + Employee development expense in the current year – Amortization of the
employee expenses (from step 3)
• Compute the value of the human capital
Investments in Regulatory Capital
• For a financial service firm that is regulated based upon capital ratios, equity earnings that are not paid out
increase the equity capital of the firm and allow it to expand its activities
 For instance, a bank that has a 5% equity capital ratio can make $100 in loans for every $5 in equity
capital. When this bank reports net income of $15 million and pays out only $5 million, it is increasing its
equity capital by $10 million. This, in turn, will allow it to make $200 million in additional loans and
presumably increase its growth rate in future periods
• Look at the equity capital ratios of the firm over time and compare them to the regulatory constraints.
17 Source : Benninga/Sarig, Valuing financial
institutions

18. Asset Based Valuation
 Equity Value of a Bank = Value of the Loan Portfolio
(assets of the bank) – Market Value of Debt & other
outstanding claims.
 Value of the loan portfolio = Price at which the loan
portfolio can be sold to other financial firm OR
 Value of loan portfolio = Present value of expected
future cash flows.
Source – Valuation of Banks By Aswath Damodaran

19. Example
 Loan Portfolio = $1 billion
 Weighted average maturity = 8 years
 Interest Income per year = $70 million
 Fair market interest rates (considering default rates)
= 6.50%
 Value of loans= $70 million (PV of annuity, 8
years, 6.5%) + PV of $1 billion (at 6.5%, 8years) =
$1030 million.
Source – Valuation of Banks By Aswath Damodaran

20. Relative Valuation Method
 Price to Earning Ratio
 Price to Book Value Ratio

21. Price to Earnings Ratio
 PE ratio is a function of expected growth rate of
earnings, pay out and cost of equity
 Depend on the conservatism of bank in classification
of NPA
 Effects on Net Income lead to variation in PE ratio

22. Ratio comparison
Bank Ratio 2012 2011
SBI PE 10.86 13.54
SBI Price to BV 1.51 1.54
HDFC PE 23.1 30.3
HDCF Price to BV 4.66 4.1
http://www.business-standard.com/content/research_pdf/hdfcbank_200711_01.pdf

23. Price to Book Value Ratio
 Price to Book Value depend on
 growth rates in earnings
 payout ratios
 costs of equity
 returns on equity
 Strength of the relationship between price to book
ratios and ROE should be stronger for financial
service
 ROE is less likely to be affected by accounting
decisions

24. Asset Based Method
Advantages Disadvantages
 Simple for  The most simplified
understanding and valuation model
practical usage  Requires access to all
 Does not require of the bank’s internal
guesswork and data
assumptions  Does not consider the
long-term development
perspectives

25. Relative Valuation Method
Advantages Disadvantages
 Uses actual data  Most of the important
 Simple application assumptions are
(derives estimates of  Hidden
value from relatively  No good guideline
simple financial ratios) companies exist
 Does not rely on explicit  Laborious and time-
consuming
forecasts
 Based on the present
situation, resulting in
losing long-term trends

26. Income Approach
Advantages Disadvantages
 Flexible for changes  Controversial results
 Considers future  Requires estimates of
expectations appropriate discount
 Considers market rates Partially based on
performance (through probabilities and
excess return on expertise
market)  Problems with
application in the
emerging markets
 The valuation results
can be easily

27. The Black-Scholes Model
To calculate a theoretical call price
- Using determinants like:
 Stock price
 Strike price
 Volatility
 Time to expiration
 Short term(risk free) interest rate
The original formula for calculating the theoretical option price (OP) is as follows:
S = stock price
Where, X = strike price
t = time remaining until expiration, expressed as a
percent of a year
r = current continuously compounded risk-free
interest rate
v = annual volatility of stock price (the standard
deviation of the short-term returns over one year).
N(x) = standard normal cumulative distribution
function

28. The binomial model
 Breaks down the time to expiration into potentially a very
large number of time intervals
 At each step it is assumed that the stock price will move
up or down by an amount calculated using volatility and
time to expiration which produces a binomial distribution
or recombining tree of underlying stock prices
 Next the option prices at each step of the tree are
calculated working back from expiration to the present

29. Excess return model
 In the present value of excess returns that the firm
expects to make in the future
 Value of Equity = Equity Capital invested currently +
Present Value of Expected Excess Returns to Equity
investors
 Two inputs needed for this model:
- Measure of equity capital currently invested in the firm.
- Expected excess returns to equity investors in future
periods
 is model, the value of a firm can be written as the sum of
capital invested currently in the firm and the

30. Regulatory Overlay
 Banks required to maintain regulatory capital ratios
 Ratios are computed based upon the book value of
equity and their operations
 They are to ensure that they do not go beyond their
means
 RBI has set guidelines for investment activities for a
bank