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PA LG R AV E M AC M I L L A N S T U D I E S I N

BANKING AND FINANCIAL INSTITUTIONS


S E R I E S E D I TO R : P H I L I P M O LY N E U X

Valuing Banks
A New Corporate Finance Approach

Federico Beltrame
Daniele Previtali
Palgrave Macmillan Studies in Banking
and Financial Institutions

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Bangor Business School
Bangor University
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FedericoBeltrame DanielePrevitali

Valuing Banks
A New Corporate Finance Approach
FedericoBeltrame DanielePrevitali
University of Udine Luiss Guido Carli University
Italy Rome, Italy

Palgrave Macmillan Studies in Banking and Financial Institutions


ISBN 978-1-137-56141-1 ISBN 978-1-137-56142-8 (eBook)
DOI 10.1057/978-1-137-56142-8

Library of Congress Control Number: 2016938714

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To Giorgio, Silva and Ivana
(Federico Beltrame)
To Virginia, Daniela and Antonio
(Daniele Previtali)
for their love and support
Foreword

Why a new book on bank valuation? And why not a new book on firm
valuation? Maybe the answer is in the question itself, as sometimes
happens, and, according to Beltrame and Previtali, this is the case. Of
course, there are many relevant issues in company valuation that are
worth discussing, from the general approach to more specific operational
techniques, such as cash flow identification, discount rate setting, asset
appraisal, and so on. But this book focuses on the application of the
generally accepted valuation approaches to financial institutions, not just
taking into consideration the general theory of firm valuation, but also
trying to ascertain whether such a theory works when it comes to banks.
The issue is not new or, if you prefer, it is rather an old one. So, why
are we still interested in it? From my point of view, the reason is that we
have not yet solved all the problems, so a generally accepted approach to
bank valuation is still some way off. As a matter of fact, both practitioners
and scholars have their own framework for bank valuation, even though
they often admit to a certain lack of accuracy when general valuation
techniques are applied to financial institutions. If we seek a concrete
demonstration of such inaccuracy, it is sufficient to look at the huge
fluctuations of bank share prices during the financial crisis. One must
admit that the word inaccuracy is an understatement.
But what really differs between banks and other companies? What
makes financial institutions so special as opposed to all other kinds of
vii
viii Foreword

firm? Most practitioners and scholars share the idea that banks are differ-
ent from other firms in two main ways: the role and the nature of their
regulationnamely, capital requirements; and the role of debtwhich is
not merely a funding instrument but, rather, is part of the products that
a bank sells. If we put these roles together, we conclude that the right side
of a banks balance sheet is so peculiar that, in order to evaluate a financial
institution, we cannot simply apply the generally accepted methodolo-
gies. By the way, I would like to stress that, in turn, the differences in the
funding structure of banks reflect the special nature of these firms. The
crucial point is that bank debt is the most common means of payment;
bank debt is money, not just a funding source, and this is also the reason
why regulation is so tough. The central role of banks in the modern
economy is of such great importance that governments and authorities
worry about banks soundness in order to protect deposits and to preserve
the stability of the overall economic system. Such a deep macroeconomic
peculiarity is relevant also from the microeconomic point of view, and
this is why the evaluation of banks remains an issue for practitioners and
academics.
The starting point of the authors is these differences, which they try to
overcome by attributing a specific value to the liabilities side. More
generally, the proposed methodology gives many different answers to the
issue concerning bank valuation that the existing literature has consis-
tently stressed. The authors achieve this by using a new corporate finance
approach. I do not wish to anticipate the solutions they see, but I would
like to say something about it.
First, I share their technical approach with regard both to the capital
requirements issue and to the instrumental nature of debt. The aim of the
proposed model is to better quantify the cash flow that is to be put in the
classical discounted cash flow (DCF) models. Needless to say, the accurate
definition of the cash flows is crucial in order to obtain a correct measure
of a firms value. In this respect, the qualification of bank debt not merely
as a funding instrument, but rather as an operating tool in the produc-
tion process of intermediation opens different perspectives in the
construction of the model. It should be emphasized that the model is
coherent with all the prudential and accountancy rules usually adopted in
the banking sector, so the application of the model does not require any
Foreword ix

steps other than the ordinary reclassification of the balance sheet and the
income statement. This is important because it allows the proposed
model to be compared with traditional techniques.
The book also offers an interesting literature review that gives readers
the chance to reflect on the various approaches usually applied in bank
valuation. It suggests that it may be useful to devote more studies to the
analysis of the effect of regulation on banks value. I refer particularly to
the effects of capital requirements on the appraisal exercise, where the
common praxis is to include in the free cash flow to equity only the excess
capital or, more generally speaking, only the amount of resources that
could be distributed to shareholders without notching the minimum
requirements set by the regulations. The assumption is easily understand-
able in the light of the financial approach, which states that the value of
a firm, and even of a bank, is simply the present value of the future cash
flows from the investment. If, therefore, a bank is not able to distribute
any cash flow due to the necessity to maintain the required gearing ratio,
does it mean that it is worth zero or even below zero? In other words, does
it mean that the required equity of a bank is valueless? Of course, if we
adopt, for a while, a gone approach, it is evident that such equity is worth
the difference between the value of assets and liabilities. In an ongoing
approach, this value seems to disappear, even if it is the fundamental
engine of the banking activity. I feel further analysis and reflection are
needed on this subject.
Another intriguing point is the role of the interest rate in bank
valuation. As everybody knows, the discount rate is crucial even in the
valuation of other types of company, but its effect is limited to the area of
the determination of the present value of the expected cash flow. Every
change in the general level of the interest rate affects only the discount
factor and not future cash flows, at least directly. As far as banks are
concerned, interest rate fluctuation influences both the returns and the
discount factor; significantly, these two effects are in opposition to each
other. Here, we can see another positive aspect of the proposed model
because it makes possible the isolation of the effect of interest rate changes
on both the operating profit and on the debt. This demonstrates that
banks goodwill depends heavily on their debts and, in turn, it underlies
the very nature of commercial banks (and not necessarily of every kind of
x Foreword

bank). Banks do not simple transfer money from Mister A to Mister B


but, rather, offer to the market debt instruments of very high quality that
may be used as payment instruments or a reserve of value. This is why
banks are special, particularly their liabilities, and, therefore, why they
need to be valued differently from other companies, especially when it
comes to the right side of their balance sheet.

Luiss Guido Carli University MarioComana


Rome, Italy
Acknowledgements

We would especially like to thank Mario Comana, who supported our


idea and kindly contributed the foreword to this book. We are also grate-
ful to Aswath Damodaran, Laura Zanetti, Raffaele Oriani, Maurizio
Polato, Gianluca Mattarocci and Vincenzo Farina for their helpful com-
ments and advice.

xi
Contents

1 Introduction 1
References 5

2 Valuation inBanking: Issues andModels 7


2.1 Introduction 7
2.1.1 A Different Role forEquity: TheRegulatory
Constraints 8
2.1.2 The Role ofDebt 12
2.1.3 Loan Loss Provisioning andCharge-Offs 14
2.1.4 Cash Flow Estimation 16
2.2 Valuation Methods ofBanks: ACritical Review 19
2.2.1 Discounted Cash Flow Models 19
2.2.2 Excess Returns Valuation 23
2.2.3 Asset andMixed-Based Valuation 27
2.2.4 Relative Market Valuation 31
2.2.5 Contingent Claim Valuation 37
2.3 Conclusion 37
References 38

3 Value, Capital Structure andCost ofCapital:


ATheoretical Framework 41
3.1 Introduction 41
3.2 Limitations oftheEquity-Side Approach 42
xiii
xiv Contents

3.3 An Asset-Side Approach toBank Valuation:


AnIntroduction 44
3.4 Bank Cost ofCapital andtheModiglianiMiller
Propositions: AReview 46
3.5 Bank Valuation: AScheme withSeparate
Quantification ofMark-Down 55
3.5.1 Valuation Scheme without Taxation
andGrowth 55
3.5.2 Valuation Scheme withTax Benefits 61
3.5.3 Valuation Scheme withTaxation
andGrowth 63
3.5.4 The AMM: AnOverview 67
3.6 The Restatement ofModigliani andMillers
Theories fortheBanking Industry 70
3.6.1 Absence ofTaxes 70
3.6.2 Presence ofTaxes 72
3.7 Consistency oftheAMM with
Excess Returns Models 73
3.8 Conclusion 78
References 79

4 Measuring theCash Flows ofBanks:


TheFCFA Asset-Side Approach 83
4.1 Introduction 83
4.2 The Balance Sheet Reclassification 84
4.3 The Income Statement Reclassification 91
4.4 From Incomes toCash Flows 95
4.5 FCFA andFCFE: TheCase ofIntesa
San Paolo Bank 99
4.6 Conclusion 107
References 109

5 The Banks Cost of Capital Theories and


Empirical Evidence 111
5.1 Introduction 111
5.2 Pricing Systematic Risk 113
Contents xv

5.2.1 Pricing Systematic Risk in the


Banking Industry 114
5.2.2 Determinants of Banks Equity Beta 115
5.2.3 Separating Business Risk from
Financial Risk: The Effect of Bank Leverage 117
5.3 Pricing Total Risk 122
5.3.1 Pricing Total Risk through Implied
Cost of Capital Metrics 124
5.3.2 Pricing Total Risk through
Standard Deviation 128
5.4 Valuing Unlisted Banks through a Cost of
Capital Comparable Approach: A Practical Example 141
5.4.1 The Financial Data of a Small Bank 142
5.4.2 Cost of Asset Estimation through
the Beta of Comparable Banks 142
5.4.3 Cost of Asset Estimation through Total
Beta Bank Comparable 143
5.4.4 Cost of Asset Estimation through CaRM:
An Account Approach 145
5.5 Conclusion 149
References 150

6 Banks Asset-Side Multiples: Profitability,


Growth, Leverage andDeposits Effect 155
6.1 Introduction 155
6.2 Literature Review: TheSimilarities Between
theTarget Firm andIts Comparables 158
6.3 Banks Market Multiples: Feasible Adjustments 160
6.3.1 Profitability andGrowth Adjustments
onEquity-Side Multiples 160
6.3.2 Asset-Side Adjustments: Additional
Bank Market Multiples 163
6.4 Leverage andDeposits Effect onBank Multiples 167
6.4.1 Unlevered Multiple inthe
Absence ofGrowth 167
xvi Contents

6.4.2 Unlevered Multiples inthe


Presence ofGrowth 169
6.4.3 Calculating theUnlevered Multiple:
APractical Example 169
6.5 Conclusion 172
References 173

7 A Comparison between Valuation


Metrics ina Real Case 175
7.1 Introduction 175
7.2 ABC Bank: Financial Statements andBusiness Plan 176
7.3 Measuring theCost ofCapital ofABCBank 185
7.3.1 The CaRM 185
7.3.2 The CAPM 191
7.3.3 The CAPM with Total Beta 190
7.4 Valuing ABC Bank: TheApplication oftheAMM 190
7.4.1 Balance Sheet Reclassification
andIncome Statement Adjustments 191
7.4.2 FCFA, Mark-Down andTax Benefits 191
7.4.3 The ABC Bank Value using theAMM 198
7.5 Valuing ABC Bank: TheApplication
oftheDDM 203
7.6 Valuing ABC Bank: TheApplication
of theFCFE Model 207
7.7 Valuing ABC Bank: TheApplication
of Market Multiples 210
7.7.1 Equity-Side Approach: PBV, PTBV, PE 212
7.7.2 Asset-Side Approach: EV/OP
andP/BVun (EV/A) 216
7.8 Conclusion: Comparing Valuation Methods 220
References 225

References 227

Index 237
About the Authors

Federico Beltrame is Lecturer in Banking and Finance in the Department of


Economics and Statistics, University of Udine, where he teaches corporate
finance. He graduated in Economics at the University of Udine, where he also
received his Ph.D. in Business Science. His main research interests are related to
SMEs cost of capital, banks capital structure and mutual guarantee credit
institutions.
DanielePrevitali is a Lecturer at Luiss Guido Carli University, Rome, Italy. He
holds a Ph.D. in banking and finance from the University of Rome Tor Vergata.
In 2012, he was a visiting researcher at the Stern School of Business, New York.
His main research interests concern the valuation and capital structure of banks.
He also works as a consultant for a professional agency that is involved in a stra-
tegic advisory capacity to banks and other financial intermediaries.

xvii
List of Figures

2.1 Basel III Phase-in arrangements 9


2.2 Pillar 1 and Pillar 2 capital requirements 10
2.3 Commercial banks financial structure. The sample
is composed of 141 European listed banks.
The reported values are the means of the
respective balance sheets data 12
3.1 Breakdown of bank firm value by the AMM 70
3.2 MMs Second Proposition with no taxes for banks 74
3.3 MMs Second Proposition with taxes for banks 76
7.1 AMMComposition of the Banks firm
value by CAPM (explicit forecast period
and terminal value) 203
7.2 AMMBanks firm value breakdown by CAPM 204
7.3 AMMComposition of the Banks firm value
by CAPM Total Beta (explicit forecast
period and terminal value) 204
7.4 AMMBanks firm value breakdown
by CAPM Total Beta 205
7.5 Composition of the Banks firm value by CaRM
(explicit forecast period and terminal value) 205
7.6 AMMBanks firm value breakdown by CaRM 206
7.7 DDMBanks firm value breakdown by CAPM 209

xix
xx List of Figures

7.8 DDMBanks firm value breakdown


by CAPM Total Beta 209
7.9 DDMBanks firm value breakdown by CaRM 210
7.10 FCFE modelBanks firm value breakdown
by CAPM 213
7.11 FCFE modelBanks firm value breakdown
by CAPM Total Beta 213
7.12 FCFE modelBanks firm value breakdown by CaRM 214
7.13 EVun/Op (adj)Banks firm value breakdown 222
List of Tables

2.1 Industrial vs banking companies: FCFE estimation 17


2.2 Bank-specific FCFE quantification 18
2.3 Other banks market multiples 35
3.1 Dynamic of the WACC for different level of leverage 53
3.2 Bank valuation with no taxes and growth 63
3.3 Bank valuation with taxes 66
3.4 Bank valuation with taxes and growth 69
3.5 Dynamic of the coefficient 80
4.1 IAS compliant bank balance sheet 87
4.2 Macro-class of assets and liabilities
of a banks balance sheet 88
4.3 Balance sheet reclassification 92
4.4 IAS compliant bank income statement 94
4.5 Income statement reclassification 95
4.6 Cash flow statement: from FCFA to FCFE 98
4.7 The balance sheet of Intesa San Paolo Bank
(data in million) 102
4.8 Macro-classes of assets and liabilities
(data in million) 103
4.9 The balance sheet reclassification (data in mln/) 104
4.10 The income statement of Intesa San
Paolo Bank (data in million) 105

xxi
xxii List of Tables

4.11 The income statement reclassification


(data in million) 106
4.12 The FCFA and FCFE of Intesa San Paolo Bank
(data in million) 108
4.13 Asset-side model and simplified FCFE model
(data in million) 110
5.1 Totally levered expected loss rate for different
levels of asset standard deviation 137
5.2 Unlevered expected loss rate for different
levels of asset standard deviation 139
5.3 Liabilities, equity and adjusted income
statementHighlights of a small bank
(data in million) 143
5.4 Beta comparable (12-31/2013) (data in million) 144
5.5 Beta comparable (12-31/2013) (data in billion) 146
5.6 ROA value at risk and K factors for a sample of bank
in the European Union [28] (period 20082012) 148
5.7 ROA standard deviation on comparable banks 149
6.1 Price Earnings of Beta, Gamma and Sigma 158
6.2 Main market multiples used in practice 158
6.3 Comparables data (12-31/2013) 173
7.1 ABC Banks balance sheet (data in 000s) 179
7.2 ABC Banks income statement (data in 000s) 180
7.3 ABC Banks Tier 1 and payouts 181
7.4 ABC Banks balance sheet projections (data in 000s) 182
7.5 ABCs income statement projections (data in 000s) 184
7.6 Balance sheet reclassification: asset and
liabilities (data in 000s) 194
7.7 Balance sheet reclassification: bearing asset
and liabilities (data in 000s) 195
7.8 Income statement adjustments (data in 000s) 196
7.9 Free cash flow from assets (data in 000s) 198
7.10 FCFA of ABC Bank (data in 000s) 200
7.11 ABCs mark-down (data in 000s) 200
7.12 ABCs Cost of deposits 200
7.13 ABCs tax benefits on deposits (data in 000s) 200
7.14 ABCs tax benefits on non-deposit debt (data in 000s) 200
List of Tables xxiii

7.15 Value of FCFA in the explicit forecast for


ABC Bank (data in 000s) 201
7.16 Mark-down value in the explicit forecast for ABC Bank 201
7.17 Value of tax benefits on deposits in the explicit
forecast for ABC Bank 202
7.18 Value of tax benefits on non-deposits debt
in the explicit forecast for ABC Bank 202
7.19 Value oflong-term FCFA, mark-down and tax
benefits for ABC Bank 202
7.20 ABC shareholders cash flow 207
7.21 DDM valuation and the Cost of capital of ABC Bank 208
7.22 Cash flow to equity of ABC Bank 211
7.23 FCFE valuation and the cost of capital of ABC Bank 212
7.24 Market multiplesEquity side approach, full sample 215
7.25 Relative value ABC BankEquity-side approach,
full sample 215
7.26 Market multiplesEquity side approach,
restricted sample 215
7.27 Relative value ABC BankEquity side approach,
restricted sample 216
7.28 Adjusted market multiplesEquity-side
approach, full sample 217
7.29 Relative adjusted value ABC BankEquity-side
approach, full sample 217
7.30 Adjusted market multiplesEquity-side
approach, restricted sample 217
7.31 Relative adjusted value ABC BankEquity-side
approach, restricted sample 217
7.32 Market multiplesAsset-side approach,
full sample 218
7.33 Relative value ABC BankAsset-side
approach, fullsample 219
7.34 Market multiplesAsset-side approach,
restricted sample 219
7.35 Relative value ABC BankAsset-side
approach, restricted sample 219
7.36 Adjusted market multiplesAsset-side
approach, fullsample 220
xxiv List of Tables

7.37 Relative adjusted value ABC BankAsset-side


approach, full sample 220
7.38 Adjusted market multiplesAsset-side
approach, restricted sample 220
7.39 Relative adjusted value ABC BankAsset-side
approach, restricted sample 220
7.40 Operating profit on total asset
31December 2014, fullsample 221
7.41 ABC Bank byvalue map regression,
current level of ROA 221
7.42 ABC Bank byvalue map regression, expected ROA 222
7.43 Comparison between valuation methods
for ABC Bank 223
7.44 Comparison between valuation methods for ABC Bank
in relation to market capitalization 224
1
Introduction

Bank valuation is one of the most difficult topics to address in corporate


finance. This is because banks are characterized by business peculiarities
that make them a special case for valuation compared with other indus-
trial firms. Although they represent only a small part of the full range
of industries, they constitute the cornerstone of economic and financial
systems, and a considerable proportion of the index market capitalization
of the major developed countries.
If the financial crisis of 2007 has a merit, it is its having renewed
the interest of the financial community and academics in the topic of
bank valuation, leading to significant growth in the number of contri-
butions to the literature since that time. Some of the authors explained
the methods currently used in practice (among others Damodaran 2009,
2013; Koller et al. 2010; Massari et al. 2014), while others presented
new valuation models (e.g. Calomiris and Nissim 2007; Dermine 2010),
demonstrating the growing importance of the topic.
But why is the valuation of banks different from that of other industrial
companies? The specifics of bankssuch as the nature of the business
process, the role of equity and debt capital, the pervasive regulation on

The Editor(s) (if applicable) and The Author(s) 2016 1


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
in Banking and Financial Institutions, DOI10.1057/978-1-137-56142-8_1
2 Valuing Banks

the asset and liabilities sidehave several implications with regard to val-
uation. In particular, it can be very difficult to obtain reliable estimates of
many important variablessuch as net working capital, capital expendi-
tures, weighted average cost of capital (WACC)and, above all, to pro-
vide a measure of free cash flow from operations. These limitations force
the application of a simplified equity-side approach based on dividends.
However, there is no clear view of the value creation process in terms
of cash flows, because dividends represent a synthetic measure of cash.
Therefore, the equity-side approach can be considered a flawed method,
because it does not allow analysis of the cash generation created by the
assets and liabilities. Specifically, we can neither appreciate the cash flows
from assets, nor the contribution to value of mark-down and tax benefits.
And all these aspects are of considerable relevance in practice, because a
valuation should highlight where the value originates in relation to assets
and liabilities. Such information is fundamental in several situations:
strategy, business planning, shareholder value management, mergers and
acquisitions, initial public offerings (IPOs), and so on.
In this book, after having reviewed the extant literature and valuation
methods currently applied, in practice we try to overcome the problems
we have just now recalled, providing a bank-specific valuation theoretical
framework and a new asset-side model. The method used, which we called
the Asset Mark-down Model (AMM), is an adjusted present value model
that highlights the main value creation sources of a bank; in our model,
these are the free cash flow from assets (FCFA), mark-down on deposits
and tax benefits on bearing liabilities (deposits and non-deposit debt).
In particular, in Chap. 2, Valuation in Banking: Issues and Models,
we discuss the problems in valuing banks that affect the application of the
standard models of valuation used for industrial firms. In particular, we
refer to the different role of debt and capital, the regulatory framework
and the provisioning effect, and above all to the issues related to cash flow
measurement (net working capital and capital expenditure determina-
tion). In the second part of Chap. 2, we discuss the equity- and asset-side
valuation metrics which academic literature and professionals consider
the most suitable for banks. For each method, we highlight the main
characteristics, the formalization and the advantages or disadvantages in
their application.
1 Introduction 3

In Chap. 3, Value, Capital Structure and Cost of Capital: A


Theoretical Framework, we discuss the implementation of an asset-side
approach in order to overcome the problems of the equity-side models.
Unlike non-financial firms, bank deposits generate value. Such an effect
is explored through several empirical studies concerning the relation
between capital requirements and the WACC and, consequently, bank
value (e.g. Kashyap etal. 2010; Cosimano and Hakura 2011; Baker and
Wurgler 2013; Miles et al. 2013). Moreover, in Chap. 3, we use such
empirical evidence to highlight the problems related to the applicabil-
ity of ModiglianiMiller propositions in regard to the banking industry.
Specifically, the main concern of Chap. 3 is to propose a new corpo-
rate finance theoretical framework for bank valuation, exploring a new
issue representing a relevant gap in the literature. Using such theoreti-
cal framework, we elaborate the AMM to highlight the value generated
from the unlevered assets, deposits and tax shields. To do this, we for-
malize the link between the cost of assets and the WACC, and propose
a restatement of the ModiglianiMiller propositions using bank-specific
adjustments. Additionally, we compare and reconcile the AMM to excess
return models.
In Chap. 4, Measuring the Cash Flows of Banks: The FCFA Asset-
side Approach, following the theoretical framework of the AMM, we
discuss the free cash flow from asset measurement. In particular, we pro-
pose a valuation framework which splits a banks cash flows into those
originating from assets and those from liabilities. In particular, the most
important assumption is that bank debt is considered as a financial lia-
bility. This has several implications for the balance sheet, income state-
ment and cash flow reclassifications. For those reasons, we develop a new
model for reclassifying banks financial statements in order to obtain a
measure of free cash flow from assets. In addition, we reconcile the latter
to the free cash flow to equity, taking into account the overall debt finan-
cial operations. Such reconstruction of the model is very important, as
all the current literature has estimated direct cash flow to equity without
reconciling it to cash flow from operations. Our model tries to close this
gap in the literature. In addition, in Chap. 4, we propose a solution to
the problems related to the net working capital and capital expenditure
estimation of banks. After having discussed the free cash flow model in
4 Valuing Banks

terms of theory, we propose the application of free cash flow from assets
in relation to a real case.
In Chap. 5, The Cost of Capital of Banks: Theories and Empirical
Evidence, we discuss the methodologies used for the estimation of the
cost of capital in the banking industry. In particular, first, we discuss the
generic treatment of the cost of equity calculation metrics that we divided
into methods quantifying the systematic risk premium and methods
measuring the total risk premium. The first aim of Chap. 5 is to modify
the Hamada (1972) formula excluding value of deposits from a banks
asset beta. According to this approach, we obtain a better measure with
which to represent asset risks, which additionally is independent from
bank leverage. The second aim is to discuss the equity pricing methods
that enable the total risk (such as total beta and the implied cost of capital
measures) to be quantified in particular, adapting the Capital at Risk
Model (CaRM) (Beltrame etal. 2014) to the banking industry. In order
to better understand the applicability of the models, the chapter provides
several numerical examples.
In Chap. 6, Banks Asset-side Multiples: Profitability, Growth,
Leverage and Deposits Effect, the focus is on bank market multiples.
In particular, we show the influence of firm growth on market multiples.
Then, according to the theoretical framework we presented in Chap. 3,
we propose alternative options of asset-side multiples that can be used
in the relative valuation of banks. In addition, we implement a new
approach that mixes the use of asset-side multiples with a separate evalu-
ation of deposits and tax shields.
Finally, in Chap. 7 A Comparison between Valuation Metrics in a
Case Study, we run a simulation on a real case of a bank valuation with
the application of the AMM and its derived market multiples, and we
compare this with the traditional metrics currently used in banking.
Results show that the AMM allows us to better understand where the
value of a bank lies and attributes greater value to the liabilities side than
the traditional valuation approach. The asset-side model we present could
represent a useful method to compare with the equity-side approach cur-
rently used in bank valuation.
1 Introduction 5

References
Baker, M., & Wurgler, J. (2013). Do strict capital requirements raise the cost of
capital? Banking regulation and the low risk anomaly (no. w19018). National
Bureau of Economic Research.
Beltrame, F., Cappelletto, R., & Toniolo, G. (2014). Estimating SMEs cost of
equity using a value at risk approach: The capital at risk model. London: Palgrave
Macmillan.
Calomiris, C.W., & Nissim, D. (2007). Activity-based valuation of bank hold-
ing companies. NBER working paper no. 12918.
Cosimano T.F., & Hakura D.S. (2011). Bank behavior in response to Basel III:
A cross-country analysis. IMF working paper 11/119.
Damodaran, A. (2009). Valuing financial service firms/A.Stern Business.
Damodaran, A. (2013). Valuing financial service firms. Journal of Financial
Perspectives, 1, 116.
Dermine, J. (2010). Bank valuation with an application to the implicit duration
of non-maturing deposits. International Journal of Banking, Accounting and
Finance, 2, 130.
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risk of common stocks. The Journal of Finance, 3(2), 435452.
Kashyap, A.K., Stein, J.C., & Hanson, S. (2010). An analysis of the impact of
substantially heightened capital requirements on large financial institutions.
Mimeo: Booth School of Business, University of Chicago.
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managing the value of companies (5th ed.). NewYork, NY: Wiley & Sons.
Massari, M., Gianfrate, G., & Zanetti, L. (2014). The valuation of financial
companies. Chichester: Wiley & Sons.
Miles, D., Yang, J., & Marcheggiano, G. (2013). Optimal bank capital. The
Economic Journal, 123(567), 137.
2
Valuation inBanking: Issues andModels

2.1 Introduction
Several specifics concerning the banking business make it difficult to
apply the valuation methods commonly used for non-financial compa-
nies. The literature has universally acknowledged that pervasive regula-
tion, the composition of assets and liabilities, the definition of debt and
a completely different structure of business and product cycle represent
some of the most relevant issues to deal with in bank valuation. Such
limitations require several adjustments of standard valuation metrics in
order to take into account of banks peculiarities. In the following sec-
tions, we first review such banks specifics in order to show how they
affect the value generation process, and, second, we present the valuation
methods commonly accepted by the literature and applied by practitio-
ners in banking.

The Editor(s) (if applicable) and The Author(s) 2016 7


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
inBanking and Financial Institutions, DOI10.1057/978-1-137-56142-8_2
8 Valuing Banks

2.1.1 A
 Different Role forEquity: TheRegulatory
Constraints

Banks are subject to pervasive regulation and the power of enforcement


and control lies with the international and national supervisory authori-
ties. The standards with which banks are required to comply represent
real operating and budget constraints and, consequently, they have a con-
siderable impact on the way banks are managed in the short and in the
long term.
Generally, banking regulation affects many aspects of financial institu-
tions operations both on the assets and liabilities side. Among them, the
most important factor affecting valuation is widely acknowledged to be
the capital constraints imposed by the Basel framework (e.g. Bagna 2012;
Damodaran 2013; Koller et al. 2010; Massari et al. 2014; Rutigliano
2012). The focus on capital is basically due to the following three factors:

1. The nature of banks businesswhich deals with savings, credits,


investments and paymentsneeds a strong form of protection from
market failures.
2. High capital buffers protect claimholders from default and they

contribute to raising banking sector resilience to potential systemic
financial crises.
3. Capital in banking has a different role compared to that of other indus-
trial companies. In banking, capital depends on the composition of
assets and on their riskiness.

According to the latest release of the Basel framework (Basel III), the
phase-in mechanism of which we report in Fig. 2.1, banks have to meet
specific requirements of capital adequacy and liquidity standards.
Basically, the Basel framework forces banks to set aside a minimum
amount of capital in relation to their assets riskiness, which are mea-
sured in terms risk weighted assets (RWAs). In particular, Basels mini-
mum capital requirements are related to the traditional risks of banking
activity (credit, counterparty, market and operational risk), also known
as Pillar 1 risks. Therefore, as long as RWAs grow in terms of size along
the cash flows projections of a hypothetical business plan, all other things
2 Valuation inBanking: Issues andModels 9

Fig. 2.1 Basel III Phase-in arrangements. * Including amounts exceeding the
limit for deferred tax assets (DTAs), mortgage servicing rights (MSRs) and
financials. ** National Authorities will be allowed to raise the requirement.
Source: Authors elaboration from http://www.bis.org/bcbs/basel3.htm

remaining equal, the capital requirements must be proportional to the


planned level of RWAs. In this way, there can be an internal equilib-
rium between assets at risk and the capital base. Similarly, if manage-
ment foresees an increase in the assets riskiness (which does not matter
size, for example, credit quality deterioration), all other things remaining
equal, capital requirements will move upward to reflect the increasing
asset risk. Therefore, there is a clear proportional relation between RWAs
and capital that is clearly defined by the minimum capital ratio of the
Basel framework.
As one can imagine, such potential restrictions are particularly signifi-
cant in valuation, since the regulatory capital and its internal composi-
tion are a formal constraint on growth opportunities. In fact, a capital
shortfall reduces bank capacity to increase assets, or even to manage their
internal composition in relation to their intrinsic risk. Such a rigidity
of asset and capital management might affect banks ability to produce
10 Valuing Banks

e arnings and, therefore, to distribute dividends. Therefore, when we run


a bank valuation, we should assess not only its growth in asset and earn-
ings, but also its strategy for meeting the increasing capital requirements.
In particular, it must be ensured that all the business options allow regu-
latory requirements to be met over time. In other words, strategic vision
and operational actions must be conceived in light of the regulatory needs
imposed by national and international authorities.
An additional consideration relates to capital adequacy. The Basel
framework requires that capital adequacy is reached only when a banks
capital is at least equal to the total internal capital; that is, the capital
needed for covering current and future risks (including all risks other
than those of Pillar 1). Therefore, in order to grant compliance with the
regulatory requirements, we should assess whether a bank is able to main-
tain a sufficient capital base to cover the measurable and quantifiable
risks also of Pillar 2 of Basel Accord (Fig. 2.2). However, from an external
perspective, such information is not publicly available, because it fol-
lows the Internal Capital Adequacy Assessment Process (ICAAP) and the
Supervisory Review Evaluation Process (SREP) which, under the extant
regulation, is not disclosed to the public. Hence, in the case of an external
analyst, the only way to assess the internal consistency of the business
plan (and correlated cash flows) is in relation to Pillar 1. In any event, the
adjustment for Pillar 1 requirements represents a good proxy for the total

Typology of risk to be assessed Level of capital


Credit risk
Pillar 1

Counterparty risk Regulatory


Market risk requirements
Operation risk
Pillar 1 Risks Other risks
Credit risk Concentration risk
Pillar 2

Counterparty risk + Interest risk on banking book Total Internal


Market risk Residual risk Capital
Operation risk Risks related to securitizations
Other quantifiable risks

Fig. 2.2 Pillar 1 and Pillar 2 capital requirements. Source: Authors elaboration
2 Valuation inBanking: Issues andModels 11

capital. In fact, Pillar 2 should not be required to be covered by equity


capital since not all risks are measurable and quantifiable.
Another capital constraint is represented by the leverage ratio intro-
duced by the third release of the Basel Accord. Leverage ratio demands
that a 3 % minimum standard of Tier 1 over the in-balance and off-
balance sheet total assets be held. Clearly, such a restriction has the role of
controlling banks capital adequacy also for below-the-line risks which are
not taken into account by the Tier 1 ratio. In terms of valuation, the lever-
age ratio should be one of the growth size limits to control for, even if, in
practice, capital adequacy is assessed only from a Pillar 1 point of view.
Thus, regulation undoubtedly affects banks future performance,
as it affects reinvestment and growth rates (Damodaran 2013).
Additionally, the uncertainty linked to the incremental level of macro-
prudential regulation, or the change of specific national rules (such as
specific capital buffers, limits on dividends distribution, and so on),
may, once again, affect the pace of growth for banks, their capacity
for earnings production and, consequently, dividends distribution. In
particular, regulation usually tightens (and becomes more uncertain)
during periods of financial turmoil, as a response to negative shocks in
the financial system (Moshirian 2011). In addition, in order to main-
tain keen attention to exposure to risks,1 plural regulatory authorities
undertake reviews on asset quality and capital adequacy. Finally, dif-
ferences in national regulation may even affect value. As a matter of
fact, different regulatory regimes may have differing degrees of rigor in
their application of banking law. Thus, a banks risk profile needs to be
contextualized in light of the legislation to which that bank is subject
to. This aspect can be particularly important when comparing banks
in different countries. On the one hand, different sets of rules may
affect the comparison of banks between countries; on the other hand,
in the case of international players, analysts should evaluate the effect
of varying regulatory overlay on banks cash flows.

1
An example is the Asset Quality Review and Stress Test which was conducted in 2013 and 2014
both in the USA and the UE.The results of the tests forced the under-capitalized banks to raise
more capital.
12 Valuing Banks

2.1.2 The Role ofDebt

Banks, on average, are characterized by a high level of indebtedness. As


shown in Fig. 2.3, the average level of debt of a sample of 184 listed
European banks is over 80% of the total assets.
Four basic reasons contribute to this situation:

1. Regulatory authorities define the minimum capital standards and,


therefore, the most part of liabilities is made up by debt.
2. The role of debt in banking is different from that of industrial compa-
nies since debt may be considered as the raw material of banks and, at
least theoretically, it could be defined as the only source of funding,
since the equity capital, according to the Basel framework, has the
primary function of absorbing losses.
3. Debt creates value.
4. Operating with too much capital beyond the regulatory limit and/or
industry average is costly and inefficient, if it is not invested in profit-
able assets or external growth (i.e. mergers and acquisitions).

100.00
90.00 17.47 13.68 13.47 13.94
80.00
70.00
60.00
50.00
40.00 82.53 86.32 86.53 86.06
30.00
20.00
10.00
0.00
2013 2012 2011 2010
Debt Total Asset Ratio Equity Total Asset Ratio

Fig. 2.3 Commercial banks financial structure. The sample is composed of


141 European listed banks. The reported values are the means of the respec-
tive balance sheets data. Source: Authors elaboration.
2 Valuation inBanking: Issues andModels 13

According to the literature, the most important issue in bank valuation


is really represented by the definition of debt. Debt can be considered
as the raw material of banks, since their principal activity is to trans-
form it into other financial assets, taking on the maturity transformation
risk. Thus, if we consider all the debt as raw material, then, financial
institutions should not be deemed as financially indebted companies,
because such kinds of obligation are considered afferent to the operations
management. However, notwithstanding there is a practical distinction
between financial and operational debt, the main problem to be faced
when we value banks is that we cannot execute a precise separation of
financial management from operations management. This is because, in
banking, financial management is part of operational management. The
problem of operational and financial debt separation derives also from
the fact that a banks income statement does not provide any specific sec-
tion or item for financial expenses, as would be the case for industrial
companies financial statements. In other words, we cannot separate the
flows of the different typologies of debt instrument.
Another important issue involving bank debt is that it cannot be
entirely subtracted by the market value of assets when an asset side model
is employed, since debt is a source of value. This is so because banks
raise the most part of their funding from retail and other banks deposits
(including those from central banks) at a lower cost than other com-
mon technical instruments (e.g. bonds). In particular, the spread between
the interbank-ratio and the cost of deposits is known as mark-down,
which, as we will see in the following chapters, is an important source of
value in banking. Accordingly, banks create value even on the liabilities
side, which creates some important issues to take into account in the
valuation process.
Another issue is related to the definition and composition of weights in
the weighted average cost of capital (WACC). The first issue to deal with
is related to defining, again, what is financial debt and distinguishing it
from the several forms of financial instruments. However, assuming that
an objective criterion can be adopted, the second issue to resolve would
be related to the pricing of debt which, owing to the different typolo-
gies of financial obligation, would be confusing to address. Hence, the
impossibility of separating operational debt from financial debt affects
14 Valuing Banks

the WACC calculation. According to theory, if we were to treat all the


debt as financial debt, the result would be under-estimated cost of capital
compared with the effective one, because the component of debt would
be much higher than that for equity capital.
On the whole, due to the complications we have discussed so far, schol-
ars and practitioners agree in using an equity side approach when valuing
banks. However, the literature so far has provided neither a consistent
discounted cash flow method based on a banks asset side, nor reconcili-
ation between asset and equity-side valuations, which would represent
a better valuation framework within which to understand and measure
where economic value and risk are created.

2.1.3 Loan Loss Provisioning andCharge-Offs

Another important issue in bank valuation relates to the assessment of


loan loss provisions (LLPs). LLPs are the provisions made by banks in
order to face a potential distortion of credit portfolios quality and they
can be considered as one of the main accrual expenses for banks (Curcio
and Hasan 2015). Generally, LLPs are discretionary and this is the reason
why they have to be normalized in the expected earnings calculation.
There are several objectives pursued by provisioning:

Taxes: the higher the provisions, the lower the annual tax expenses.
Managers can adjust provisions in order to achieve a target net profit;
Capital adequacy: managers can use provisions in order to meet capital
requirements since, under specific circumstances,2 they can be consid-
ered as Tier 2 capital in the Basel framework;

2
Under Basel II, LLPs can be included in the Tier 2 capital provided the bank uses a standard or
internal rating-based approach. If it employs a standard approach, the regulatory framework antici-
pates that LLPs can be included up to the limit of 1.25% of the RWA.For those which have an
internal rating model, banks must compare the expected credit losses with the total provisions.
When expected credit losses are higher than total provisions, banks deduct the difference (50%
from Tier 1 capital and 50% from Tier 2 capital). Conversely, when total provisions are greater
than expected losses, the difference is computed as Tier 2 capital, but only up to a maximum of
0.6% of credit RWA.
2 Valuation inBanking: Issues andModels 15

Income smoothing: that is the practice which is intended to stabilize net


profits over time. This goal can be explained by the fact that managers
are inclined to:
keep bank profitability around a determined range of values in
order to maintain a constant mean (Collins etal. 1995);
achieve a mean benchmark (Kanagaretnam etal. 2005);
keep their annual compensation steady (Bhat 1996);
Signaling: where significant LLPs are considered more as a signal of
future profitability rather than of credit losses. In practice, provisions
can be divided into discretionary and non-discretionary provisions.
The former are those managers control, while the latter are due to the
technical evolution of the credit portfolio. Through discretionary pro-
visions, managers provide a signal that the expected earnings can
absorb additional provisions (Beaver and Engel 1996; Bouvatier and
Lepetit 2008; Curcio and Hasan 2015).

The uncertainty of bank provisions compared with their actual losses


may lead to incorrect estimations of net profits and retention ratios. As
future growth depends on those two basic factors, it can be claimed that
the intrinsic value of a bank is also related to the value of provisions set
aside over the years. Hence, when adjustments on dividends have to be
made in valuation, potential misalignments between provisions and real
losses have to be assessed. In this context, the problem related to the
double binary of the International Financial Reporting Standards (IFRS)
and Basel practice of accounting provisions must be mentioned. Under
the IFRS, LLPs must be calculated considering the incurred losses, which
are losses that have already occurred, or it is presumed will be incurred,
on the basis of an event that has already taken place. Under Basel II,
LLPs should be set taking into account expected losses. In July 2014,
the International Accounting Standard Board (IASB) adopted the new
IFRS9, which comes into play on 1 January 2018 and will adopt a view
of provisioning more closely aligned to that of the Basel framework.
All these adjustments are usually made by taking into account an his-
torical value of credit losses, and thus assessing them through-the-cycle
rather than by a point-in-time perspective.
16 Valuing Banks

2.1.4 Cash Flow Estimation

Other complications in bank valuation concern quantifying free cash


flows, which are more difficult to estimate compared with those of
industrial companies. As we have seen previously, the problems related
to cash flow measurement arise from the critical nature of separating
operations, investment and financing activities.
In terms of cash flow to equity derivation, while net income adjust-
ments for non-cash operations are feasible (as is the case for industrial
firms), net working capital, capital expenditures and debt reimbursement
are defined in a different way in banking.
With regard to the definition of net working capital, inventory is not
easily recognizable since all products and services are basically intangibles
and, consequently, cannot be physically stored. Moreover, current assets
and liabilities are of a commercial nature (if we follow the theoretical
framework of the not-indebted bank), but that amount would be clearly
characterized by a strong instability, even in the short-term. In fact, each
day banks trade part of their short-term assets and liabilities, so giving
a clear and reliable definition of working capital may be complicated.
Hence, the definition and estimation of working capital also depend on
the problems related to the separation of commercial and financial opera-
tions, in terms of both assets and liabilities.
With regard to capital expenditures, banks are characterized by a low
level of amortizations as the majority of their investments are not tangible
assets. Rather, banks invest in human capital, processes and procedures
enhancement, Information and Communication Technology (ICT) and
brand; these are normally accounted as operational costs rather than fixed
investments. In order to proceed to their capitalization, the main prob-
lem for an external analyst is to separate the single items of investment
from operational costs. Thus, capital expenditure adjustments, such as is
made for industrial companies, are not feasible in banking owing to the
differences in terms of fixed investment typologies.
However, the literature has widely accepted that bank returns should
be adjusted for capital adequacy requirements as a form of bank-specific
capital expenditures (Bagna 2012; Damodaran 2013; Koller etal. 2010;
2 Valuation inBanking: Issues andModels 17

Massari et al. 2014; Rutigliano 2012). The practical convention is to


adjust for the regulatory ratio in relation to the RWAs growth. However,
such an adjustment would be partial, since banks need to have a larger
capital base in order to meet the overall capital adequacy and operational
flexibility (see Sect. 2.1.1). In other words, in order to adjust correctly for
the degree of risk of assets, it might be necessary to consider a retention
ratio that is higher than the formal regulatory requirements. Such a rate
could be set by the bank in its business plan or, also, the mean value of
its peer group.
The third net income adjustment concerns debt issuance and reim-
bursement. As we argued in paragraph in Sect. 2.1.2, it is very difficult to
separate commercial and financial debt. This is because, fundamentally,
financial operations may even be considered commercial operations.
Therefore, from the perspective of an outside analyst, the adjustment for
financial debt is very complex so that it cannot be carried out in practice.
Finally, from a cash flow to equity point of view, the adjustment for
preference share dividends can be made in the same manner as for indus-
trial companies.
On the whole, considering all the limits we have discussed so far, in
the quantification of cash flow, earnings are adjusted for cash-ineffective
transactions, regulatory capital needs and preference share dividends, but
this does not consider working capital and other capital expenditures.
In Table 2.1, we report the main differences relating to free cash flow to
equity (FCFE) between industrial and banking firms.

Table 2.1 Industrial vs banking companies: FCFE estimation


Levered approachFree cash flows
Industrial companies Banking companies
Normalized net income Normalized net income
+ Cash-ineffective operations + Cash-ineffective operations
Net working capital variation Regulatory capital adjustment
Capital expenditures Preference share dividends
+ New debt
Debt reimbursement
Preference share dividends
Free cash flow to equity Free cash flow to equity
Source: Authors elaboration
18 Valuing Banks

An alternative bank-specific approach to FCFE estimation was pre-


sented by Copeland et al. (2000). They adjusted net income for net
increase in debt (which they call uses) as a cash flow in, and for net
investments (which they call sources) as a cash flow out (see Table 2.2).
Notwithstanding the appealing proposed solution, however, in the
opinion of the authors, such a construction remains useful only from
an internal analysis perspective; it maintains the set of problems that we
have discussed, such as the identification of debt financing and capital
expenditures.

Table 2.2 Bank-specific FCFE quantification


Income statement Balance sheet
= Net income Gross loans due New loans
+ Depreciation Provisions and + Net increase in customer
unearned loans
income
+ Amortiziation = Net loans paid + Net increase in trading
and investment
securities
+ Pension provision
+ Deferred tax + Net increase in + Net capital expenditures
provision deposits in current and fixed
asset
+ Loan loss provision + Net increase in
debt financing
+ Risk provision + Net increase in
interbank funds
Adjusted risk + Net increase in
provision other liabilities
/+ Other cash-
ineffective income
and expenses
/+ Extraordinary
gains/losses
+ Retained earnings
= Cash flow + Sources Uses
Source: Authors elaboration following Copeland etal. (2000)
2 Valuation inBanking: Issues andModels 19

Generally, we can argue that the cash flow to equity approach for
banking firms is a sort of simplification of the standard process used for
industrial companies. Although the broadly accepted net income adjust-
ments refer only to cash-ineffective transactions, preference shares and
capital adequacy, by adopting this approach we miss some of the relevant
information which, to some degree, means that valuations are not fully
reliable.

2.2 V
 aluation Methods ofBanks: ACritical
Review
In Sects. 2.2.1 to 2.2.5, we discuss the valuation metrics academic lit-
erature and practitioners consider the most suitable for banks. For each
method, we highlight the main characteristics, the formalization and the
advantages and disadvantages of its application.

2.2.1 Discounted Cash Flow Models

As it is commonly held, the discounted cash flow approach is based on


the theory that the price of an asset is determined by discounting back
the expected cash flows along a determined period of time. In bank valu-
ation, there are two broadly accepted discounted cash flow models: the
Dividend Discount Model with the Excess Capital adjustment (DDM.
EC), and the Cash Flow to Equity Model (CFE).
With regard to the DDM.EC, it represents the valuation methodol-
ogy used at most for banking institutions (Damodaran 2013; Frost 2004;
Massari etal. 2014). The equity value (E) measured by the DDM.EC is
given by the sum of:

the effective distributable dividends (Div), determined by a banks


management in the business plan or expected by analysts, and dis-
counted back at the cost of equity (rE);
the present value of the excess/deficit capital (EC/DC), determined in
proportion to the RWA, adjusted for the cumulated capital distribu-
tion, and discounted back at the cost of equity;
20 Valuing Banks

the terminal value (TV) of the investment that is obtained from the
last explicit net income, adjusted for minor returns for capital distribu-
tion (Unadj), multiplied for a growth rate (g), reduced by the amount
of capital needed from RWA long-term growth, and multiplied for the
ongoing capital target ratio of the bank (TRlt), and discounted back at
the cost of equity;

n
Divt EC / DCt TV
E= + + , (2.1)
t =1 (1 + re )t
(1 + re ) t
(1 + re )n

where TV is:

Unadjn (1 + g ) - ( RWAn - RWAt ) TRlt


TV = (2.2)
re - g

It must be underlined that the assumption of excess capital distribu-


tion is controversial as few banks operate with Common Equity Tier 1
(CET1) capital aligned to the regulatory minimum standards. As a matter
of fact, as we have already pointed out, in order to hold a determined flex-
ibility for capital management and future growth, banks generally hold
several capital reserves they can use for increasing future risk exposure,
maintaining a determined target rating, facing future losses, undertaking
external growth such as acquisitions, and so on. All such contingencies
might affect the reliability of the excess capital adjustmentwhich is
distributed for the most part in time 0since the capital total distribu-
tion is only theoretical and, either way, does not follow the hypothesized
dynamic in the standard model. Conversely, the excess capital distribu-
tion should be adjusted in relation to the internal and external strategies
the bank intends to pursue during the cash flows projection.
In addition, the excess capital distribution requires that the structure
of valuation is revised considering two alternative adjustments:
2 Valuation inBanking: Issues andModels 21

1. Asset contraction: as less equity capital entails a reduction in terms of assets


with the consequence of less interest income. The adjusted earnings are mea-
sured as in equation (2.3).

Adj.Earnings = Earnings - (1 - t ) . ( Excess Capital.Risk free rate ) (2.3)



2. The substitution of equity with debt capital: this implies an adjustment
of earnings as in equation (2.4).

Adj.Earnings = Earnings - (1 - t ) . ( Excess Capital.Risk free rate ) (2.4)

Usually, the first alternative is the one more usually applied in practice.
With regard to distributable dividends, they are obtained by dividends
expected by the business plans payout ratios consistently with growth,
expected profitability and capital minimum standards. In particular, divi-
dends can be extracted by payout ratios which are historically observable
(or disclosed in business plans, or provided by analysts). An alternative
way to derive potential effective payouts is to verify the internal consis-
tency between dividends, growth and earnings. This is done basically by
estimating a normalized sustainable long-term return on equity (ROE),
which is the real value driver of growth (g).

g
Payout = 1 (2.5)
RoElt

For the valuation of excess capital distribution, in time 1, the cash flow
is determined by the difference between the available CET 1 capital and
the targets the bank plans to hold.

EC / DC1 = CET 1eff1 CET 1tar1 (2.6)



From period 2 until the end of the explicit forecast, the distributed
capital can be determined by subtracting the part that has already been
distributed in preceding years from the difference between effective and
22 Valuing Banks

target CET1 capital,. In addition, the effective CET1 after time 1 does
consider the adjustment for asset contraction.
t 1

( )
EC / DCt = CET 1efft CET 1tart EC / DCt k (2.7)
k =1
The other equity side-DCF method is the CFE model.
The CFE model assumes that the free cash flow to equity estimation
is possible if reinvestments are measured differently than is convention-
ally the case for industrial firms. In fact, if we define reinvestment as that
in the regulatory capital, and we consider also the capital management
operations (e.g. capital increase), it is possible to explicate FCFE as:

FCFE = Earnings - Capital Reinvestment Capital Management Operaations



(2.8)

where the FCFE represents the available cash flows to shareholders, after
having met the regulatory requirements and capital management opera-
tions. Also, in this case, the excess capital adjustment has to be made in
order to take into account the potential available capital to be returned
to shareholders.
Comparing the DDM.EC and the CFE metrics, we can claim that the
two models lead to an equal result when the bank pays out all distribut-
able earnings. In particular, this condition comes true when the payout
ratio is equal to 100 %. However, according to Massari et al. (2014),
banks do not distribute all the potential dividends. To the contrary, they
tend to carry out what is called dividend smoothing; this is the mecha-
nism by which, considering the internal and external strategies and the
economic cycle alternation, managers tend to stabilize dividend cash
flows over time (e.g. Anandarajan etal. 2003, 2007; Bhat 1996; Collins
et al. 1995; Kanagaretnam et al. 2005; Liu and Ryan 1995; Liu and
Wahlen 1997; Prez etal. 2008).
On the whole, considering the main features of the discounted cash
flow models applied in the banking sector, the main propositions we can
draw are that:
2 Valuation inBanking: Issues andModels 23

the DDM.EC is a more reasonable model to use in practice because


free cash flows to equity cannot be estimated in banking unless certain
strong assumptions are made. In addition, banks do not pay out all
annual earnings, as they tend to smooth shareholders cash flows over
time. Notwithstanding the limitations, dividends are considered the
best proxy of free cash flows available for shareholders.
dividends are the result of a banks distribution policy, which is very
difficult to foresee in the long-run, especially from the perspective of
an outside analyst. Notwithstanding this, although historical data may
represent a good benchmark, valuation looks at the future. And when
the future is difficult to predict, as in the case of financial crises, DDM.
EC valuation could become unreliable. In these cases, a prudential
perspective should bring a control for an asset-side method of valua-
tion or, at least, a probabilistic sensitivity analysis.

Finally, one of the most important components of the DCF models is


the cost of equity. Notwithstanding that, in practice, the most frequently
applied methodology for the estimation of a banks cost of equity is the
Capital Asset Pricing Model (CAPM) (Damodaran 2013), there could
be some useful alternatives; for example, the methodologies that consider
the possibility that investors are under-diversified. Chapter 5 is totally
devoted to discussion of this topic.

2.2.2 Excess Returns Valuation

DCF metrics do not give any information about value creation. In order
to adopt a different perspective that is more useful in order to assess
whether firms achieve higher returns than the cost of capital, we need to
switch our attention to the Residual Income Models (RIMs), also known
in the accounting literature as excess returns or abnormal earnings mod-
els. The theoretical framework dates back to 1890 with the contribution
of Marshall,3 in which he introduced the concept of value as being the
excess profit after having deducted a capital charge. Through RIMs, the
3
For a detailed investigation on the evolution of the theory of the excess returns model, see Magni
(2009).
24 Valuing Banks

value of a firm can be measured on the basis of its ability to achieve a flow
of returns higher than the return the invested capital could generate if it
were invested in other financial assets with the same risk profile (i.e. the
opportunity cost).
From an academic perspective, excess returns metrics follow the
Feltham and Ohlson model (Feltham and Ohlson 1995) and do not hold
simply on accounting data; rather, they weight returns for a fair cost of
capital. From this perspective, the value of a firm strictly depends on
whether returns exceed the cost of capital (i.e. the excess return). In the
event that such a condition is not achieved within the forecast period, the
value of the business is purely its net asset value.
The traditional version of the RIM is represented by equation (2.9) or,
alternatively, equation (2.10) but, among the most popular models used
by practitioners, are the Economic Value Added (EVA) (Stewart 1990),4
and the Economic Profit (EP) (Copeland etal. 2000), which differ for
the definition of the estimation variables but, in practice, can be consid-
ered as overlapping.

Residual Income = ( ROIC - WACC ) Invested Capital (2.9)



Residual Income = Operating earnings - ( WACC Invested Capital ) (2.10)

However, as we have previously discussed, since in banking an equity-
side approach to valuation is required, the RIM can also be applied. The
literature (e.g. Damodaran 2013; Massari etal. 2014) has presented the
equity-side RIM as shown in equation (2.11) or equation (2.12):

Residual Income = ( ROE - re ) Equity Capitalt- 1 (2.11)


Residual Income = Net Income - ( re Equity Capital t -1 ) (2.12)



Thus, the equity value of a bank can be written as the sum of the equity
book value (BV) plus the present value of expected residual incomes:

For an application to banks, see Fiordelisi and Molyneux (2006).


4
2 Valuation inBanking: Issues andModels 25

t=n
RI t TV
E = BV + + (2.13)
t =1 (1 + re ) (1 + re )n
t

where TV is:

RI t +1
TV = (2.14)
(re g )

Notwithstanding the ease of the model, however, certain important


assumptions and adjustments need to be made in the application of the
equity-side RIM, both for returns and for equity components of the
model.
With regard to returns, ROE is considered an useful ratio by practitio-
ners as it is assumed to be a good indicator of bank profitability (Massari
et al. 2014). However, the European Central Bank (ECB) (2010) has
pointed out that ROE has several limitations. In particular, ROE is not a
good predictor of a banks future performance and, more importantly, it
is unable to offer a reliable synthesis of the potential effects of risks and
of leveraging and deleveraging on future performance. This limitation
becomes even more evident during periods of financial turmoil, when
long-term strategies and results are more difficult to predict, particularly
in terms of unaccounted and emerging risks. Thus, when ROE has to be
estimated in the RIM, rigorous adjustments need to be made in order
to take into consideration not only accounting distortions, but also the
reasonable repercussions of the sustainability of medium- and long-term
strategies (e.g. erosion of competitive advantage), so as to allow for the
potential impact of business and risks.
With regard to the cost of capital components in the excess returns
estimation, the invested capital equals the equity capital, which is usu-
ally composed of common equity, reserves and net income. Additionally,
the invested capital should also take into account stock buybacks, capital
increases and all the other capital management operations.
It must also be emphasized that the RIM framework holds on an
important assumption in relation to the comparison between ROE and
26 Valuing Banks

the cost of equity. ROE follows an accounting approach, while cost of


equity follows a market approach. Thus, the two variables are comparable
only if we assume that the book value of equity is closer to its market
value. In other words, if there is a considerable gap between the market
capitalization and the book value of equity (and therefore the price to
book value is considerably different from 1), then the CAPM is not a
fair model to use to compare returns to the cost of capital (Sironi 2001).
In terms of the literature, scholars have considered whether the RIM
is superior to the DDM (e.g. Francis etal. 2000; Penman and Souggianis
1998). The ongoing debate seems to be convergent on the fact that the
two models should lead to the same results if Clean Surplus Accounting is
respected (Dechow etal. 1999; Lundholm and O'Keefe 2001). But bank
business is characterized by a relevant proportion of Other Comprehensive
Income (OCI) (such as unrealized capital gains, and revaluation of
tangible and intangible assets) which, potentially, might break up the
Clean Surplus Accounting assumption. In this case, forecasting effective
expected dividend distribution is particularly complicated in the presence
of consistent OCI; therefore, the RIM could represent a better choice
for valuation. However, analysts are used to considering OCI at pres-
ent value equal to zero and, thus, it is not taken into account as part of
intrinsic value.
With regard to the banking literature, the excess returns models have
been tested by comparison with other valuation models (basically, DCF) in
a value relevance context. Results are basically convergent (e.g. Fiordelisi and
Molyneux 2006; Bagna 2012): excess returns measures perform better than
the others in terms of market book ratios and market returns. This may be
due to the evidence that excess returns models not only follow a shareholder
value approach, but also because they have developed bank-specific measures
of excess returns with specific adjustments.5 Hence, it can be claimed that
RIMs better match a market approach, since its valuation perspective is that
of the equity holders.

5
With regard to Fiordelisi and Molyneux (2006), the NOPAT was adjusted for loan loss provisions
and loan loss reserves, taxes, restructuring charges, security accounting, and general risk reserves.
Bagna (2012) proposed an adjusted residual income model which takes into account bank-specific
intangibles, such as core deposits, indirect funding and unrealized capital gains on the banking
book.
2 Valuation inBanking: Issues andModels 27

On the whole, the literature considers the DDM and RIM as equiva-
lent models (Fernandez 2002), notwithstanding this, in banking the most
widely applied model is the DDM method even if RIM can be useful as
a back-testing model since it is based on:

a focused use of accounting data which are easy to find and object to
less elaboration than free cash flows;
independence from dividends distribution or negative free cash flows;
a value-based management approach which is easily communicable
and understandable.

2.2.3 Asset andMixed-Based Valuation

Although asset-based models are not frequently used in practice in bank


valuation, the literature suggests that they can be applied in two specific
cases:

1. When banks have reached a very high level of maturity in terms of


business and, thus, when there is a very small or no margin for growth;
2. When banks are evaluated for liquidation.

In these terms, the asset-based model is frequently presented by the


literature as the Net Asset Valuation (NAV), and in a recent contribution
from Massari etal. (2014) as the Asset-Liability Model. In particular, it
assesses the value of assets at a fair market value or at their replacement
cost and, then, nets for all the outstanding debt in order to calculate
the value of equity.6 It can be considered a residual method as it does
not allow the measurement of the overall value of a bank, but only of
its current assets in place and not of its growth assets. This is the main
reason why such kinds of model are not normally used for valuation of
banks that are ongoing concerns, as they all undertake strategies which
set growth objectives.

6
For each item of a banks balance sheet, Massari etal. (2014) show a list of formulas for the market
value measurement of the main assets and liabilities.
28 Valuing Banks

Finally, a further complication of the model is that NAV valuation


might be particularly difficult to run from an outside perspective, as there
is a need for very detailed data which are usually not publicly available
or easily achievable. Therefore, if we want to assess a fair value of equity
from an outside perspective, we should make the effort to build strong
base assumptions.
Alternatively, an asset-based modelwhich is better classified as asset-
return mixed methodthat allows for growth is the Union European
of Accounting Experts model, also known as the UEC model, which is
sometimes used in bank mergers and acquisitions valuation (Franceschi
2008). The UEC is an asset-return model with a separate estimation
for goodwill, which helps to solve the main limitation of the residual
income modelthe conservation of the extra-returns7 in perpetuity (i.e.
in the terminal value). Through the use of the UEC model, the abnormal
returns are estimated on:

1 . the market value of equity (MVE) for a determined period of time;


2. direct funding (e.g. customer deposits and bonds) and indirect fund-
ing (customers funds), which represent the components for the esti-
mation of goodwill.

Formally, the UEC model can be written as shown in equation (2.15),8


where the value of a bank is equal to the sum of the market value of
equity (MVE); the goodwill on direct and indirect funding (GDF),
which is estimated by fixed coefficients which are taken from comparable
transactions9 and are not differentiated between banks; and an annuity
income of the abnormal earnings, which are determined by the differ-
ence of a normalized profit (NP) and the cost of capital (rE) for similar
investments.

7
We would emphasize that extra-returns are a function of a competitive advantage which stem
from a banks market position and brand, and its relationship with its clients. The greater the
advantage, the higher are the margins on funding and investments.
8
The UEC model can be considered somewhere in between an asset-based and excess-return
model.
9
Bagna (2012) has highlighted that such coefficients can also be individually calculated using bal-
ance sheet data.
2 Valuation inBanking: Issues andModels 29

E = MVE + GDF + NP ( MVE re ) a ni (2.15)

The model has the merit of measuring equity at its market value as
in NAV valuation, but it adds the ongoing concern approach, which is
necessary if the bank is not in liquidation and is running its business as
usual. However, the UEC holds on some strong assumptions which limit
its potential applicability in real cases. The most important is that good-
will can stem only from the funding side, while the assets side (basically,
loans and securities management) is not considered as a source of good-
will and thus is not taken into account in the valuation. The second order
problem is that such coefficients are not individually calculated; rather,
they are fixed for all banks and extracted from comparable transactions.
Coefficients are taken as constant because the assumption of the model is
that profitability will tend to be aligned to that of the sector. Generally,
the discretion in their application can strongly bias results. The model
(and its variants) was frequently employed in the 1980s and 1990s, but is
no longer applied in practice.
Similar to the UEC model in terms of theoretical framework,
Dermine (2010) proposed a new bank-specific model that he called the
Fundamental Valuation Formula (FVF). The model measures the value
of equity by a combination of:

the liquidation value of the equity, which can be led back to the NAV
valuation;
the franchise value on deposits, which is the spread earned from
bonds and deposits;
the franchise value on loans, which is the spread earned from loans
and bonds;
the present value of operational (non-interests) costs, which includes
capital expenditures.10
the Modigliani-Miller tax penalty.

10
The capital expenditures are not considered here in terms of capital reinvestments but simply as
technological infrastructure.
30 Valuing Banks

For discounting each operation in assets, bonds and deposits, Dermine


does not take into account specific risk-adjusted discount rates, but he
proposes an expected return on corporate bonds of similar risk as an
opportunity cost for bank shareholders. The basic assumption is that
shareholders take risks related to the asset mix of banks. In this respect,
the asset mix is supposed to be similar to a bond (e.g. that of a loan) and
it is modeled as a proxy of the shareholder risk-return rate.
The model has three main limitations. First, as we have noted, a NAV
approach can be very difficult to implement from an outside perspective
and is very discretional in its quantification. Second, assuming a clear
separation between on-balance sheet and off-balance sheet operations,
the FVF suggests the valuing of fee-based income with separate standard
valuation methods, but fees are not only related to off-balance sheet oper-
ations. Third, it nets for a tax penalty assuming that banks have no debt,
hypothesizing that a bank is fully funded by equity. On the contrary, the
FVF discounts liquidation and franchise values in light of the corporate
bonds and credit derivatives market.
Following an asset-side approach, Reuse (2011) proposed the treasury
approach. This model calculates the value of a bank as a sort of sum of
the parts,11 measuring the contribution of single value centersboth in
terms of asset and liabilitiesto the overall corporate value of a bank.
Although the model presented by Reuse has several limitations, such as
the clear separation between value centers and data availability that make
the model difficult to apply for an external analyst, it shows the need for
analysis of the fundamental areas of value creation.
On the whole, a purely asset based model cannot be considered a use-
ful model when the bank is an ongoing concern. This is because growth
represents a determinant asset of a banks value, so that not taking growth
assets into account automatically dictates a partial valuation of the com-
pany that excludes the major part of value which comes from future
growth. In the opinion of the authors, the UEC, even if it allows for
the accounting of growth and however it assesses the goodwill from the
funding side, is limited and highly discretional. Also, as with the NAV
valuation, the basic component of value is the market value of equity

A sum of the part method for banks has also been presented by Miller (Miller W.D. 1995).
11
2 Valuation inBanking: Issues andModels 31

which, as we discussed above, is very difficult to measure from an outside


perspective as a difference of asset and debt market values. In addition,
as can be easily understood, the number of assets and liabilities standing
on a banks balance sheet entails further discretion, which complicates the
reliability of the model.

2.2.4 Relative Market Valuation

The market valuation approach lays its foundation on the assumption of


liquidity and the efficiency of financial markets. If markets are efficient,
then similar assets with the same risk-return profile should trade within a
close range of prices. Market multiples and value maps are the valuation
methods which exploit such a principle and price the value of a bank
through the value of similar listed financial institutions.
Both these methods require a set of comparable banks which have to
be similar in terms of business model, size, diversification, profitability,
efficiency and growth. However, finding a list of banks with such a set
of similarities can be particularly difficult. Thus, in order to maintain a
trade-off between a samples representativeness and the number of banks,
more relaxed criteria are frequently adopted, having a balance between
accuracy and quality of data. In fact, the risk of inaccuracy and the risk
of potential mispricing are two of the fundamental reasons why market
models should be used as control methods and not as the main method
in valuation.
Multiples and value maps can also be applicable to the valuation of
financial institutions. They both assess the value of a bank through the
value of similar banks: the main difference can be found in the statisti-
cal estimator; for multiples, this comprises the (arithmetic or geomet-
ric) mean and median, and, in case of value maps, the mean squared
deviation.
Considering multiples,12 the three equity-side ratios most frequently
applied in banking are the price earnings ratio (PE), the price to book

12
Multiples can be trailing, current and forward in relation to the estimation of the variable which
standardized the multiple.
32 Valuing Banks

value (PBV), and the price to tangible book value (PTBV) (Damodaran
2013; Imam etal. 2008; Massari etal. 2014).
As is widely known, the PE is represented by the ratio of:

Price
PE = (2.16)
EPS

where EPS represents earnings per share. Since each multiple can be theo-
retically derived from a stable growth model, the leading variables of the
ratio can be resumed in the following relation as current (equation 2.17)
and forward (equation 2.18) PE:

Price b0 (1 + g )
PE = = (2.17)
EPS0 re g
Price b
PE = = 1 (2.18)
EPS1 re g

where g is the expected growth in earnings and b is the payout ratio


which, in the case of positive growth, is equal to:

g
b = 1 (2.19)
RoE

so that:13

g
1
Price RoE
PE = = (2.20)
EPS1 re g

The breakdown of the PE is useful in order to understand and, conse-


quently, analyze the companion variables of the ratio which, in the case of

In the event that the bank has not yet achieved stable growth, the PE can be split into explicit
13

extraordinary growth and stable growth using the DDM.


2 Valuation inBanking: Issues andModels 33

wide dispersion, should be able to explain the multiples variance. Hence,


banks distributing more dividendsor, ceteris paribus, fast growing,
profitable and costless (in terms of the cost of equity)should have a
higher PE.However, sources and degree of risks undertaken by the bank
in order to reach such a level of earnings are not taken into account by
the PE.And this represents one of the main limits of the multiple. As
a matter of fact, high growth in earnings might be due to high short-
term risk exposure which, in the case of value destruction due to those
excessive risks, may turn into lower long-term profitability. In addition,
since banks are multi-business firms, not all business areas have the same
return-risk profile, so investors will be willing to pay higher multiples for
the most remunerative assets rather than those characterized by narrower
margins (Damodaran 2013). Such a condition makes easy comparison of
the PE between banks difficult when they have different business models
and asset mixes. A viable solution can be achieved by breaking down the
PE for business areas (e.g. going through historical revenues) in order
to be able to catch the importance of each unit in terms of the overall
invested capital. Although this can only offer a partial solution to the
problem, it is the only way a business model risk can be considered when
looking at the PE multiple.
The other two multiples are the PBV (equation 2.21) and PTBV (equa-
tion 2.22), which are distinguished, at the denominator, for the exclusion
of intangibles from the book value. This is because intangibles are dif-
ficult to convert into cash in the event of bankruptcy and, t herefore, it is
useful to consider a net value of equity14 that for banks can be considered
a reliable proxy of Common Equity Tier 1 capital.

Price
PBV = (2.21)
Book Value
Price
PTBV = (2.22)
Tangible Book Value

All the following formulas are also applicable in the case of the PTBV by substituting the book
14

value with the tangible book value.


34 Valuing Banks

From the Gordon Growth model, theoretically, the multiples driving


variables are expressed by the following relation:

DPS BV RoE b0 (1 + g ) P RoE b1


P= = = (2.23)
re g re g BV re g

and substituting equation (2.19) in equation (2.23), we have:15

P RoE g
= (2.24)
BV re g

and:
RoE g
P= BV (2.25)
re g
which is also acknowledged as the Warranted Equity Method (equation
2.25), which can be treated as a sort of excess returns model, because it
compares the profitability and the cost of the invested capital.
It is worth noting that, in the case of large excess capital, PE, PBV (and
PTBV, as well) should be adjusted in order to avoid possible distortions
due to the fact that excess capital is usually not invested in risky assets,
thus the market value is very close to the book value (Massari etal. 2014).
The bank-specific adjustment requires that:

For PE: the numerator should be netted for the excess capital and, at
the denominator, earnings should be netted of the amount of interest
income coming from the minor investments in risk-free assets;
For PBV (and PTBV): both the numerator and denominator of the
ratios should be netted for the amount of excess capital.

Finally, the literature has highlighted that other market multiples are
likely to be applied to banking firms, such as fundamental and deal mul-
tiples (Massari etal. 2014).

In the event that the bank has not yet achieved stable growth, the PTBV can be split into explicit
15

extraordinary growth and stable growth using the DDM.


2 Valuation inBanking: Issues andModels 35

With regards to the additional equity multiples in Massari etal. (see


Table 2.3), although they made a first step toward the use of other mul-
tiples that could relate more closely to the fundamentals of banking, such
ratios have neither been objective regarding specific studies from the aca-
demic literature, nor broadly applied by practitioners up to this time. In
this sense, further research can help the ongoing debate on what other
multiples can be used in banking, specifically during periods of financial
crises.
In addition, in the opinion of the authors, viable solutions to the treat-
ment of bank debt can lead to the application of asset-side multiples. In
this sense, we devote Chap. 6 to the discussion of bank valuation using
additional multiples that take into account the most important bank
specificity: debt treatment.
On the other hand, deal multiples price the value of a bank looking at
the market of mergers and acquisitions in which the multiple is built on
the basis of comparable transactions. Such valuations are effectively biased
by control premiums, method of payment, liquidity of markets and spe-
cific negotiation contingencies, which need to be carefully managed in
order to reach a representative relative value. In the opinion of the authors,
deal multiples should only be used as a method for the comparison of
similar transactions; for example, all the operations related to the market
of corporate control. However, even in that situation, it is important to
adjust and clean the multiple of the specifics of that determined transac-
tion in order to reach a reliable ratio.

Table 2.3 Other banks market multiples


Multiples (per share) Driver
Price/Deposits Deposits
Price/Revenues Revenues
Price/Operating income Operating income before extraordinary
items and taxes
Price/NAV Net assets value
Price/Pre-Provision-Profit Total net revenue less non-interest expense
Price/Asset Under Management Asset under management
Price/Branches Number of branches
Source: Authors elaboration on Massari etal. (2014) p.127
36 Valuing Banks

Alternatively, the market relative value of a bank can be measured using


cross-sectional regressions. Generally, analysts regress PBV and the PTBV
value on ROE and ROTE (Return on Tangible Equity) respectively.

PBV = a + b RoE (2.26)

PTBV = a + b RoTE (2.27)


Conventionally, such regressions are (inappropriately) considered as
reliable if the R2 is high, so the independent variables can be used as a
good predictors of the multiple and, consequently, of the relative value.
However, it is important to control and weight results taking into account
the following issues:

Assessment of whether the linear relation between the multiple and


independent variables is consistent, and whether other forms of rela-
tionship with higher explanatory power might be standing (e.g. a qua-
dratic relationship);
Controlling for other fundamental and market variables (e.g. loan loss
provisions, capital adequacy or time and market trends) that may drive
the multiple. Generally, there is a substantial risk that many other
explanatory variables are omitted from regressions. Thus, there is a
high degree of risk of mispricing the target bank or, depending on the
aim of valuation, having incorrect information about investments;
Control for outliers. They should be rigorously treated as they may
strongly affect the estimation of coefficients.

Following the value maps approach, from an academic literature per-


spective, Calomiris and Nissim (2007) have developed a bank-specific
valuation model which is based on the cross-sectional variation of price to
book value. Their model, the Banking Holding Companies model (BHC),
assuming that, on average, the empirical relationships are reflected in the
observed price to book value, calculates the value of a bank using a regres-
sion where the independent variables are related to that banks assets and
liabilities, intangibles and additional attributes (e.g. size). Their empirical
findings showed a good fit in explaining the cross-sectional variation of
market to book values and residuals from cross-sectional regressions of
market to book values are useful to predict future stock returns. However,
2 Valuation inBanking: Issues andModels 37

potential problems of statistical significance may stem from the high


number (32) and correlation between explanatory variables.

2.2.5 Contingent Claim Valuation

Finally, attempts to build a new valuation model based on option pricing


are worthy of mention, even if in practice they are not frequently applied. A
recent contribution by Adams and Rudolf (2010) derived an option pricing
valuation approach based on the matched maturity marginal value of funds,
the structural model presented by Merton (1974) and the Black and Scholes
pricing model dividing banks economic value into three value sources:
deposits, loan business and asset-liability management. For each of them,
Adams and Rudolf provided different valuation techniques. However, the
model has still several drawbacks: it does not take into account the regula-
tory setting, reserve requirements and non-cash items (such as the tax effect
on value) (Deev 2011). Hence, since all these aspects represent relevant
variables affecting the economic value of a bank, these models are now not
applicable in practice, but future developments on the topic are welcomed.

2.3 Conclusion
As we have discussed in this chapter, bank valuation is markedly differ-
ent from the valuation of other industrial firms. Bank specifics, such as
the different role of equity and debt capital, the problems related to cash
flow estimation and provisioning, are some of the more relevant issues
that require the usage of a simplified equity-side approach based on divi-
dends. In addition, excess capital distribution merely represents a figura-
tive cash flow for shareholders. This is the model more frequently applied
in practice for valuing financial institutions.
The review of the valuation methods in this chapter demonstrates that
there are no asset-side metrics for financial institutions, although themost
relevant part of their value comes from the profitability and q uality of
assets. In these terms, the NAV methodology can only be applied in
specific residual situations and assumes that all assets and liabilities are
priced at their fair market value. In addition, growth is not deemed to
38 Valuing Banks

be a considerable part of the value. In addition, notwithstanding the


importance of the liabilities side in banking, there are no other valuation
methods that assess the value of debt as a fundamental component of
the intrinsic value of a financial institution, other than the UEC model
(among the most frequently applied models in the past). But, according
to this model, the way the value of debt is calculated is too discretional.
On the whole, the dividend approach and the other equity-side mod-
els we reviewed are unable to show where the value of a bank is generated,
using a synthetic and approximate measure of cash flow as a fundamen-
tal component of value. In the opinion of the authors, financial insti-
tutions are special firms generating value both from the assets and
liabilities sides. Accordingly, they should be valued following an asset-
side approach, which takes into account the cash flows generated from
investments, and separately assesses the value of debt, which stems from
the mark-down and tax benefits. In the following chapters, we focus our
attention on a new asset-side valuation model, one that considers all these
components as fundamental for the definition of the intrinsic value of a
financial institution. We will discuss the new model, introducing a new
corporate finance approach for bank valuation.

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3
Value, Capital Structure andCost
ofCapital: ATheoretical Framework

3.1 Introduction
Corporate finance classical theory deepens the relationship between
capital structure and firm value. Generally, textbooks and research articles
provide an extensive theoretical framework devoted to discussion of the
dynamics of leverage on corporate value and on the WACC.
Although the intervention of the regulatory authorities in rising
bank capital requirements has led many academics to conduct empiri-
cal studies into the effect of a higher proportion of equity on the cost
of funding, almost all research contributions on bank valuation have
not developed a clear theoretical framework as is usually available for
non-financial companies. Without a clear value generation model that
analyzes the impact of the financial structure on the equity value, bank
valuation might simply become a practical exercise. Such a literature
gap is particularly relevant, because bank debtbasically, depositsis a
source of value creation.

The Editor(s) (if applicable) and The Author(s) 2016 41


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
in Banking and Financial Institutions, DOI10.1057/978-1-137-56142-8_3
42Valuing Banks

The development of a theoretical framework on the impact of


debt on bank value requires the usage of an asset-side approach. In
these terms, the aims of this chapter are twofold: first, to discuss a
theoretical scheme for bank valuation, creating a model that allows
the main empirical and theoretical evidence (such as the application
of Modigliani and Miller theories to the banking industry) to be taken
into account; second, to provide a bank valuation model that can be
used following either an asset or equity-side approach, one that is easily
applicable to the real world.

3.2 Limitations oftheEquity-Side Approach


As illustrated in Chap. 2, the issues related to bank specifics forces the
adoption of an equity-side valuation approach. Conversely, asset-side
metrics are often used for non-financial firms, where equity value is
measured as the difference between the assets and debt values.
In the case of a banks valuation, the literature and practitioners almost
never suggest first the estimation of asset value and then the estimation of
equity value using discounted cash flow methods or m arket multiples. This
is because of the close dependence between a banks funding and lending
activity, which makes very difficult to separate the leverage effect on cash
flows, on invested capitalin several configurationsand on the cost of
capital. In others words, in financial institutions the difference between free
cash flows from operations (FCFO) and free cash flow to equity (FCFE),
thereby the estimation of an unlevered (r0) and levered (rE) cost of capital, is
particularly problematic because of the unclear separation between funding
and investment operations. As an example, deposits, in the form of cur-
rent accounts, may be considered as short-term funding oran investment
instrument, depending on the way clients maintain a positive or negative
position over the financial instrument. Additionally, even the connection
between funding made up by bonds and investments in mortgages or loans
may help in understanding the problems related to the separation between
funding and operations.
As we pointed out in Chap. 2, the debt of a bank does not have the
same function as that of a non-financial firm; rather, it is a liability of
3 Value, Capital Structure and Cost of Capital... 43

an operational nature, closely related to the intermediation process


that is typical of a bank. This concept is expressed well by Damodaran
(2009), who states:

Rather than view debt as a source of capital, most financial service firms seem
to view it as a raw material. In other words, debt is to a bank what steel is to a
manufacturing company, something to be molded into other products which
can then be sold at a higher price and yield a profit. Consequently, capital at
financial service firms seems to be narrowly defined as including only equity
capital. (My emphasis)

Therefore, according to Damodaran (2009), bank liabilities should


be treated in exactly the same way as operating debts (i.e. payment
receivables) that, in industrial companies, are deducted from assets to
obtain a more appropriate representation of the invested capital. In this
sense, Ferretti and Sandri (1992) claimed the equality between FCFO
and FCFE in the banking industry and, consequently, that the asset- and
equity-side approaches overlap. As a matter of fact, in banking, the cost
of funding represents an operating cost rather than a financial expense,
also because there is no true financing cost and therefore there is no
financial debt (Rutigliano 2012). A slightly different position is that of
Benninga and Sarig (2001), who consider only the medium long-term
debt as financial debt, while short-term term is treated as a component of
an operational nature.
Thus, it is held in the literature that the connection between i nvestment
and financing operations lays at the heart of the preference for the equity-
side approach in bank valuation. However, in the opinion of the authors,
such a propensity may also be motivated by the lack of more precise
and consistent methodologies, which forces the usage of an equity-side
approach as a shortcut. But, notwithstanding that equity-side and asset-
side approaches should lead to the same results in terms of the value of
equity, the equity-side approach has many significant limitations:

Equity-side methods lack transparency as they do not allow the


understanding of several important aspects, such as the impact of
debton value, the advantage linked to the cost of deposits, taxation
44Valuing Banks

and the growth effect on the cost of equity. More specifically, if these
variables are not considered in a valuation, we cannot make useful
adjustments to the cost of capital for considering the effects that these
factors might have on the risk profile over the forecast period. This
entails the use of a constant cost of equity, which could lead to estima-
tion errors accentuated to varying degrees in the forecast period and in
the terminal value.
The use of profits, dividends and equity book value directly leads
toan inability to highlight (albeit not entirely) the value generated
from core banking activities like the value of loans, securities, tangi-
ble and intangible assets that make up total assets. Making a simple
comparison, it would be like assessing the value of a real estate firm
that rents its own properties without considering their value, instead
only considering the amount of dividends that the company distrib-
utes to shareholders annually. Both in the case of banks and of real
estate companies, the quality of the outstanding assets is the main
driver of economic value creation, unlike industrial companies for
which the major part of the assets are represented by uncashed earn-
ings (i.e. stocks and credit receivables). So banks, even more than
industrial enterprises, should be evaluated using an asset-side
approach, as their main source of cash flows comes from assets.
Risk is not considered in the same framework of regulatory authori-
ties. As a matter of fact, bank risk is not considered in terms of an
equity risk, but, rather, as an asset risk. As we saw in Chap. 2, Basel
regulation is focused on traditional bank risks, which affect RWAs in
their unexpected loss component. A bank-specific valuation method
should determine the asset value of the company, taking into account
the potential effects of such relevant risks.

3.3 A
 n Asset-Side Approach toBank
Valuation: AnIntroduction
The many limitations of an equity-side approach we have discussed so
far motivate us to switch our attention to the asset-side approach for
bank valuation.
3 Value, Capital Structure and Cost of Capital... 45

As we noted in Chap. 2, asset-side methods introduced by the


literature and applied in practice can be considered as residuals, in
comparison with the other valuation metrics. As a matter of fact, so far
as the authors are aware, there is no acceptable and shared theoretical
framework supporting an asset-side valuation of banks, except for when it
is considered at its liquidation value (e.g. Massari etal. 2014), or as a sum
of the parts (Miller W.D. 1995; Reuse 2011). In addition, to theauthors
knowledge, asset-side models are almost never used for the valuation of
banks that are ongoing concerns.
However, the infrequent use of the asset-side approach for bank
valuation could be interpreted in the sense of the literature not yet having
solved the issues related to the separation of the operations and financial
areas, rather than as a problem of structural inapplicability. Obviously,
both deposits and loans are part of operating activities, making it impos-
sible to identify what is financial debt in the strict sense, but this does not
imply that a valuation of a banks assets cannot be undertaken.
In particular, in order to overcome most of the drawbacks of the
current applied methodologies, and therefore frame a robust asset-side
valuation, we should explore whether it might be possible:

to separate cash flows between the assets and debts side;


to identify a cost of capital that uniquely represents the assets risk, and
which is not influenced by the level of debt, by the cost of funds and
by the tax benefits and growth.

With regard to cash flows, an asset-side method requires the provision


of a definition of a free cash flow from assets (FCFA)rather than
FCFOisolating cash flows produced by assets (such as interest income
and other financial income) from cash flows generated by debt and, in
particular, by deposits.
The FCFA should be discounted back at an elementary rate that is
independent of debt, taxes and growth and, therefore, is strictly related
to asset risk. In these terms, in the literature, there are examples of
studies employing asset value to come up with a definition of bank
default. Consistent with the Merton model (1977) and applying contin-
gent claim analysis (i.e. structural models), these studies have suggested
46Valuing Banks

useful methods by which to calculate the probability of default, given the


volatility of bank assets. In these studies, the value of assets is measured
as the sum of the market value of the equity and debt, adjusted for the
risk of default of the intermediary (Sinha etal. 2013; Sironi and Zazzara
2004; Yayla et al. 2008). However, we do not have a clear theoretical
framework and a method that allows the clear identification of an asset-
side elementary rate.
In order to overcome this shortcoming, it is important to study
whether ModiglianiMiller propositions in the absence of taxes
(1958) are applicable also for banks. In other words, it is necessary
to investigate under what assumptions the value is influenced by the
financial structure and, consequently, the dynamics of the cost of the
equity and the WACC in relation to a change in debt. Moreover, the
study of ModiglianiMiller application on banking firms allows us to
understand whether a banks value is affected by tax-shields and the
underpriced deposit effect.

3.4 B
 ank Cost ofCapital andtheModigliani
Miller Propositions: AReview
As we noted in the previous section, in order to build a theoretical
framework for an asset-side model, we should first focus on whether the
principle of value conservation holds true; that is, how the value of a bank
as a firm is influenced by its financial structure. In fact, in the equity-side
approach the method is so synthetic that it is likely to offer just a partial
view of the overall firm value; this approach also precludes the analysis of
the value generation for all capital holdersboth equity and debt.
In order to work on an asset-side method, with the aim of deepening
the interrelations between banking debt and value, we must discuss the
applicability of the ModiglianiMiller propositions, in order to frame a
robust and reliable asset valuation metric.
The topic of the ModiglianiMiller propositions in banking has had
a resurgence in the literature in terms of the effect that increasing capital
charges may have on value. In particular, the gradual increase of m inimum
capital requirements has renewed the interest of scholars regarding the
3 Value, Capital Structure and Cost of Capital... 47

impact of the financial structure on bank cost of capital and, in particu-


lar, on the WACC.In this sense, there is the belief that, although the new
capital accord makes banks more robust and better able to cover risks, the
new equity issuance might affect the overall cost of capital. Other things
remaining equal, an equity increase should change the weight of equity
on the WACC and, therefore, the cost of capital should be higher. This
can be explained with a simple example, through which it is possible to
calculate the WACC (in a first approximation without considering the
tax effect) as:

E D
WACC = rE + rD (3.1)
E +D E +D

Let us suppose that the bank is characterized by a cost of equity of


12%, a cost of debt of 5% and a percentage of equity financing on firm
value of 10%. The WACC will be equal to:

WACC = 12% 10% + 5% 90% = 5.7% (3.2)

Ceteris paribus, if we assume an increase in capital requirements and


the weight of equity rises to 20%, the WACC becomes:

WACC = 12% 20% + 5% 80% = 6.4% (3.3)

Based on these calculations, shifting the financial structure towards


equity, which is more expensive, increases the total overall cost of capital
by 0.7%. And there is the belief that high capital requirements affect the
WACC positively.Hence, the bank would have to increment the pricing
on loans extensively, negatively affecting lending requests.
However, this example, does not consider the impact that c hanging lev-
els of leverage may have on the cost of equity and therefore, on the overall
cost of capital. In other words, these calculations ignore ModiglianiMiller
propositions, which were designed to explain the impact of the capital
structure on firm value and cost of capital. In this sense, the mistake in the
example we presented is to consider the cost of equity as constant (Admati
48Valuing Banks

etal. 2013; Miller M.H. 1995). Modigliani and Miller argued that, in the
absence of frictions (i.e. where there is noasymmetric information, taxes
and distress costs), changing the financial structure we have no impact
on firm value. Also if leverage is increased, there is a linear increase in the
cost of equity and the overall cost of capitalremains unchanged. This is
because, according to the more general risk-return principle, an increase
in the level of leverage would mean a greater risk for shareholders and,
therefore, higher expected returns. Conversely, a decrease in leverage, by
replacing debt with equity, would lead to a lower equity risk premium for
shareholders.
In order to analyze the applicability of Modigliani and Millers
propositions for banking firms, we need to remember that there are other
important assumptions to make, namely:

Asset volatility is considered stable, leaving unchanged the business


risk profile (and therefore the assets) of the company.
Equity and debt value are considered at market value and not at their
book values.
Cash flows are equal to earnings and are considered constant and
perpetual. This involves no consideration of growth in the basic
formulation of the theory.

In the literature, most of the studies showed the inapplicability of


Modigliani and Millers propositions in the case of banks. The reasons
are the same as those that mean the ModiglianiMiller theorem cannot
be applied in the case of non-financial firms (Mehran and Thakor 2011),
such as the presence of asymmetric information (for which it is more
appropriate to apply the pecking order theory), the costs of financial
distress and matters related to tax benefits. In particular, for the latter, it is
evident that higher tax level affects leverage positively (Desai etal. 2004;
Weichenrieder and Klautke 2008). We believe that these findings are not
sufficient to claim that Modigliani and Millers propositions cannot work
for banking firms.
However, there are arguments that support the non-applicability of
ModiglianiMiller theories with regard to banks and these are related to:
3 Value, Capital Structure and Cost of Capital... 49

the role and the value creation effect of deposits;


the role of a bank as liquidity provider.

In terms of deposits, the main reason for considering the Modigliani


Miller theories as being unsuitable is based on the typical role of deposits,
which is closer to the custody of funds and to the ensuring of payment ser-
vices operations, rather than a conventional source of financing. For these
reasons, deposits are remunerated at a lower cost compared with a risk-free
rate (typically, interbank rates), and therefore constitute an economic ben-
efit for every financial intermediary.
The lower cost of deposits is also due to the fact that they cannot be
considered as risky for customers since:

the presence of minimum capital requirements aims to protect


depositors in order to maintain the value of the deposits;
the presence of deposit insurance strengthens the guarantee for
depositors in the event of bank default.1

In fact, if we use structural models (i.e. Merton 1974), the standard


deviation of a banks assets is less than that for industrial firms and, there-
fore, the variation in the value of assets is less. Hence, the statistically min-
imum value of assets is greater than deposits (Gropp and Heider 2009).
In this sense, assuming a constant cash flow of interest payments, the
value of deposits can be quantified as:

DD,Dep . iD,Dep
DD,Dep discount = (3.4)
rf

where DD,Depdiscount is the present value of deposits, DD,Dep is the nominal


value of deposits, iD,Dep is the deposits return and rf is the risk-free rate.

1
The non-riskiness of deposits is questioned in the case of bail-in mechanisms, where customers
share private losses of banks.
50Valuing Banks

The method to value core deposits that we showed in (3.4) is also known
as the Cost saving approach2 (Contractor 2001; Miller W.D. 1995;
Rezaee 2004). In the original model, the actualization of the cash outflows
associated with core deposits is done using the returns on alternative source
of funds (i.e. certificates of deposit) but, in practice, such information is
not available and, consequently, the zero-coupon Treasury instrument is
used. Moreover, in the original model the discounted amount is not only
the cost of interests on deposits, but also the cost of maintenance netted
of fees. On this point, although deposits allow the bank to receive a return
in terms of commissions (fees), it is believed that such forms of gain, being
related to deposits, loans and other services, cannot be attributed exclu-
sively to debt items; rather, they mainly depend on intermediated volumes
by banks. In addition, the costs of maintenance are difficult to separate.
So, we cannot easily divide the cost of maintenance and fees component
deriving from deposits in respect of those arising from loans or other types
of services.
The difference between the risk-free rate3 and the true cost of deposits
expressed by the return rate is an operating gain called mark-down,
which we can write as:

MARK - DOWN = DD , Dep ( rf - iD , Dep ) (3.5)


The value generated by mark-down increases the value of both the


assets and the equity. We can quantify this as follows:

2
Miller describes two other types of core deposit valuation methods: the Historical Development
Cost Approach and the Future Income Approach. The first establishes the value of deposits, deter-
mining the costs actually incurred to attract those deposits (i.e. the amount spent for advertising).
The second establishes that the value depends on the difference between the cost of deposits and
the income generated by deposits (fees) or income obtained using those deposits to invest in
loansand other assets. The quantification of attracting cost to obtain deposits is very difficult to
implement; the first method is therefore difficult to realize in practice. The second approach can
bring about a double-counting of value, due to the use of income from loans and other assets on
the evaluation of both core deposits and assets. For this reason, in the present work we have only
made use of the Cost Saving Approach.
3
Even if, in practice, mark-down is calculated by taking into account interbank rates such as
Euribor or Libor, in the theoretical discussion we use the term risk-free as commonly found in
corporate finance contributions.
3 Value, Capital Structure and Cost of Capital... 51

Table 3.1 Dynamic of the WACC for different level of leverage


D/V
80% 85% 90% 95%
Risk free rate 5.00% 5.00% 5.00% 5.00%
Deposit return 2.00% 2.00% 2.00% 2.00%
WACC in absence of 5.50% 5.50% 5.50% 5.50%
underpricing deposits
Cost of equity 7.50% 8.33% 10.00% 15.00%
WACC with underpricing deposits 3.10% 2.95% 2.80% 2.65%
Source: Authors elaboration

DD , Dep iD , Dep Dd , Dep ( rf - iD , Dep )


VMark - Down = DD , Dep - = (3.6)
rf rf

It may well be proved that the Modigliani and Miller theories in the
absence of taxation (1958) may not work because the WACC decreases
with increasing debt due to the presence of underpricing deposits. In
particular, if one considers the example contained in Table 3.1, in which
the debt of a bank is composed only of deposits and there are no other
frictions, the cost equity is calculated as:

rE = WACC + WACC rf ( ) DE (3.7)


where WACC is the WACC calculated on deposits priced at the risk-


free rate. In this case, we assumed that there are no deposits priced at a
ratelower than the risk-free rate.
In the presence of deposits at a rate that is lower than the risk-free rate,
the configuration of the WACC that reflects the lower cost of deposits
(WACC*) is calculated as follows:

E D
WACC * = rE + iD, Dep (3.8)
E+D E+D

where D includes only deposits and no other form of financing.


52Valuing Banks

As we will see in Sect. 3.6, the calculation of the cost of equity must be
made modifying the original ModiglianiMiller second proposition. For
greater clarity, in this step we simplified the treatment according to the
original formulation.
As one can note, in the absence of benefits on deposits the WACC is
constant; this is also confirmed by Elliott (2009). Conversely, in the case
of underpricing deposits, the WACC decreases when debt increases. In
these terms, the cheaper deposits, the greater the incentive to use deposits
(Park 1994).
The second aspect is related to the role of banking intermediaries in
liquidity provision (Diamond and Rajan 2000; Masera and Mazzoni
2013) and liquidity synergies generated between the deposits and
short-
term assets (Mehran and Thakor 2011). Specifically, replacing
short-term deposits (basically, current accounts) with equity, all other
things remaining equal, there is less liquidity multiplication on deposits
through the economic system. It was found that replacing deposits with
equity entails a decline in firm value (Kashyap etal. 2010). As stated, this
should occur not for a change in the risk profile expressed in overall cost
of capital but, rather, for the decrease in cash flows attributable to a com-
bined effect between short-term liabilities and short-term assets. In other
words, the overall value decreases not only for a reduction in deposits, but
also for a lower level of short-term lending activity.
Empirical results of the applicability of Modigliani and Millers
propositions have been conflicting. Among those who showed that

Modigliani and Miller might offer a good approximation of the cost of


capital dynamic in a bank, Kashyap etal. (2010) showed that the beta (in
the context of CAPM) is not only directly related to the leverage ratio, but
it is also inversely related to the PBV ratio. Hence, the first Modigliani
Miller propositionthat the value of the firm declines when risk risesis
verified. In addition, they highlighted that the cost of equity measured by
the CAPM is not fixed; rather, it rises in response to increasing leverage.
Therefore, the second ModiglianiMiller propositionthat, when lever-
age increases, the cost of equity risesis also verified. Quantitatively, the
increase in leverage ratio has little effect on loans repricing (as a proxy of
the WACC) in the order of 2545 basis points for every 10 percentage
points. Similar conclusions are reached by Miles et al. (2013) with two
3 Value, Capital Structure and Cost of Capital... 53

models that highlighted the dependence of the cost of equity compared


with leverage ratio in the case of deposits priced at a risk-free rate. In the
first model, using a CAPM approach, the linear growth of the cost of equity
is not sufficient to maintain a constant WACC, as predicted by Modigliani
and Miller. In the second model, quantifying the cost of equity with the
inverse of the Price Earnings (Earnings Yield), the WACC remained almost
unchanged. Moreover, in this second study, doubling capital requirements
meant thatthe effect on the WACC was very small, in the order of 1040
percentage points. According to Gropp and Heider (2009), banks with
abundant equity choose to optimize their financial structure in the same
way as non-financial firms, highlighting that there are similarities between
industrial firms and banks. The main result is that the WACC remained
almost constant as in ModiglianiMiller without taxes.
With regard to the studies which found the unsuitability of
ModiglianiMiller for banks, the main evidence is that the greater the
equity, the higher the cost of capital. In these terms, Cosimano and
Hakura (2011) showed that a 1% increase of equity to assets caused an
increase of 12 basis points in the loans rate. Moreover, the impact was
lower for those banks which were active in countries more exposed to
the financial crisis in the period 20072009. Baker and Wrgler (2013)
showed that a 10% increase in the Tier 1 ratio led to an increase in the
cost of capital of 90 basis points. In particular, this would be due to the
low risk anomaly, whereby high beta stocks (such as banks) tended to
have a lower performance, resulting in a flatter returns curve.
None of these studies considered any relevant aspects to explain the
dynamic of the WACC in relation to a banks financial structure and risk
of assets. More specifically, in industrial firms, when we study the effect of
financial structure over value using ModiglianiMiller, we assume that the
risk of assets is constant over time. Conversely, in banking the change of
financial structure might be given not only by a debt-equity policy as usually
happens in industrial companies, but also by an increase in asset risk which
forces banks to hold more equity. In this context, notwithstanding it might
be possible to separate the effect of an RWA increase over cost of capital (i.e.
whether the increase of the WACC is due to RWA or leverage), we would
not be able to consider the risk perceived by investors, which might be dif-
ferent from that of the regulator approach. Thus, it is empirically difficult
54Valuing Banks

test the effect of financial structure on value being equal to asset risk. In
this context, once again, it would not be possible to test Modigliani-Miller
propositions, as they underlie the stability of the asset risk in terms of volatil-
ity (Masera and Mazzoni 2013).
Finally, the recent study of Masera and Mazzoni (2013) on the
unsuitability of ModiglianiMiller is limited in the interpretation of
resultsbecause they measured debt through its book value and not at
market value, as pointed out by Miller M.H. (1995). As a matter of fact,
the accounting value has nothing to do with the cost of capital, which is
related to the market values of debt and equity. This has obvious impli-
cations because an accounting approach does not consider the value
generated by deposits, and this considerably changes the configuration
of debt and equity weights. This effect can be adjusted to reach the cost
of assets configuration instead of WACC, which is free from deposit
benefits and tax benefits.
On the whole, we can claim that there are two main issues for the
inapplicability of ModiglianiMiller:

The first issue is the impossibility of separating operational risk from


financial risk. Even if we could differentiate the two effects, RWA
could be a non-elastic measure for asset risk.
The second issue is that, in the empirical studies, the literature used a
book value approach, instead of a market approach. This affects the
reliability of the findings, since ModiglianiMiller propositions
arebased on market values. Hence, ModiglianiMiller is built on an
economic value rather than a book value.

After having analyzed the problems related to the inapplicability of the


ModiglianiMiller proposition to banks, in order to move to an asset-side
approach we need to create a theoretical framework that uses a configura-
tion of cost of capital that is free from leverage effects and, therefore, only
take asset risk into account.
3 Value, Capital Structure and Cost of Capital... 55

3.5 Bank Valuation: AScheme withSeparate


Quantification ofMark-Down
The discussion above has allowed us to highlight the basic concepts that
lay at the heart of an asset-side valuation model. In particular, the asset
value of a bank is affected by:

the lower cost of funds raised in the form of deposits;


tax benefits, which can also play an important role for banking
companies, given their massive recourse to debt capital;
growth, which could have a significant impact both on cash flows and
on cost of capital.

These components are at the theoretical and practical fulcrum of


our asset-side valuation model and, in the opinion of the authors, they
can explain the determinants of firm value in a wider perspective than
that usually undertaken by the financial community. In fact, as has
been underlined, the best practice, with regard to the use of the DCF
methodology, implements an equity-side approach that does not allow
the impact of the capital structure on bank value to deepen, often
proposing a constant cost of equity over time throughout the cash
flow forecast period. This results in incorrect estimations (Massari and
Zanetti 2008), as changes in leverage affect the amount of the cost
ofcapital. Furthermore, the use of such methods makes it impossible
to split asset risk from the banks leverage risk and, therefore, is not
possible to obtain an elementary rate (cost of assets) whose primary
hypothesis of constancy over time is more realistic than that of the
cost of equity.

3.5.1 Valuation Scheme without Taxation andGrowth

We begin the explanation of our model considering a valuation scheme


with an absence of medium long-term debt and, consequently, with the
presence of deposits only.
56Valuing Banks

(a) Absence of medium long-term debt.

Assuming the absence of taxation and of forms of funding different from


deposits, we show the calculation of the WACC as a weighted average
between the cost of equity and the cost of debt (Miles etal. 2013):

E D
WACC = rE + rD, Dep (3.9)
E+D E+D

Deposits are evaluated at nominal value. Considering risk-free deposits,


we can rewrite equation (3.9) in the following terms:

E D
WACC = rE + rf (3.10)
E+D E+D

Assuming the steady-state hypothesis4 and using the valuation


schemeusually applied to banking firms, we can thus write the equity
market value as:

FCFE
E= (3.11)
rE

With no reinvestments, no equity increase and a dividend payout


equal to 100%, this approach is in line with the DDM and CFE methods
(which we presented in Chap. 2).
Using equation (3.11) we can rewrite equation (3.10) as follows:

FCFE + D rf
E+D= (3.12)
WACC

The value of the bank is expressed as the sum of equity and debt,
andis calculated by discounting the cash flow expressed in the numera-
tor at the WACC.
4
The steady-state hypotheses determine that the cash flows are constant, equal to earnings and
perpetual. More precisely, for a bank this implies that: (1) there are no changes in assets and liabili-
ties; and (2) depreciation and LLPs correspond to cash outflow to ensure the same firm value.
3 Value, Capital Structure and Cost of Capital... 57

The FCFE can be calculated as the cash flow which is independent


from the funding cost (which is the FCFA) minus the cost of deposits:

FCFE = FCFA D iD, Dep (3.13)


Combining equation (3.12) with equation (3.13), we arrive at the


asset-side evaluation in stable growth:

V=
(
FCFA + D rf iD, Dep ) (3.14)
WACC

As one can note, the bank value is influenced by the cash flows from
interest income and fees, netted of provisions and operating costs, but
also by the mark-down value.
Alternatively, this model can be modified by completely considering the
mark-down benefits at the denominator, using the modified WACC(*),
which we write as:

WACC * =
FCFA
V
= WACC
D
V
( E
)
rf iD, Dep = rE + iD, Dep
V
D
V
(3.15)

The WACC* is nothing more than the WACC calculated using


the effective interest rate on deposits as a cost of debt. This equation
corresponds to the (E11) by Park (1994) and allows the quantification of
how much the WACC* decreases in relation to a debt increase, given the
underpricing deposit effect.
At this point, it is possible to explain the mark-down benefits separately
with a disaggregated model that illustrates the stand-alone value of assets
and the mark-down value. In a manner similar to benefits arising from
the deductibility of interest expenses for non-financial firms, on one
hand, we discounted the FCFA at a rate that depends on asset risk; on
the other hand, we discounted positive cash flows from deposits at a risk-
free rate, since deposits, as we previously pointed out in Sect. 3.4, can be
considered risk-free. Therefore, equation (3.14) becomes:
58Valuing Banks

FCFA rf iD, Dep


V = VAsset + VMK Down = +D (3.16)
rA rf

where rA represents the cost of assets, not dependent on the value


g enerated on deposits.
This model can be defined as an asset-side approach with a separate
evaluation of the mark-down that we define the Asset Mark-down Model
(AMM).
If we set interest expenses paid to depositors at a constant rate, the bank
firm value increases due to the increase in deposit value. This appears
consistent with the majority of studies according to which, the presence
of funds in the form of deposits creates value (among others: Park 1994),
in contrast with the application of the first ModiglianiMiller proposi-
tion in the absence of taxes (1958). If deposits are set to 0, the mark-
down effects will be equal to 0.
Consequently, according to the AMM, the replacement of deposits in
favor of equity would not change the firm value in the event that deposits
are remunerated at a risk-free rate, because the second term of equation
(3.16) becomes equal to 0. In reality, as mentioned, some commissions
and fees depend on deposits and, therefore, the firm value will tend
to decline as a result of lower revenues charged on customers current
accounts. Such proceeds are, however, indirectly related to deposits and
refer to the more general activities typical of the bank. Moreover, as we
have explained, different configurations of liabilities have several effects
on the value, but not necessarily on the expected returns on assets. In
other words, the change of the financial structure does not affect asset
risk but, eventually, only the FCFA.
Therefore, we preferred to isolate the benefits directly attributable to
deposits. This approach appears to be consistent when you consider that
the most appropriate rate to discount the cash flows from the total fees
isnot a risk-free rate but is, rather, related to the fluctuations of the busi-
ness cycle and, therefore, related to banking risk in general, which is the rA.
After having extrapolated the cost of equity or the WACC from the
stock market prices, it is possible to reach our rA (we will discuss this in
Chap. 5, which is devoted to cost of capital estimation).
3 Value, Capital Structure and Cost of Capital... 59

Thus, using equation (3.15), the FCFA can now be defined as:

FCFA = V WACC * (3.17)

Substituting equation (3.17) in equation (3.16), we obtain:

V WACC * rf iD, Dep


V= +D (3.18)
rA rf

from which

D rf iD, Dep
WACC * = rA 1 (3.19)
V rf

As one can see, deposit growth increases the benefits attributable to


the lower cost of financing sources due to the use of less costly forms
ofcollection than debt price to risk-free rate. In the event that there
are no deposits, the WACC would correspond to the expected return
on assets. The term rA constitutes an elementary cost of capital because
is not affected by the financial risk created through debt and is netted
of the value generated by it.
If the valuation concerns a non-banking firm, it loses the advantage
due to the differential between the risk-free rate and the true cost of
thedeposits and, therefore, once again, we obtain the equality betweenthe
overall cost of capital and the expected return on assets.

(b) Presence of debt different from deposits.

We can extend the model shown in the previous subsection by


introducing a different form of funding than deposits. Such kind of
debt (typically corporate bonds and other forms of long-term funding)
might be characterized by an interest rate higher than risk-free. Normally,
the cost of these sources of funding depends not only on the reference
interbank rates, but also by country risk and a banks creditworthiness,
usually stated in the rating grade assigned by the credit rating agencies
60Valuing Banks

(CRAs). In this sense, the cost of these funding instruments has very
similar characteristics to the financial debt of non-financial companies.
Thus, if we consider deposits and financial debt (in which we can include
all the debt that is different from deposits), we can restate the WACC as:

E DD, Non Dep DD, Dep


WACC = rE + rD, Non Dep + rf (3.20)
V V V

where: rD,Non Dep is the cost of capital on debts different form deposits.
DD,NonDep is the debt value different form deposits; DD,NonDep is the depos-
its nominal value; V is the firm value.
In this case, the non-deposits value is:

Interest D, Non Dep


DD, Non Dep = (3.21)
rD, Non Dep

As can be noted, unlike the deposits, which are considered at their


nominal value, all the remaining debt is assessed at its market value.
Therefore, FCFE becomes:

FCFE = FCFA InterestsD, Non Dep DD , Dep iD, Dep (3.22)


Supposing that the effective return and expected return rate of debt
different from those of deposits are equal (iD,NonDep=rD,NonDep), then equa-
tions (3.14), (3.16) and (3.19) remain valid substituting D with DD,Dep.
This leads us to conclude that, according to the model, in the absence
of taxation and changes in capital requirements, replacing equity with
non-deposits debt does not cause the value of a bank to change.
In Table 3.2, we propose a demonstration aimed at showing how
theCFE, AMM, WACC (in which the value generated by underpricing
deposits is discounted in the WACC) and WACC* model converge to
the same result. It is important to underline that, for financial companies,
firm value and asset value have different meanings: the former includes
the mark-down value and the latter is the pure value of assets.
3 Value, Capital Structure and Cost of Capital... 61

Table 3.2 Bank valuation with no taxes and growth

Data
FCFA 6.00
Deposits 40.00
Cost of deposits 2.00 %
Other debt 50.00
Cost of other debt 5.00 %
Risk-free rate 5.00 %
Cost of assets 6.00 %
FTE/DDM
FCFE (earnings) 2.70
Cost equity 7.94 %
Equity value 34.00
Mark-down model
FCFA 6.00
Cost of assets 6.00 %
Asset value 100.00
Mark-down value 24.00
Firm value 124.00
Equity value 34.00
WACC model
FCFA 6.00
Mark-down benefits 1.20
FCFA and Mark-down benefits 7.20
WACC 5.81 %
Firm value 124.00
Equity value 34.00
WACC modified model
FCFA 6.00
WACC* 4.84 %
Firm value 124.00
Equity 34.00
Source: Authors elaboration

3.5.2 Valuation Scheme withTax Benefits

As we know, in the presence of taxes, firm value is affected not only by


discounted FCFO, but also by the tax benefits given by the deductibility
of interest expenses on debt raised from investors. In this section, we will
adjust the valuation model incorporating the tax benefits related to debt
upward to define the relationship between the WACC and the discount
rate of after-taxes FCFA.
62Valuing Banks

Assuming a tax rate of tc, the WACC and firm value can be rewritten as:

E DD,Non Dep D D,Dep


WACC = rE + rD,Non Dep (1 - tc ) + r f (1 - tc ) (3.23)
V V V

FCFA + D ( rf - iDep ) (1 - tc )
V= (3.24)
WACC

where FCFA is netted from taxes. The WACC is adjusted to take into
account the true cost of deposits and the value of the firm calculated
using the discount rates can be expressed as:

E DD,Non Dep DD,Dep


WACC* = rE + rD,Non Dep (1 - tc ) + iD,Dep (1 - tc ) (3.25)
V V V

FCFA
V= (3.26)
WACC *

From this, it is possible to explain the disaggregated model, which is


composed of the value of assets, the value of mark-down benefits and the
value of the tax-shield on debt other than deposits (VTS)5:

FCFA rf - iD,Dep
V = VAsset +VMK - Down +VTS = + DD,Dep
rA rf
DD,Dep iD,Dep tc
+ + DD,Non Dep tc (3.27)
rf

Substituting equation (3.26) in equation (3.27), we can obtain the


relationship between the expected return on assets and WACC* as:

We assume that the non-deposit interest rate of return is equal to the cost of debt.
5
3 Value, Capital Structure and Cost of Capital... 63

DD ,Dep r f - iD ,Dep (1 - t c ) DD ,Non Dep


WACC * = rA 1 - - t c (3.28)
V rf V

This equation is able to measure the benefits on total debt given by


ark-down and tax benefits. In the absence of taxation, equation (3.28)
m
changes to become like equation (3.19). It is interesting to note that, in
the absence of mark-down, the equation becomes the classic link between
the cost of assetsand WACC used in non-financial companies. In a world
without taxes and mark-down benefits, this rate corresponds to the
WACC, thus ensuring the consistency of this rate for any level of debt.
In addition, if it is assumed that non-deposit debt is paid at a risk-free
rate, the WACC* can be simplified by calculating the benefits of the
overall funding, rather than that of deposits:

D r f - iD , Average (1 - t c )
WACC * = rA 1 - (3.29)
V rf

where iD,Average is the average cost between deposits and non-deposit debts.
Equation (3.29) will be the equation used to find, from the WACC*,
an expected return on assets (cost of assets) to be used in a bank valuation.
In this way, we can obtain a discount rate that does not include mark-
down and tax benefits, which will be quantified separately.
In Table 3.3, we provide a new valuation exercise that, again, puts the
four methods we have discussed so far in relation to each other.

3.5.3 Valuation Scheme withTaxation andGrowth

If we introduce the hypothesis that the FCFA and debt grow at a certain
rate g, we need to modify the valuation scheme for calculating the
appropriate WACC and cost of equity. This is because we must consider
the effect of growth on mark-down and tax benefits. In fact, using the
64Valuing Banks

Table 3.3 Bank valuation with taxes

Data
FCFA 4.80
Deposits 40.00
Cost of deposits 2.00 %
Other debt 50.00
Cost of other debt 5.00 %
Risk-free rate 5.00 %
Cost of assets 6.00 %
Tax rate 20.00 %
FTE/DDM
FCFE (earnings) 2.16
Cost equity 7.94 %
Equity value 27.20
Mark-down model
FCFA 4.80
Cost of assets 6.00 %
Asset value 80.00
Mark-down value 24.00
Tax-shield value on deposits 3.20
Tax-shield value on other debt 10.00
Firm value 117.20
Equity value 27.20
WACC model
FCFA 4.80
Mark-down benefits after taxes 0.96
FCFA and Mark-down benefits 5.76
WACC 4.91 %
Firm value 117.20
Equity value 27.20
WACC modified model
FCFA 4.80
WACC* 4.10 %
Firm value 117.20
Equity 27.20
Source: Authors elaboration

WACC calculated above, we can simply obtain an estimation of value


that required a steady state scenario. Considering growth, equation
(3.27) becomes:
3 Value, Capital Structure and Cost of Capital... 65

V = VAsset +VMK - Down +VTS

FCFA1 rf - iD,Dep DD,Dep iD,Dep tc DD,Dnon dep rD,Non Dep tc


= + DD,Dep + +
rA - g rf - g rf - g rD,Non Dep - g

(3.30)

Accordingly, equation (3.26) should consider a WACC* adjusted to


take account of growth:

FCFA1
V= , (3.31)
*
WACCgrowth g

where FCFA at time zero corresponds to the net earnings on assets (oper-
ating income), minus the pace of growth of assets:

Assets0
FCFA0 = Operating income0 (1 tc ) g (3.32)
1+ g

FCFA at time one is FCFA at time zero plus growth:

FCFA1 = FCFA0 (1 + g )
Assets0
= Operating income0 (1 - tc ) - g (1 + g )
1+ g
= Operating income0 (1 - tc ) (1 + g ) - Assets0 g (3.33)

in line with the variation on debt. Therefore, the modified WACC is


calculated as follows:

DD,Dep rf - iD,Dep (1 - tc )
WACC*growth = 1 -
V rf - g
DD,Non Dep rD,D Non Dep tc
- ( rA - g ) + g (3.34)
V rD,D non Dep - g

66Valuing Banks

Assuming that non-deposit debt is paid at the risk-free rate, we can


simplify these terms as follows:

D r f - iD , Average (1 - t c )
*
WACC growth = ( rA - g ) 1 - + g (3.35)
V rf - g

In the same manner, we adjust WACC and cost of equity to keep the
growth effect:

V=
( )
FCFA1 + D rf iDep (1 tc )
(3.36)
WACCgrowth g

To obtain the equity value from the asset-side approach, we have to


subtract debt value from the banks firm value:

E =V D

If we want obtain equity directly, we use this equation:

FCFE1
E= (3.37)
rE , growth g

In Table 3.4, we provide a new valuation exercise showing how, even


in presence of growth, the four models converge toward the same value.
In particular, the FCFA at time 1 corresponds to the FCFA increased at
the g rate; the mark-down and tax-shield are calculated at time 1, but in
relation to the level of debt of the previous year. FCFE is influenced not
only by the growth of FCFA and cost of funding, but also by the inflow
of the increase in shareholder capital:

FCFE1 = FCFA1 - ( D0,D,Dep iD,Dep + D0,D,Non dep rD,Non dep ) ( 1 - tc )


+ ( D0,D,Dep + D0,D,Non dep ) g (3.38)

3 Value, Capital Structure and Cost of Capital... 67

Table 3.4 Bank valuation with taxes and growth

Data
FCFA time=1 4.90
Deposits 40.00
Cost of deposits 2.00 %
Other debt 50.00
Cost of other debt 5.00 %
Risk-free rate 5.00 %
Cost of assets 6.00 %
Tax rate 20.00 %
Growth 2.00 %
FTE/DDM
FCFE time=1 4.06
Cost equity 6.30 %
Equity value 94.40
Mark-down model
FCFA time=1 4.90
Cost of assets 6.00 %
Asset value 122.40
Mark-down value 40.00
Tax-shield value on deposits 5.33
Tax-shield value on other debt 16.67
Firm value 184.40
Equity value 94.40
WACC model
FCFA time=1 4.90
Mark-down benefits after taxes 0.96
FCFA and Mark-down benefits 5.86
WACC growth 5.18 %
Firm value 184.40
Equity 94.40
WACC modified model
FCFA time=1 4.90
WACC* growth 4.66 %
Firm value 184.40
Equity 94.40
Source: Authors elaboration

3.5.4 The AMM: AnOverview

After having discussed the AMMs key elements, in Fig. 3.1 we provide
a visual summary of the model that resumes the position of a banks firm
value as the sum of:
68Valuing Banks

Other Debt
DCF model applied at interests paid on
Value of Assets non-deposits discounted at r d
DCF model applied at the FCFA
discounted at r A

Deposits
Value of Deposits nominal value
DCF model applied at mark-down benefits
discounted at r f

Value of Tax shield Equity


DCF model applied at tax benefits discounted
DCF model applied at the FCFE
at r d
discounted at r E

Fig. 3.1 Breakdown of bank firm value by the AMM.


Source: Authors elaboration.

1. the value of assets measured by as a discounted cash flow model using


FCFA;
2. the value of deposits measured discounting the mark-down benefits;
3. the value of tax-shields measured discounting the tax benefits.

From the firm value, if we net for the value of debt (deposits and other
debt), we obtain the value of equity.
Using a two-stage model, where we have an explicit period of forecast
and a terminal value that takes into account long-term growth, we can
write the AMM for the explicit forecast valuation as:
3 Value, Capital Structure and Cost of Capital... 69

n
FCFAt DD,Dept ( rf - iD,Dep ) DD,Dep t iD,Dep tc
V= + +
( 1+ rA ) ( 1+ r ) ( 1+ r )
t t t
t=1
f f

DD,Non Dep t rD,Non Dep tc


+ (3.39)
( 1+ r )
t

D,Non Dep

and for the long-term growth, the Terminal Value will be equal to:

FCFAn+1 DD,Depn ( rf - iD,Dep ) DD,Dep n iD,Dep tc




rA - g rf - g rf - g

TV = + +
( 1+ rA ) ( 1+ rf ) ( 1+ rf )
n n n

DD,Non Dep n rD,Non Dep tc



rD,Non Dep - g
+ (3.40)
( 1+ r )
n

D,Non Dep

As one can note, for the long-term FCFA, we employed the hypothesis
of growing at the assets growth rate, where the growth of assets represents
a banks reinvestment. Thus, the long-term FCFA is equal to the After-
taxes operating profit6 (AT Opn) multiplied for (1 + g) minus the last
years total asset (A) multiplied for g.
The value of equity in time 0 can be found by netting from the banks
firm value the value of debt (other debt plus deposits) in time 0.

Bank Equity = Bank firm value Deposits ( nominal ) Other debts


In these terms, it is important to underline that some authors have


stated that the usage of nominal value for a deposit value is not the
correct way (Copeland etal. 2000) to take into account the true value

Refer to Chap.4 for the determination of the After taxes Operating Profit.
6
70Valuing Banks

of the liabilities that are not traded. To the contrary, we reframe this
statement since:

the short-term nature of such liabilities implies a repayment value


at the nominal value used, in line with the IAS/IFRS accounting
standard;
the guarantees related to deposits allows them to be considered as a
risk-free investment for customers, so that, for a bank, the value of
deposits is obtained according to equation 2.4 (i.e. interest expenses,
discounted back at the risk-free rate). This is in line with the num-
ber of practitioners that propose the Cost Saving Approach to the
value of deposits (Mard et al. 2002). This value is added to the
assets value and equity because it is in favor of shareholders, and
not of depositors.

3.6 T
 he Restatement ofModigliani
andMillers Theories fortheBanking
Industry
According to what we have discussed so far, we can now restate the
ModiglianiMiller propositions in the absence and presence of taxes
withregard to banks.

3.6.1 Absence ofTaxes

ModiglianiMiller first proposition with an application to banks:


Bank value does not change if the equity is replaced by non-deposit
debt, and vice versa.
In other words, if deposits were to be replaced by other forms of
debt or equity, in the event that cost of the deposits is lower than
therisk-free rate (i.e. there is a mark-down), the value generated by a
bank will be lower.
In support of this first proposition, we can point out that an increase
in deposits and the simultaneous decline in equity or other forms of
debtleads to:
3 Value, Capital Structure and Cost of Capital... 71

an increase in fees and commissions on current accounts which


influences cash flows, consequently, increasing the value of a bank;
a simultaneous increase, although not necessarily proportional, of
short-term assets. Therefore, a different composition of assets might
entail a different cost of assets due to the different underlying risks.
Consequently, changing risks on assets, the cost of assets will change
aswell. In this case, it would violate the hypotheses of the Modigliani-
Miller theorem, which stated the constancy of asset risk and the only
variation being leverage.

Hence, if deposits are substituted with other forms of debt or


equity, the ModiglianiMiller theorem does not hold true. Therefore,
the ModiglianiMiller theorem is verified only when consider-
ing a substitution of non-deposits debt with equity (and vice versa).
Notwithstanding deposits are, technically, financial debt, their dynamic
violates the ModiglianiMiller theorem.

ModiglianiMiller second proposition with an application to banks:


The cost of equity will grow linearly with the increase in leverage at
its market value, the greater is the difference between risk-free rate
and the true cost of debt (that is the average of the true cost of debt
and true cost of deposits).
If we write our second proposition in formulas, putting together equa-
tions (3.15) and (3.19), considering the average true cost on debt (iD,Average)
rather than the true cost of deposits (iD,Dep) only, and considering that all
debt is priced as risk-free, we can write the second proposition as:

iD,Average D
rE = rA + ( rA - rf ) (3.41)
rf E

Here, it is possible to observe changes in the cost of equity and the


WACC for increasing levels of leverage (Fig. 3.2).
As one can note, it is possible to see how the cost of equity (rE) rises
when debt grows, while the WACC decreases for the effect of mark-
down value on the weights. The WACC* drops down more than the
WACC because, in its formula, it considers the true cost of deposits.
72Valuing Banks

0,09

0,085

0,08

0,075

0,07

0,065

0,06

0,055

0,05

0,045

0,04
- 0,50 1,00 1,50 2,00 2,50 3,00 3,50

rA rf rE WACC WACC*

Fig. 3.2 MMs Second Proposition with no taxes for banks.


Source: Authors elaboration.

Inthe WACC there is a composition effect in the financial structure; in


the WACC*, there is a composition effect plus the underpricing effect.
Therefore, in light of this consideration and looking at Fig. 3.2, we can
state that an increase of equity implies a small increase in the WACC as
predicted by Kashyap etal. (2010), Cosimano and Hakura (2011), Miles
etal. (2013), Baker and Wrgler (2013).

3.6.2 Presence ofTaxes

ModiglianiMiller first proposition with an application to banks:


Bank value depends on capital structure due to deposits remunerated
at a rate less than the risk-free rate, on the income earned on deposits
and because of the tax benefits.
3 Value, Capital Structure and Cost of Capital... 73

Compared with the first proposition which holds true, in this case we
discover that tax benefits affect value, even in the event that there is the
substitution among all the typologies of debt and equity (and vice versa).
ModiglianiMiller second proposition with an application to banks:
The cost of equity will grow linearly with the increase in leverage at
its market value, the greater is the difference between risk-free rate
and the true cost of debt (i.e. the average of the true cost of debt and
true cost of deposits).
iD, Average D
( )
rE = rA + rA rf (1 tc )
rf E
(3.42)

This second proposition with taxes equals that without taxes, but the
tax effect (1tc) must be considered. It is possible to observe the changes
in the cost of equity and WACC for increasing levels of leverage and also
considering the tax-shield effect (Fig. 3.3).
As one can see, both WACC and WACC*, decrease more than in the
case without taxes. This is due to the presence of the tax benefits. This
finding confirms Admati et al. (2013): when debt has a tax advantage
over equity, increased equity requirements increase the funding cost for
banks because they reduce the ability of banks to benefit from the tax shield
associated with interest payment on debt.

3.7 C
 onsistency oftheAMM with Excess
Returns Models
From the previous section, we might claim that the AMM we presented
is framed as an asset-return metric. In this section, we analyze the main
points of convergence between the excess returns model we presented
in Chap. 2 and the AMM.This is with the aim of underlining how our
model allows the summarizing and making analytical and applicable
those methods which estimate the goodwill using a multiple on funding.
As illustrated in Chap. 2, the excess returns model assumes that the
credit institution considers two main parts of the value:
74Valuing Banks

0,075

0,07

0,065

0,06

0,055

0,05

0,045

0,04
- 0,50 1,00 1,50 2,00 2,50
rA rf rE WACC WACC*

Fig. 3.3 MMs Second Proposition with taxes for banks.


Source: Authors elaboration

Net asset value, possibly adjusted to take into account of unrealized


gains and losses;
Excess return value of profit over the cost of capital, calculated on the
shareholders expected returns.

The excess returns model corresponds to the residual income model in


use for non-financial companies in which the generated abnormal return
is equal to the Economic Value Added (EVA). This methodology is useful
for companies, such as banks, which are capital-intensive and for which
the value is largely dependent on their investments in equity.
As shown in the previous section, we can adapt such methodology
according to an asset valuation approach instead of that of equity. But,
inaddition, it is possible to add a separate assessment of tax and deposits
benefits.
3 Value, Capital Structure and Cost of Capital... 75

Beginning from the firm value in the presence of taxes, we can write
that the asset value is given by:

FCFA
VAsset = , (3.43)
rA

where FCFA corresponds to the income on asset.


Adding and subtracting from the numerator rA and if asset income is
expressed by multiplying ROA for the book value of assets, we can sepa-
rately express the excess returns as:

ROA Assets (1 tc ) + rA Assets rA Assets


VAsset = (3.44)
rA

from which

ROA (1 tc ) rA
VAsset = Assets + Assets , (3.45)
rA

where ROA is not traditionally calculated using net income, but it


is quantified including all the items of profit, except the cost of debt
(Masera and Mazzoni 2013).
From the difference between ROA (with taxes) and the cost of assets
(rA), we obtain goodwill or badwill:

in the event of higher profitability than the cost assets, the asset value
is higher than the asset book value;
in the event of lower profitability than the cost of assets, the asset value
is lower than the asset book value;
in of the event that profitability is equal to the cost of assets, the asset
value is equal to asset book value.
76Valuing Banks

If we consider tax benefits and deposit benefits, the model becomes:

VAsset = Assets +VEVA,Asset +VMK - Down +VD,Dep,TS +VD,DNon dep,TS


ROA ( 1 - tc ) - rA rf - iD,Dep
= Assets + Assets + DD,Dep
rA rf
DD,Dep iD,Dep tc DD,Dnon dep rD,Non Dep tc
+ + (3.46)
rf rD,Non Dep

The method described highlight all the drivers of bank, value


g enerations allowing a more justifiable and transparent assessment. In
particular, we can separately highlight the variables that affect goodwill
or badwill generated by a bank:

ROA ( 1 - tc ) - rA rf - iD,Dep
Goodwill = Assets + DD,Dep
rA rf
DD,Dep iD,Dep tc DD,Dnon dep rD,Non Dep tc
+ + (3.47)
rf rD,Non Dep

So, the goodwill or badwill will depend on the banks asset risk profile
(rA), asset return (ROA), taxation level (tc), non-deposit debt risk pro-
file (rD,Non Dep), market risk-free rate (rf ) and the composition of a banks
liabilities in terms of deposits and non-deposit funding. As can be noted
in equation (3.48), if the net return on assets is equal to the cost of assets,
goodwill is mainly affected by debts as:

rf - iD,Dep DD,Dep iD,Dep tc DD,Dnon dep rD,Non Dep tc


Goodwill = DD,Dep + + (3.48)
rf rf rD,Non Dep

If non-deposit debts rD,Non Dep is equal to the risk-free rate, we can sim-
plify the equation as:
3 Value, Capital Structure and Cost of Capital... 77

rf iD , Average (1 tc )
Goodwill = D , (3.49)
rf

where iD,Average is:

DDep DNon Dep


iD, Average = iD, Dep + rf (3.50)
D D

As one can see, the goodwill or badwill depends linearly on a


banksdebt. This is in line with the traditional method that measures the
goodwill as a multiplication of a banks debt and an alpha coefficient.

Goodwill = D (3.51)

According to Preda (1980), the coefficient is determined by the mar-


ginalities of funding instruments or by referring to the interbank rate con-
sidered as a replacement cost of customers deposits (my emphasis).
With regard to the interbank rate, if we assume that it would be equal
to the risk-free rate, we can appreciate the effect of value generation from
the underpriced deposits.
Hence, according to the method we have presented in this chapter, we
can quantify the coefficient as following:

rf - iD,Average (1 - t c )
= (3.52)
rf

Some authors take an alpha value between 0.07 and 0.15 (e.g.
DAmico 1996; Guatri 1990; Preda 1980). Specifically, this value
depends on the level of market rates, taxation and, in particular, on the
ratio to deposits and non-deposit funding. If a bank has no depositdebt
(such as investment banks), goodwill would depend only on the value
78Valuing Banks

Table 3.5 Dynamic of the coefficient


Deposit percentage on debt iD average Alpha coefficient
0% 3.50% 33.0%
10% 3.35% 35.9%
20% 3.20% 38.7%
30% 3.05% 41.6%
40% 2.90% 44.5%
50% 2.75% 47.4%
60% 2.60% 50.2%
70% 2.45% 53.1%
80% 2.30% 56.0%
90% 2.15% 58.8%
100% 2.00% 61.7%
Source: Authors elaboration

generated through the tax-shield. Conversely, the value of goodwill


will grow with the increase of the proportion of deposit funding.
Consider now the following example: a tax rate of 33%, a risk-free
rate of 3.5% and a return on debts of 2%. According to these data
and to equation (3.52), we can show the dynamic of the coefficient
(see Table 3.5).
As one can note coefficients are considerably higher than
those applied by practitioners and considered by academics in their
contributions.
In particular, according to our model, this is due to the lower value of
assets (owing to the smaller ROA than the cost of assets). However, the
goodwill value calculated by funding and fiscal benefits compensates the
lower value of assets in respect of accounting value. Thus, a separated
valuation of goodwill must also take this aspect into account, because the
value of deposits cannot be the unique element of goodwill or badwill
(Laghi 1994).

3.8 Conclusion
This chapter highlighted the typical problems of a valuation based
on free cash flows to equity or dividends, adapting the usual tech-
niques for assessing the firm value of non-financial companies. Unlike
3 Value, Capital Structure and Cost of Capital... 79

on-financial companies, we need to replace the definition of free cash


n
flows from o peration (FCFO) with free cash flow from assets (FCFA),
where the latter does not consider the costs and benefits related to finan-
cial debt (deposits and non-deposit debt). This allows us to provide a
new valuation scheme that differs from the other existing methods in
the way that it separately quantifies the mark-down effect. FCFA is dis-
counted at cost of asset, while deposit benefits are discounted back at
risk-free rate.
From a theoretical point of view, the resulting method integrates the
cost of savings approach to evaluate core deposits in an adjusted present
value methodology. Consequently, it is possible to develop a theoretical
framework in order to show the debt influence on a banks firm value.
Furthermore, it provides a reconciliation with other specific methodologies
such as the excess return and the deposit multiple to quantify goodwill.
From a practical point of view, the proposed methodology is helpful to
show clearly the genesis of a banks firm value and to provide a measure
of cost of capital that is less volatile compared with the cost of equity.
Finally, as in the traditional Adjusted Present Value for non-financial
companies, the assessment does not require the use of market values of
debt and, besides, equity and leverage should not be continually restated
along the forecast period.

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4
Measuring theCash Flows ofBanks:
TheFCFA Asset-Side Approach

4.1 Introduction
The most frequently used valuation methods of banks in practice and also
acknowledged by the literature are those belonging to discounted cash
flows approach. As we have pointed out in Chaps 2 and 3, generally the
literature argues that free cash flows to equity and dividends represent the
configuration of cash flows mainly in use in bank valuation. As we have
pointed out, such a preference is basically due to the different role of debt
and to the problems related to a clear separation between financing and
lending activity. The interconnection of the two areas has the effect of
not allowing the identification and separation of financial expenses from
operating costs and, more generally, assessment of the effect of leverage
on value. But if we define and treat debt in a different way, it may be
possible to adopt a different approach to valuation. In these terms, as we
discussed in Chap. 3, the basic assumption of the AMM is that bank debt
is, in total, considered as financial debt. Obviously, such an assumption
has several consequences in a reclassification of financial statements and,
therefore, in the calculation of free cash flows. In particular, separating

The Editor(s) (if applicable) and The Author(s) 2016 83


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
inBanking and Financial Institutions, DOI10.1057/978-1-137-56142-8_4
84 Valuing Banks

asset operations from liabilities helps in the modeling of a more struc-


tured and comprehensive cash flow estimation, in addition to explaining
the main value creation sources.
In this chapter, according to the theoretical framework of the asset
side model we presented in Chap. 3, we discuss how the balance sheet
and income statement should be reclassified in order to reach an asset-
side measure of free cash flow (FCFA). In particular, the objective of the
chapter is not only to discuss how to construct the FCFA, but we also aim
to reconcile the FCFA to the FCFE, also taking into consideration the
regulatory equity capital reinvestments, as broadly given in the literature
and followed by practitioners.

4.2 The Balance Sheet Reclassification


The first step to reach a breakdown of a banks cash flows is to reclassify
the balance sheet. This is necessary for two reasons: first, to have a more
general view of the intensity of the invested capital in each business area
and, second, to highlight the main sources of income which characterize
the operating margins.
Starting from an IAS compliant bank balance sheet in Table 4.1, we
grouped the macro-classes of assets and liabilities (Table 4.2).
On the asset side, we group:

Cash and cash balance. We include in this category all the currencies having
legal tender, such as banknotes and Central Bank(s) deposits. Cash and
cash balances increase interest revenues of a banks income statement.
Loans and receivables with banks and customers. We include within this
macro-class all those loans which are not quoted on any active mar-
ket. Usually, for a commercial bank, loans represent the greatest part
of the total assets. Grouped here are all the traditional financing
instruments associated with lending, such as mortgages, leases, factor-
ing financial instruments, and so on. In terms of the impact on the
income statement, loans mainly have two effects: first, that of interest
incomes and product-correlated commissions; second, that of impair-
ment and losses for the deterioration of credit, which represents one
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 85

Table 4.1 IAS compliant bank balance sheet


Asset Liabilities and equity
Cash and cash balances Deposits from banks
Financial asset held for trading Deposits from customers
Financial assets at fair value through Debt securities in issue
profit and loss
Financial assets available for sale Financial liabilities held for trading
Investments held to maturity Financial liabilities at fair value through
profit and loss
Loans and receivables with banks Hedging derivatives
Loans and receivables with customers Changes in fair value of portfolio
hedged items (+/)
Hedging derivatives Tax liabilities
Changes in fair value of portfolio Liabilities included in disposal groups
hedged items (+/) classified as held for sale
Investments in associates and joint Other liabilities
ventures
Insurance reserves attributable to Provisions for employee severance pay
reinsurers
Property, plant and equipment Technical reserves
Intangible assets Provisions for risks and charges
of which goodwill Revaluation reserves
Tax assets Reserves and Share Premium
1. Current tax assets Issues capital
2. Deferred tax assets Treasury shares
Non-current assets and disposal Minorities
groups classified as held for sale
Other assets Net profit(loss) for the year (+/)
Total asset Total liabilities and shareholder equity
Source: Authors elaboration.

the most important negative components in the income statement of


a traditional commercial bank.
Financial assets. Financial intermediation represents usually the second
source of income for commercial banks. Within this macro-class, we
can find several typologies of financial asset which are also character-
ized by different accounting methods.
86 Valuing Banks

Table 4.2 Macro-class of assets and liabilities of a banks balance sheet


Asset Liabilities
Cash and cash balances Deposits from banks and customers
Loans and receivables with banks Debt securities in issue
Loans and receivables with customers Financial liabilities
Financial assets Provisions for employees
Tangible and intangible assets Tax liabilities
Tax asset Other liabilities
Other assets Equity
Source: Authors elaboration.

Held for trading (HFT). Held for trading financial assets are held by
banks with the object of drawing short-term profits coherently with
an adequate interest rate and liquidity risk management. Net
income from held for trading is registered in the income statement
as are the interest, dividends and similar incomes which together
increase the interest and intermediation margins.
Fair value to profit or loss (FVTPL). Fair value to profit or loss assets
are all financial assets for cash accounted using their fair value
option, even if not closely related to the negotiation activity. In the
income statement, all fair value variations, interest incomes, divi-
dends and similar revenues related to fair value to profit or loss
increase interest income and interest margins.
Available for sale (AVS). Included in the typology available for sale
are all non-derivative financial assets that do not represent a trading
investment and which the bank has decided to hold for an indefi-
nite period of time. Fair value variation is not directly registered in
the income statement but, rather, in a revaluation reserve which is
on the liabilities side until they are sold back to the market.
Available for sale assets contribute to the operating margins by
increasing interest income, dividends and similar incomes.
Held to maturity (HTM). This category includes debt securities with
fixed or determinable payments and fixed terms that the bank decides
to hold until their maturity. Held to maturity assets affect the income
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 87

statement not only in terms of interest income, but also when they
are subject to impairment, or, exceptionally, sold or repurchased.
Hedging derivatives. This macro-class includes all derivatives with
positive fair value subscribed in order to hedge from main banking
risks, such as counterparty default risk, interest rate risk, foreign
exchange risk, price risk, and so on. Hedging derivatives affect the
income statement through the net result of hedging activity, and
even by an interest-similar income on the net value between posi-
tive and negative exposures.
Associates. There are included all equity shares held in subsidiaries,
jointly controlled entities and those subject to significant influence
held by the bank where the investment function is not of a short-
term nature. The balance of gains and losses from subsidiaries and
jointly controlled entities, and subject to significant influence, are
registered in the income statement. In addition, the net result of
impairments is included in the income statement.
Tangible and intangible assets. This typology comprises all those assets
that are intended to be consumed in the course of business activities
such as, buildings, equipment, fixtures and fittings, means of trans-
port, and so onthat have been acquired by means of financial leases.
Also included within this category non-functional banking activities
which are held for investment purposes to achieve a profit or increase
in value over time. Conversely, included within intangible assets are
franchises, brand, rights, and so on, including goodwill and the assets
subject to financial leases (for the lessee) and operating leases (for the
lessor). Gain and losses, such as impairments and write-backs on tan-
gible and intangible assets, are all recorded in the income statement.
Tax assets. The current and deferred tax assets and liabilities represent
the balance of the fiscal position of the bank against the tax authority.
Taxes for the year are recognized in the income statement on the basis
of accrual accounting.
Other assets. Within this item we include all other activities that do not
fit into any other category; for example, gold, silver and precious met-
als, or the positive value of servicing assets and others. In addition, we
include insurance reserves attributable to reinsuring, all non-current
assets and groups of assets held for sale.
88 Valuing Banks

In the liabilities side, we group:

Deposits from banks and customers. The items included in this category
are basically related to the direct funding of a traditional commercial
bank, considered both at the retail and wholesale levels. Usually, in a
commercial bank, deposits represent the biggest slice of direct fund-
ing. Such typologies of funding are made at a lower cost than other
funding products. Their impact in a banks income statement is repre-
sented by interest expenses.
Debt securities in issue. Outstanding securities in issue are those securi-
ties issued by the bank to finance their investments and they are usu-
ally represented by bonds, savings bonds, certificates of deposit, and so
on. The debt securities in issue typology includes all the funding the
bank receives regardless of the form it takes. The impact on the income
statement of these items is mainly exerted on interest expenses and on
gains and losses resulting from the repurchase of financial liabilities.
Financial liabilities. In the typology financial liabilities are included:
Financial liabilities held for trading. They include debt securities, loans
and the negative value of non-hedging derivatives. Financial liabilities
held for trading affect the income statement through interest expenses.
Financial liabilities at fair value through profit or loss. Financial liabil-
ities measured at fair value are specular to the financial assets.
Within this item are liabilities for which the bank has chosen to use
the fair value option as in IAS 39. Their change is detected in the
income statement. In addition, in the income statement, liabilities
measured at fair value increase interest expenses.
Hedging derivatives. This category includes hedging derivatives that,
at the valuation date, have a negative market value. Their change in
value is recognized in the income statement. Hedging derivatives
also produce interest-similar expenses.
Provisions for employee severance pay. This represents the share of sever-
ance indemnities bank workers have accrued and concerning which
the bank holds an obligation.
Tax liabilities. This category includes all the tax debts divided into cur-
rent and deferred, including those having the nature of credit risk
provisions.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 89

Other liabilities. This residual macro-class groups together all those


liabilities not classified elsewhere. Also included are provisions for risk,
and charges made in compliance with social security legislation and
those relating to certain expenses in that amount arising from past
events but for which there is no timeframe for settlement. Additionally,
insurance reserves fall into this category.
Equity. Equity is given by the sum of revaluation reserves, reserves,
redeemable shares, equity instruments, share premium, issued capital,
treasury shares, minorities and the net profit (loss) for the year.

In addition to the asset and liabilities reported in the financial statements,


it is important to highlight that further revenues, costs and obligations may
come from the off-balance sheet. In the below the line assets, we could
find the overall exposure in derivatives, credit and given financial guaran-
tees, and irrevocable commitments to disburse funds. It is worth noting
that none of those items appear in the financial statements; however, they
generate income components and constitute a significant part of a banks
potential future exposure.
After having revealed what are the main macro-categories of asset and
liabilities, it is now important to reclassify the balance sheet.
According to the literature, a banks balance sheet can be reclassified
using a functional approach; that is, considering the single asset and
liability contribution to profits and losses to the income statement. This
follows the need to identify the fundamental areas of business of a bank
and, therefore, to analyze the main strategies of funding and investment.
Only by resorting to such a reclassification is it possible to assess the
size of the invested capital and of the corresponding effective returns.
Hence, assets and liabilities are divided according to their contribution
and impact on operating margins.
In Table 4.3, we report a condensed scheme in which we show the
reclassification of a banks balance sheet according to the functional
approach.
Assets are split into:

Bearing assets. These include all interest bearing and financial assets
producing positive flows of income from credit, financial operations
90 Valuing Banks

Table 4.3 Balance sheet reclassification


Asset Liabilities and equity
Cash and cash balances Deposits
Loans and receivables with banks Debt securities in issue
Loans and receivables with customers Financial liabilities
Financial assets Bearing liabilities
Bearing assets Other liabilities

Tangible and intangible assets Non-bearing liabilities

Other assets
Equity
Non-bearing assets
Total asset Total liabilities and equity

Below the line

Assets under management


Credit commitments
Source: Authors elaboration.

and services. Included in financial investments are: investments in asso-


ciates and joint ventures, held for trading, fair value through profit or
loss, available for sale and held to maturity. It has to be pointed out that
although assets under management are not included in the asset side of
the balance sheet, they do have a relevant impact on intermediation
margin in terms of commissions. Included in off-balance, credit com-
mitments can also add interest incomes and positive commissions.
Non-bearing assets. These include all those assets not producing any
kind of financial income, or any contribution from assets that has a
non-financial nature. Obviously, in the non-bearing assets category we
place all the residual assets not included in the bearing assets.

Following the same framework, liabilities are split into:

Bearing liabilities. Included in this category are all the liabilities gener-
ating interest expenses or similar charges. In particular, we divide bear-
ing liabilities into three sub-classes: deposits, including those from
customers and banks; debt securities in issue and financial liabilities.
In financial liabilities we include: held for trading and fair value
through profit or loss and hedging derivatives.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 91

Non-bearing liabilities. In the non-bearing liabilities category we include


all the other liabilities not generating any specific negative contribution
or costs of a financial nature in the income statement. In addition, even
in this situation, it is important to emphasize that assets under manage-
ment and credit commitments can produce financial costs.
Equity. This represents the book value of the difference between total
assets and liabilities, and gathers together: revaluation reserves, reserves,
redeemable shares, equity instruments, share premium, issued capital,
treasury shares, minorities, net profit (loss) for the year.

4.3 The Income Statement Reclassification


By reclassifying the income statement, we aim to build up a synthetic
scheme that illustrates the contribution of assets and liabilities to the
determination of profit (or loss). In order to reach this objective, the
scheme must follow the balance sheet reclassification and, consequently,
has to highlight the contribution of bearing assets and liabilities (but
also those of below the line components) to the operating profit and
net income. In addition, the new scheme should report the distinction
between operating, financial and extraordinary operations.
Notwithstanding that the standard income statement of banks generally
follows a functional approach (see Table 4.4), some specific adjustments
have to be made with the objective of improving the comprehension of
profit (or loss) determination.
According to the theoretical framework of the asset-side model we
presented in Chap. 3, we assume a banks debt as all financial debt
and, therefore, interest expenses are treated not as operating costs but,
instead, as financial expenses. In other words, we differentiate between
the literature and common practice, considering debt in its real finan-
cial nature and not in its theoretical operational meaning. Such an
assumption helps to create a clear separation of asset from liabilities
operations, and enables the analysis of the contribution of the single
asset and liabilities class to the operating profit.
In Table 4.5, we show the reclassification of the income statement
following the theoretical approach we have described so far.
Table 4.4 IAS compliant bank income statement
Interest income and similar revenues
Interest expenses and similar charges
Net interest margin
Fees and commission income
Fees and commission expense
Net fees and commissions
Dividend income and similar revenues
Gain and losses on financial assets and liabilities held for trading
Fair value adjustments in hedge accounting
Gain (losses) on disposal and repurchase of:
1. Loans
2. Available for sale
3. Held to maturity investments
4. Financial liabilities
Gain and losses on financial assets/liabilities at fair value through profit and loss
Operating income
Net loss/recoveries on impairment:
1. Loans
2. Available for sale
3. Held to maturity investments
4. Other financial assets
Net profit from financial activities
Premiums earned (net)
Other income (net) from insurance activities
Net profit from financial and insurance activities
Administrative costs
Net provision for risk charges
Impairment/write-backs on property, plant and equipment
Impairment/write-backs on intangible assets
Other net operating income/cost
Operating costs
Profit (loss) of associates
Gain and losses on tangible and intangible assets measured at fair value
Impairment of goodwill
Gain and losses on disposal of investments
Total profit (loss) before tax from continuing operations
Tax expense (income) related to profit or loss from continuing operations
Total profit or loss after tax from continuing operations
Profit (loss) after tax from discontinued operations
Net profit (loss) for the year
Minorities
Profit (loss) for the year
Source: Authors elaboration.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 93

Table 4.5 Income statement reclassification


Interest income and similar revenues
Fees and commission income
Fees and commission expense
a Interest and net services income
Dividend income and similar revenues
Net profit (loss) from financial operations
Profit and loss from associates
b Operating income from financial activities
c Net losses/recoveries on impairment of financial activities
d=a+bc Adjusted operating income from financial activities
e Net premiums and incomes from insurance activities
f=de Adjusted operating income from core activities
Administrative costs
Net provision for risk charges
Gain and losses of fair value on tangible and intangible assets
Other net operating income/cost
g Operating costs
h=fg Gross operating income
i Impairment/write-backs tangible and intangible assets
l=hi Operating profit
o Financial expenses (Interest expenses and similar charges)
Gain (losses) on disposal and repurchase of held to maturity
Impairment of goodwill
Gain and losses on disposal of investments
Profit (loss) after tax from discontinued operations
Other non-recurrent costs
p Non-recurrent profit (loss)
q=lop Total profit (loss) before taxes
r Tax expenses
s=qr Net profit
Minorities
Total profit for the year
Source: Authors elaboration.
94 Valuing Banks

As one can note, the Operating income from financial activities can be
separated into four fundamental value sources which correspond to the
main business areas of banks:

Credit intermediation;
Services;
Financial operations;
Insurance.

These are all considered at their net value so that all items of income
are already netted from the respective operating costs. However, the only
component of income which is not netted for the corresponding cost is
Interest incomes and similar revenues. This is because, as we have antici-
pated, interest expenses are not treated as operative costs but, rather, as
financial expenses. Hence, interest expenses are reported in the financial
operations, more specifically, after the operating profit.
Then, we adjust for Net losses and recoveries on impairment of financial
activities (excluding gain and losses on disposal of held to maturity which
are not considered as core activities) and we reached the Adjusted operat-
ing income from core activities. Such an adjusted margin, gathers together
very important information on the capacity of the bank to extract value
from its core operations.
However, particular attention should be paid to loan provisions. In
fact, provisioning is used by managers to smooth earnings over time in
order to meet profitability expectations (e.g. Curcio and Hasan 2015),
manage capital requirements (e.g. Fonseca and Gonzales 2008), and to
signal unexpected asset quality information to the stock market (e.g.
Beaver et al. 1989; Wahlen 1994). In particular, reserves are annually
incremented for provisions and reduced by charge-offs and recoveries.
When earnings are low, managers tend to lower provisions while, when
earnings are high, managers are inclined to increase provisions. As we
anticipated, such a contingency has the effect of stabilizing earnings and,
consequently, of reducing the volatility of profits over economic cycles.
Since provisions are partially discretional (in particular, we refer to gen-
eral risk provisions since those of loan losses are continuously monitored
by the authorities), external analysts, in absence of specific informa-
tion, could under-estimate or overestimate the free cash flows due to the
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 95

indeterminate nature of the amount of provisions. According to the lit-


erature, a useful way to take into account the fair level of provisions is to
add back and then deduct for the historical data on a percentage of the
effective amount of charge-offs. A similar approach can be employed for
deferred taxes as well, since they have to be considered as current period
expenses (Fiordelisi and Molyneux 2006).
If we then subtract from the Adjusted operating income from core
activities the administrative costs, provisions for risk charges, gain and
losses on tangible and intangible assets and other net operating income/
cost, we can obtain the Gross Operating Income, from which subtract-
ing Impairment/write-backs on tangible and intangible assets, we obtain
the Operating Profit, which represents the contribution of a banks core
operations to the determination of Net profit.
From the Operating Profit, we take financing operations into account, net-
ting for the Interest expenses and similar charges which, according to our model,
represent the outflow for debt service. According to the asset-side model theo-
retical framework we presented, the main adjustment in the income state-
ment is to be found by following this logical procedure. In fact, as anticipated,
the debt is fully treated as a financial cost and not in terms of operational debt.

4.4 From Incomes toCash Flows


In this section, we show a cash flow statement with the objective of defin-
ing the FCFA and reconciling it to the FCFE.In particular, the valuation
approach we present separates the assets and liabilities side of a bank,
valuing them individually. Along these lines, we can analyze how much
value is created both on the assets side and the liabilities side, in particu-
lar, by deposits which contribute to value through the mark-down and
tax benefits on interest expenses.
As acknowledged in the best corporate finance literature, the determina-
tion of a free cash flow is based on the construction of a prospectus giving a
resum of the results and adjustments regarding the operating, the financial
and the extraordinary areas. In particular, included in the operating area
are all those repetitive operations that a firm performs while running its
business and those related to the tangible and intangible assets. Regarding
the records of the financial area, all the financial operations are realized
96 Valuing Banks

through debt and equity management. The extraordinary area gathers


together all non-recurrent results. In our FCFA model, we do not change
the traditional structure of the free cash flow calculation; rather, we adjust
it in order to take into account the specifics of banking and, in particular,
of the value creating role of assets, deposits and tax benefits. In Table 4.6,
we report the FCFA cash flow statement with the reconciliation to FCFE.
Table 4.6 Cash flow statement: from FCFA to FCFE
FCFA and FCFE estimation and reconciliation
Operating profit
Operating taxes
Effective taxes+(Marginal tax rateInterest expenses and similar charges)
After-taxes operating profit
Cash ineffective transactions
+ Impairment/write-backs on tangible and intangible assets
Net working capital

Cash and cash balances


Loans and receivables with banks
Loans and receivables with customers
Financial assets
Other assets
+ Other liabilities
Cash flow from financial activities
Tangible and intangible assets
Net tangible and intangible assets
Free cash flow from assets (FCFA)
Financing operations

Interest expenses and similar charges on non-deposit debt


Interest expenses and similar charges on deposits at risk-free rate (Deposits * rf)
+ Deposits * (rfi)i is Interest expenses on deposits/Deposits
+ Interest expenses and similar chargesMarginal tax rate
+ Deposits
+ Financing sources other than deposits
Non-recurrent profit (loss) and minorities
Free cash flow to equity (FCFE)
Source: Authors elaboration.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 97

As one can notice, from Operating profit we calculate the Operating


taxes by adding together Effective taxes and the figurative taxes on
interest expenses. The correction aims to reconcile the effective taxes
and those theoretically payable on operating profits. Such an adjust-
ment is more accurate than applying the marginal tax rate to Operating
profit. In fact, the effective tax rate is rarely equal to the marginal one.
Thus, if the analyst has precise information about tax planning and
cash flows, the approach that should be used is the adjustment for
figurative taxes on interest expenses. To the contrary, when effective
taxes are difficult to predict, it would be better to take into account
the marginal tax rate.
Applying such an adjustment, we obtain the After-taxes operating
profit that we netted for the cash-ineffective transactions that, in our
model, are basically represented by Impairment/write-backs on tangible
and intangible assets.
At this stage, we have to point out that we do not sum to the After-taxes
operating profit, the Net losses and recoveries on loans and on other financial
assets and liabilities, Net provisions for risk and charges and other similar
cash-ineffective transactions. This is because, as we will discuss later, they
are counterbalanced by a corresponding variation in the net working capi-
tal. In fact, if we sum back all cash-ineffective operations to the After-taxes
operating profit, it would entail a double-accounting when the net working
capital is considered to measure cash absorption or release.
As a matter of fact, the net working capital is determined by con-
sidering variations of specific assets and liabilities according to the
balance sheet reclassification. In practice, as in all the cash flow state-
ments, the increase of assets and the reduction of liabilities are consid-
ered as cash-absorbent, while the reduction of assets and the increase
of liabilities are computed as a cash-in. In our cash-flow statement, we
add Cash and cash balances, but we net for Loans and receivables with
banks and customers, Financial assets and Other assets and we add the
Other liabilities variations. The Cash flow from financial activities is the
sum of After-taxes operating profit, cash-ineffective transactions and net
working capital variation.
98 Valuing Banks

The final step in order to get to the FCFA is to take into account the
cash flow from net investment activity, including intangible assets.
With the FCFA, we formally reach a configuration of cash flow
which is strictly focused on the asset side, and which explains the cash
flows from assets through the analysis of operating profits, non-cash
operations, net working capital and fixed investments.
As we have underlined in the theoretical framework of the asset-side
model we discussed in Chap. 3, the intrinsic value is given not only by
the present value of FCFA, but also that of mark-down and tax benefits.
In order to catch the respective cash flows, from the FCFA we considered
the financing operation of a bank. In particular, we proposed to net, at
first, for interest expenses from non-deposits and deposit debt in case it
is possibile to measure and separate them from each other. In fact, from
an outside analysts perspective, the balance sheet does not often exhibit
a separation between deposit and non-deposis expenses. In the event that
such a subdivision cannot be made, all debt can be considered at the
risk-free rate.
According to the first hypothesis, we first net for Interest expenses and
similar charges on non-deposit debt and, subsequently, for Interest expenses
and similar charges on deposits at risk-free rate. Conversely, in the event it is
not possibile to split interest expenses, the two items can be combined in
Interest expenses and similar charges at risk-free rate, which is calculated by
the multiplication of bearing liabilities and the risk-free rate.
Then, we added back the figurative cash flow from mark-down (i.e.
the outstanding Deposits multiplied by the spread between risk-free and
effective rate from deposits) and tax benefits (which is Interest expenses
and similar charges multiplied by Marginal tax rate). Among the financ-
ing operations, we even considered the annual stock variations in terms
of debt funding sources. Therefore, we add deposits and other financ-
ing sources variations. If we subtract the net result from the FCFA from
financing operations, we get to the FCFE.
It must be emphasized that, in this case, we must not net the FCFE for
the minimum capital amount variation required by authorities that needs
to be set aside if there is an increase of risky assets in accordance with the
Basel framework. This is because the analytical framework we developed
already takes into account the regulatory capital requirement needed in
terms of assets and equity variation.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 99

4.5 F CFA andFCFE: TheCase ofIntesa San


Paolo Bank
In this section, we propose an application of the FCFA calculation on a
real case: Intesa San Paolo Bank. Intesa San Paolo is publicly listed on the
FTSE MIB (that is the most important index in the Italian stock market)
and it is under the supervision of the European Central Bank. We took its
consolidated IAS compliant financial statements for two consecutive years
(2012 and 2013) (Table 4.7) and we ran the FCFA model we have pre-
sented in previous sections. The objective is to explain how to undertake a
practical cash flows measurement with the FCFA model.
From the balance sheet, we have gathered together the similar
macro-classes of assets and liabilities as in Table 4.8. From the interpreta-
tion of the balance sheet, we can note that Intesa San Paolo is a traditional
commercial bank where the greatest part of its assets is invested in loans
to customers and financial assets, while deposits and debt securities show
the largest contribution to bank funding. In particular, the FCFA model
can be also run for investment banks which are more market-oriented
both on the assets and liabilities sides, but, in this case, without a strong
activity oriented to collecting deposits, we will not have any problems in
separating operations from financial expenses.
In Financial assets, we have included Financial assets held for trading,
Financial assets at fair value through profit and loss, Available for sale finan-
cial assets, Held to maturity investments, Hedging derivatives, Changes in fair
value of portfolio hedged items and Investments in associates and joint ven-
tures. In the Other assets, we computed the Insurance reserves attributable
to reinsurers, Non-current assets and disposal groups classified as held for sale
and all Other assets. Conversely, on the liabilities side, Financial liabilities
are composed of Financial liabilities held for trading, Financial liabilities
at fair value through profit and loss, Hedging derivatives and Changes in fair
value of portfolio hedged items. In Other liabilities, we put together Liabilities
included in disposal groups classified as held for sale, all Other liabilities,
Technical reserves, Provisions for risks and charges and Revaluation reserves.
After having highlighted the composition and the amount of the
macro-classes of assets and liabilities, in Table 4.9 we run the balance
sheet reclassification which is drawn up according to the functional
100 Valuing Banks

Table 4.7 The balance sheet of Intesa San Paolo Bank (data in million)
Asset 2013 2012
Cash and cash balances 6,525 5,301
Financial assets held for trading 49,013 63,546
Financial assets at fair value through profit and loss 37,655 36,887
Available for sale financial assets 115,302 97,209
Held to maturity investments 2,051 2,148
Loans and receivables with banks 26,673 36,533
Loans and receivables with customers 343,991 376,625
Hedging derivatives 7,534 11,651
Changes in fair value of portfolio hedged items (+/) 69 73
Investments in associates and joint ventures 1,991 2,706
Insurance reserves attributable to reinsurers 14 13
Property, plant and equipment 5,056 5,109
Intangible assets 7,471 14,719
of which goodwill 3,899 8,681
Tax assets 14,921 12,673
1. Current tax assets 3,942 2,730
2. Deferred tax assets 10,979 9,943
Non-current assets and disposal groups classified 108 25
as held for sale
Other assets 7,909 8,364
Total assets 626,283 673,582

Liabilities and equity 2013 2012


Deposit from banks 52,244 73,352
Deposit from customers 228,890 218,051
Debt securities in issue 138,051 159,307
Financial liabilities held for trading 39,268 52,195
Financial liabilities at fair value through profit and loss 30,733 27,047
Hedging derivatives 7,590 10,776
Changes in fair value of portfolio hedged items (+/) 1,048 1,802
Tax liabilities 2,236 3,494
(continued)
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 101

Table 4.7(continued)

Liabilities and equity 2013 2012

Liabilities included in disposal groups classified


as held for sale
Other liabilities 14,690 18,039
Provisions for employee severance pay 1,341 1,354
Technical reserves 62,236 54,660
Provisions for risks and charges 2,898 3,599
Revaluation reserves 1,074 1,692
Reserves and Share Premium 41,655 40,875
Issues capital 8,546 8,546
Treasury shares 62 14
Minorities 543 586
Net profit(loss) for the year (+/) 4,550 1,605
Total liabilities and shareholder equity 626,283 673,582
Source: Intesa San Paolo Bank.

Table 4.8 Macro-classes of assets and liabilities (data in million)


Assets 2013 2012 Liabilities 2013 2012
Cash and cash 6,525 5,301 Deposits from 281,134 291,403
balances banks and
customers

Loans and 26,673 36,533 Debt securities in 138,051 159,307


receivables with issue
banks

Loans and 343,991 376,625 Financial liabilities 78,639 91,820


receivables with
customers

Financial assets 213,615 214,220 Provisions for 1,341 1,354


employee

Tangible and 12,527 19,828 Tax liabilities 2,236 3,494


intangible
assets

Tax assets 14,921 12,673 Other liabilities 78,750 74,606

Other assets 8,031 8,402 Equity 46,132 51,598


Source: Authors elaboration.
102 Valuing Banks

Table 4.9 The balance sheet reclassification (data in mln/)


Liabilities and
Assets 2013 2012 equity 2013 2012
Cash and cash 6,525 5,301 Deposits 281,134 291,403
balances
Loans and 26,673 36,533 Debt securities in 138,051 159,307
receivables with issue
banks
Loans and 343,991 376,625 Financial 78,639 91,820
receivables with liabilities
customers
Financial assets 213,615 214,220 Bearing liabilities 497,824 542,530
Bearing assets 590,804 632,679 Other liabilities 82,327 79,454
Tangible and 12,527 19,828 Non-bearing 82,327 79,454
intangible assets liabilities
Other assets 22,952 21,075 Equity 46,132 51,598
Non-bearing assets 35,479 40,903
Total assets 626,283 673,582 Total liabilities 626,283 673,582
and equity
Source: Authors elaboration.

approach we have described above. In particular, we separate assets and


liabilities in bearing and non-bearing.
In Tables 4.10 and 4.11, we respectively reported the Intesa San Paolos
income statement and its reclassification.
As one can note, the income statement reclassification is characterized by:

The imputation of interest expenses and similar charges in the financial


operations instead of operating business. Specifically, financial expenses
are deducted from the Operating profit.
We have considered a single item to resum the result from financial
assets operations which includes Gains and losses on financial assets and
liabilities held for trading, Fair value adjustments in hedge accounting,
Gain (losses) on disposal and repurchase of loans/available for sale/financial
liabilities and Gain and losses on financial assets/liabilities at fair value
through profit and loss.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 103

Table 4.10 The income statement of Intesa San Paolo Bank (data in million)
Income statement 2013
Interest income and similar revenues 17,403
Interest expenses and similar charges 7,518
Net interest margin 9,885
Fees and commission income 7,435
Fees and commission expense 1,606
Net fee and commissions 5,829
Dividend income and similar revenues 250
Gain and losses on financial assets and liabilities held for trading 597
Fair value adjustments in hedge accounting 28
Gain (losses) on disposal and repurchase of: 728
1. Loans 1
2. Available for sale 739
3. Held to maturity investments 2
4. Financial liabilities 10
Gain and losses on financial assets/liabilities at fair value through 492
profit and loss
Operating income 17,753
Net loss/recoveries on impairment: 7,005
1. Loans 6,597
2. Available for sale 296
3. Held to maturity investments
4. Other financial assets 112
Net profit from financial activities 10,748
Premiums earned (net) 11,921
Other income (net) from insurance activities 13,750
Net profit from financial and insurance activities 8,919
Administrative costs 8,504
Net provision for risk charges 319
Impairment/write backs on property, plant and equipment 382
Impairment/write-backs on intangible assets 2,838
Other net operating income/cost 643

(continued)
104 Valuing Banks

Table 4.10(continued)
Income statement 2013
Operating costs 11,400
Profit (loss) of associates 2,326
Gain and losses on tangible and intangible assets measured at fair
value
Impairment of goodwill 4,676
Gain and losses on disposal of investments 15
Total profit (loss) before tax from continuing operations 4,816
Tax expense (income) related to profit or loss from continuing 259
operations
Total profit or loss after tax from continuing operations 4,557
Profit (loss) after tax from discontinued operations
Net profit (loss) for the year 4,557
Minorities 7
Profit (loss) for the year 4,550
Source: Intesa San Paolo Bank.

Table 4.11 The income statement reclassification (data in million)


Adjusted income statement 2013
Interest income and similar revenues 17,403
Fees and commission income 7,435
Fees and commission expense 1,606
a Interest and net services income 23,232
Dividend income and similar revenues 250
Net profit (loss) from financial operations 1,791
Profit and loss from associates 2,326
b Operating income from financial activities 27,599

c Net losses/recoveries on impairment of financial 7,005


activities
d=a+bc Adjusted operating income from financial activities 20,594

e Net premiums and income from insurance activities 1,829


f=de Adjusted operating income from core activities 18,765
Administrative costs 8,504
Net provision for risk charges 319

(continued)
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 105

Table 4.11(continued)

Adjusted income statement 2013


Gain and losses of fair value on tangible and
intangible assets
Other net operating income/cost 643
g Operating costs 8,180
h=fg Gross operating income 10,585
i Impairment/write-backs on tangible and intangible 3,220
assets
l=hi Operating profit 7,365
o Financial expenses (Interest expenses and similar 7,518
charges)
Gain (losses) on disposal and repurchase of held to 2
maturity
Impairment of goodwill 4,676
Gains and losses on disposal of investments 15
Profit (loss) after tax from discontinued operations
Other non-recurrent costs
p Non-recurrent profit (loss) 4,663
q=lop Total profit (loss) before taxes 4,816
r Tax expenses 259
s=qr Net profit for the year 4,557
Minorities 7
Total profit for the year 4,550
Source: Authors elaboration.

We included the Profit and loss from associates as a core business result.
Net losses/recoveries on impairment of financial activities takes into
account impairments on loans, available for sale assets, held to matu-
rity investments and other financial assets.
Net premiums and incomes from insurance activities is the net result between
net Premiums earned and net Other income from insurance activities.
Separate from the Operating costs, the effect of impairment/write back
on tangible and intangible assets are netted from the Gross operating
income in order to reach the Operating profit.
106 Valuing Banks

Table 4.12 The FCFA and FCFE of Intesa San Paolo Bank (data in million)
FCFA and FCFE estimation and reconciliation 2013
Operating profit 7,365
Operating taxes
Effective taxes+(Marginal tax rateInterest expenses and 2,102
similar charges)
After-taxes operating profit 5,263
Cash ineffective transactions
Impairment/write-backs on tangible and intangible assets 3,220
Net working capital
Cash and cash balances 1,224
Loans and receivables with banks 9,860
Loans and receivables with customers 32,634
Financial assets 605
Other assets 1,877
Other liabilities 2,873
Cash flow from financial activities 46,091
Tangible and intangible assets
Net tangible and intangible assets 4,081
Free cash flow from assets (FCFA) 55,435
Financing operations
Interest expenses and similar charges at risk-free rate (Bearing 14,935
liabilities * rf)
Bearing liabilities * (rfi)where i is interest 7,417
expenses/bearing liabilities
Interest expenses and similar chargesMarginal tax rate 2,361
Deposits 10,269
Other financing sources other than deposits 34,437
Non-recurrent profit (loss) and minorities 4,656
Free cash flow to equity (FCFE) 916
Source: Authors elaboration.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 107

From the reclassified balance sheet and income statement, and accord-
ing to the structure of the model we presented in section 4, we run the
FCFA model as in Table 4.12.
The basic assumptions we adopt to construct the model are:

a marginal tax-rate that is assumed to be equal to 33%1;


a risk-free rate of 3%;
that it is not possibile to separate interest expenses between those from
non-deposits and deposit debt. Interest expenses on bearing liabilities
are equal to 1.51%.
The RWA expected growth is 4% starting from an outstanding RWA
in 2013 of 276.291 billion.

After having determined the FCFA, we reach the FCFE by netting for
financial operations and, in particular, adding back the cash flow from
mark-down and tax benefits.

4.6 Conclusion
In this chapter, we have shown how the FCFA model can be run in prac-
tical terms, starting from balance sheet and income statement reclassifica-
tion through to the FCFE reconciliation.
As we have discussed, the asset-side model is based on a simple
assumption: that all debt is considered as financial debt. However, in
the literature and in practice, the difficulties related to the separation
of operational and financial debt are resolved by applying a simplified
equity-side model: the FCFE or dividends approach. In these terms,
Massari etal. (2014) have highlighted that FCFE for banking companies
is defined as net income minus/plus the equity investment in regulatory
capital and other planned change in equity capital (as in equation 4.1).

1
The tax rate has been estimated has the sum of the two main tax charges on an Italian bank: IRES
and IRAP.
108 Valuing Banks

FCFEt = Net Incomet Equity Investment in Regulatory Capital


Planned Change in Equity Capital (4.1)

As one can note, the FCFE calculation is limited, as it starts from


a net income (usually normalized), and does not take into account the
cash-ineffective transactions, net working capital, capital expenditures
and financing operations. In other words, the acknowledged limitation
in the separation of operating and financial debt brings a higher level of
simplification than considering all debt as financial debt.
As the exercise we reported in Table 4.13 shows, it is finally important
to highlight that the application of the FCFA model brings also to a sub-
stantial difference even in terms of FCFE compared with the standard
practice. Such differences are clear when we compare the results of the
simplified FCFE and those that we calculated by using the FCFA model.
From the comparison, it is clear that the differences are relevant in
a historical perspective and, in terms of an intrinsic valuation, similar
results might drive to significant mispricing.
In the opinion of the authors, notwithstanding the differences between
financial and industrial companies, the reconstruction of a free cash flow
should follow what the system applied in corporate finance literature in the
standard valuation models. Thus, a free cash flow should take into account
cash-ineffective transactions and cash absorption or release of net working
capital, and capital expenditures, so as to consider the financial operations
as well. Our model fits this methodological structure by making a very sim-

Table 4.13 Asset-side model and simplified FCFE model (data in million)

Asset-side model
FCFE 916
Simplified FCFE model

Net income for the year 4,550


Non-recurrent operations 4,663
Equity investment in regulatory capital 884
Planned changed in equity capital

FCFE 771
Source: Authors elaboration.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 109

ple assumption that, in practice, allows us to resolve the typical problems


encountered in bank valuation. As a matter of fact, considering all bank
debt as financial debt allows us to take into account net working capital and
capital expenditures, having a more comprehensive definition of free cash
flows also in relation to bank specifics, such as mark-down and tax benefits.
Additionally, the asset-side model we presented highlights that, even
when FCFE calculated by the synthetic method is negative, that derived
by using the FCFA approach can lead to a consistent valuation and, there-
fore, it could work more effectively during periods of financial distress.
On the whole, in the opinion of the authors, the separation of the assets and
liabilities valuation, and the assumption on financial debt not only allows us
to overcome most of the problems that the standard valuation model holds,
it also provides additional information on the value sources of bank specifics.

References
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the structure of bank share prices. Journal of Accounting Research, 27,
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Curcio, D., & Hasan, I. (2015). Earnings and capital management and signal-
ing: The use of loan-loss provisions by European banks. European Journal of
Finance, 21, 2650.
Fiordelisi, F., & Molyneux, P. (2006). Shareholder value in banking. London:
Palgrave Macmillan.
Fonseca, R., & Gonzales, F. (2008). Cross-country determinants of bank income
smoothing by managing loan-loss provisions. Journal of Banking & Finance,
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Massari, M., Gianfrate, G., & Zanetti, L. (2014). The valuation of financial
companies. Chichester: Wiley & Sons.
Wahlen, J.M. (1994). The nature of information in commercial bank loan loss
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5
The Banks Cost ofCapital: Theories
andEmpirical Evidence

5.1 Introduction
Every business activity requires that capital is constituted, maintained
and incremented. The return expected by shareholders and bondholders
should be commensurate to their respective level of risk. In particular, the
proportion of risk assumed by shareholders is always greater than that of
bondholders, because the former is remunerated after the interest pay-
ment on financial debt. In this sense, both parties bear the business risk,
while only shareholders hold the financial risk.
Business risk arises from the possibility that the operating cash flows
generated by a firm may undergo a downward shift owing to their vola-
tility: the higher the volatility, the larger the business risk assumed. The
dispersion of the operating cash flows mainly depends on fluctuations in
business revenues also due to their cyclical nature, besides being affected
by the level of fixed costs and by the type of the industry in which the firm
competes. More frequently, the fluctuation in revenues, in the presence
of a high amount of fixed costs, may generate negative operating cash
flow compared with a situation in which more variable costs prevail.

The Editor(s) (if applicable) and The Author(s) 2016 111


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
in Banking and Financial Institutions, DOI10.1057/978-1-137-56142-8_5
112 Valuing Banks

Instead, the financial risk relates to the level of debt held by the com-
pany. As a matter of fact, high levels of financial debt affect fluctuation in
revenues because of a higher amount of borrowing costs, and therefore a
greater likelihood that the fluctuation in revenues involves cash flow to
equity.
Since, in the banking industry, we cannot separate the business risk
from financial riskby referring to a definition of operating cash flows
because both risks arise from the typical business activity, it is appropri-
ate to refer to a different definition to distinguish free cash flow from
assets, whose volatility defines business risk, from the cost of interests
paid which depends on the level of leverage. Deepening the origins of risk
on free cash flow from assets, the main components of bank business risk
may be summarized as: credit risk, interest risk, market risk, exchange
risk, country risk, operational risks and counterparty risk. In addition to
all these traditional risks, we should also pay attention to the leverage risk
that exists for banking firms. All these risks can contribute to cash flow
volatility.
The cost of capital quantification should consider all these kinds of
risk because they all contribute to defining the risk-return profile of a
bank. In this sense, it may be important to determine the viewpoint of
the investor who contributes to equity capital. And the viewpoint affects
the model to be used to quantify the cost of capital.
In particular, investors may be diversified investors or non-diversified
investors. Diversified investors will simply look at the component of sys-
tematic risk (basically given by macroeconomic variables), since all the
other idiosyncratic risks have been virtually eliminated through portfolio
diversification. Non-diversified investorsthese are, typically, strategic
investors who intend to acquire a majority stake in a company, or, put even
more simply, an undiversified investorwill expect to be remunerated for
specific risk components also. In addition, considering the diversification
effect, it is very important for shareholders, while it is less relevant for bond-
holders. since the implicit credit risk they hold is usually a less diversifiable
risk because there is a limit in the gains represented by the nominal rate.
In other words, bondholders cannot offset extra-losses with extra-earnings.
The aim of this chapter is to provide metrics for calculating the cost
of equity in the presence and in the absence of portfolio diversification,
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 113

and provide a method with which to quantify the cost of debt as well.
Primarily, these methods will be developed with an asset-side view because
it was considered more akin to the risks related to the loan and market
portfolio; second, we provide the necessary technical connections to quan-
tify the cost of capital in an equity-side view. Moreover, we want to check
how the risk factors contained in the models presented are able to express
typical banking risks calculated using appropriate indicators contained in
the financial and income statements. This relates to systematic risk and
total risk versions as well.

5.2 Pricing Systematic Risk


As widely shared by the literature, the risk held by shareholders can be
split into two parts: non-eliminable risk, which is given by the dynamic
and intrinsic volatility of macroeconomic variables; and eliminable risk,
which stems from the specific features of an asset. Under the assump-
tion of a perfectly diversified investor, the only significant risk would be
systematic risk. In this sense, models that price the cost of equity using
systematic variables have been widely discussed in the literature and also
applied in practice.
The generality of these models can be represented well by the Arbitrage
Pricing Model (Ross 1976). In the Arbitrage Pricing Model the cost of
equity is affected by many systematic factors, such as GDP and the return
on the market portfolio, and each of them is modulated using beta coeffi-
cients, which explains the sensitivity of the return on a specific risk factor.
In formulas, the Arbitrage Pricing Model can be written as:


( ) ( ) (
ri = rf + b1 r1 - rf + b 2 r2 - rf + + bN rN - rf ) (5.1)

where r1, r2 ed rN represents the average returns of the risk factors and
1, 2, N are the coefficients that measure the intensity of a single spe-
cific factor on an assets return.
In this stream of literature, Chen etal. (1986) more precisely reported
the systematic risk factors that should be added to GDP.They claimed
114 Valuing Banks

that, also, relevant factors that should be taken into account for measuring
an assets return are the variation of the premium for default risk (which,
in line with the basic assumptions, is treated as non-diversifiable risk, e.g.
Denis and Denis (1995) and Vassalou and Xing (2004)), changes in the
interest rates term structure and inflation, and unexpected variation in
the real rate of return.
A more precise formalization of the risk factors that can adequately
approximate market risk is provided through the Three Factor Model by
Fama and French (1992). Although the authors identified the price to book
value ratio and market capitalization as the factors that are more signifi-
cantly correlated to market risk, the more widely held formulation states
that expected returns depend on the market risk premium, extra-returns
produced by the size effect (SMB), and extra-returns of the financial risk
(HML). The market risk premium is weighted for a beta coefficient, SMB
is weighted for a coefficient s, and HML for a coefficient h as following:


( )
ri = rf + b rm - rf + s SMB + h HML

(5.2)

5.2.1 Pricing Systematic Risk intheBanking Industry

Given the systemic role of banks, it is reasonable to expect that the system-
atic factors outlined above have a strong impact on a banks cost of equity.
In fact, although the limits of the capital market equilibrium hypothesis,
on the whole, is a model based on systematic variables (in the single or
multifactor version) and it seems to be the most widely applied method in
the estimation of financial institutions cost of equity (Damodaran 2013).
In the literature, Choi etal. (1992) related the stock returns of a sample of
US banks to several factors, such as the market return, the interest rate and
the exchange rate. The regression model in its complete form is as follows:

ri = b0 + b1um + b2 ur + b3ue + b4 D + b5um D + b6 ur D + b7 ue D (5.3)

where u is the use of components of unexpected changes in the market return


(m), the interest rate (r) and exchange rate (e), calculated by regressing the
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 115

average values of the market returns, the interest rates and exchange rates
with the observations of each component. D is a dummy variable that indi-
cates either the status of a bank, or a time period in relation to the type of
the variable. The empirical findings highlight how exchange trade innovation
is negatively correlated before October 1979 (the period when the Federal
Reserve changed certain procedures that had started to have an impact on the
volatility of rates) and positively related after that period. Lastly, the return of
the money center banks was significantly related to the exchange rate.
Although multifactors models have the effect of increasing the
r-squared of the regressions (e.g. in the case of the Fama and Frenchs
model mentioned earlier the r-squared is equal to 95 %), academics
and practitioners are used to applying a single risk factor: the market
risk premium. Thus, Fama and Frenchs model converges in the Capital
Asset Pricing Model (CAPM) (Sharpe 1964; Lintner 1965), where the
expected return on an asset is given by:


(
ri = rf + b rm - rf ) (5.4)

In relation to the application of the CAPM in the banking sector,


King (2009), using a single factor inflation-adjusted cost of equity, stud-
ied its trend in six countries over the period 19902009, highlighting
that, in the CAPM approach, there are many significant shortcomings,
such as the limitations of the mean-variance approach and the insuf-
ficiency of a single market factor to explain the cross-section realized
returns. Despite this, the greater simplicity in the application makes the
CAPM the most widely used metric to quantify the cost of bank equity.

5.2.2 Determinants ofBanks Equity Beta

In this section, we consider analyzing whether the systematic risk coef-


ficient (beta) is able to capture the dynamic of the traditional risk ratios
of the banking business. Despite the limits of the single risk factor model,
some empirical papers showed a link between the beta and banks finan-
cial statements ratios. In particular, some authors have tried to show the
effect of credit risk, capital adequacy, profitability and the asset-liabilities
116 Valuing Banks

structure on beta. Credit risk has been measured through loan loss provi-
sions, non-performing loans on total loans, and risk weighted asset den-
sity. Conversely, bank capitalization has been identified by the Tier 1
ratio, Total capital ratio and leverage. Profitability has been measured
basically as earnings and economic margins, while the assets-liabilities
structure referred to the proportion of specific asset and liabilities in rela-
tion to the total outstanding assets and liabilities.
In these terms, Rosenberg and Perry (1978) identified some funda-
mental predictors that influenced both systematic (expressed by beta)
and residual or specific risk (expressed by sigma). In this study, they
highlighted a strongly positive relation between beta and important
variables for the banking activity as the logarithm of total assets, equity
capitalization and assets to long-term liabilities. The logarithm of total
assets and equity capitalization are measures of size. Generally speak-
ing, the larger the size of a bank, the higher its expected systematic
risk. Besides, small banks had lower beta than large banks, because
a limited ability to diversify investments forced the small banks to
choose borrowers with a lower credit risk. Small banks were able to
lend to better borrowers owing to soft information or more collat-
eral (Stever 2007). In addition, small banks held a higher percentage
of their loan portfolio on total assets, rather than the percentage of
securities on total assets. Hence, the lower diversification of credit risk
compared with that of market risk entailed a major component of
idiosyncratic risk. This implies a lower capacity of beta to quantify
risk. In fact, the overall risk expressed by the equity v olatility is the
same in small and large banks (Stever 2007). In other words, the total
risk given by the standard deviation is equal between large and small
banks, but the internal subdivision is different since small banks are
less exposed to market risks (and therefore there is more specific risk),
while large banks hold more systematic risk and less idiosyncratic risk,
as they are able to better diversify.
The other empirical evidence of the study showed that asset to long-
term liabilities, which can be interpreted as the impact of stable funding
(the inverse of short-term liabilities on total liabilities, which gives infor-
mation on the short-term leverage), is negatively related to systematic
risk. The lower the stable funding, the higher the systematic risk. Lastly,
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 117

the study showed a negative relation of beta with dividend yield and
earnings to price ratio. Dividend yield is also a significant variable for
Jahankhani and Lynge (1980) and Lee and Brewer (1985).
Recently, Das and Sy (2012) undertook a study that confirms the
positive relation between size (measured as the logarithm of total assets)
and beta. The authors show that returns on average assets and secu-
rities on total assets negatively affect the beta coefficient. Credit risk
positively affects beta because of the increase in the proportion of non-
performing loans.
For non-US banks, Vander Vennet etal. (2005) confirmed the results of
Rosenberg and Perrys (1978) research in terms of leverage. They showed
a negative relation between beta and the proportion of core deposits and
loans on total assets; while, conversely, a positive relation with loan loss
provisions.
In the Italian market (Di Biase and DApolito 2012), the empirical
evidence showed a positive relation between beta and bank size, loans on
total assets and the proportion of intangible assets on total assets. A nega-
tive relation was found between beta and loan loss provisions on gross
loans, liquidity levels and profitability.
On the whole, empirical evidence supports the ability of the CAPM
to price systematic risk through the beta coefficient in relation to the
variation of determined financial statement ratios. In these terms, it is
important to emphasize that this, notwithstanding the specific ratios
are correlated to beta, does not mean that the latter is able to price spe-
cific risks. To the contrary, the significance of betas in relation to these
factors must be interpreted by considering how these factors widen the
effects of systematic risk. In other words, although the differences of
betas from 1 depend on specific factors, they are, nevertheless, pricing
systematic risk.

5.2.3 S
 eparating Business Risk fromFinancial Risk:
TheEffect ofBank Leverage

As we have noted in the previous section, leverage is one of the significant


variables of the cost of capital. In this section, we extend our model to
118 Valuing Banks

take into account the features of bank debt and determine the cost of
assets, which in our model is the rA.
In the traditional theory of the cost of capital of non-financial firms,
it is possible to quantify the cost of assets through the use of asset beta.
Using the Hamada formula (1972), we can derive asset beta from equity
beta, leverage and tax rate as1:

bE
bA = (5.5)
D
1 + (1 - t c )
E

where A is asset beta; E is equity beta; D E is market debt equity ratio;


tc is the tax rate. The formula shows the positive relation between lever-
age and equity beta as the empirical evidence also suggests for the bank-
ing industry (see the previous section). Moreover, in banking business
we must consider the typology of debt in order to separate the effect of
non-deposit debt from deposit debt. Despite the fact that leverage is, in
general, positive related to beta (i.e. Vander Vennet et al. 2005), con-
versely, deposit debt is negative related to beta. The inverse relationship
between equity beta and customer deposits finds support in Das and Sy
(2012), despite the independent variables seeming to be insignificant.
Floreani etal. (2015) showed the same results on the domestic money
market using short-term funding on total equity. This is because non-
deposit debt may generate value due to the underpricing effect in respect
to the risk-free rate, which could be different between banks. Thus, in
an evaluation scheme it is important to separate both leverage and the
non-deposit effect to obtain an asset beta free from long-term and short-
term debt policy. To do this, we modified the Hamada formula (1972)
to consider the tax impact of non-deposit debt and the overall impact of
short-term debt. From the Chap. 3, we take equations (3.25) and (3.28):

Beta debt is assumed equal to zero.


1
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 119

E DD, Non Dep DD, Dep


WACC * = rE + rD, Non Dep (1 tc ) + iD, Dep (1 tc )
V V V

DD,Dep rf - iD ,Dep (1 - t c ) DD ,Non Dep
WACC * = rA 1 - - tc

V rf V

So, we have:

DD,Dep rf - iD,Dep (1 - t c ) DD,Non Dep


rA 1 - - tc
V rf V
E D
= rE + rD,Non Dep (1 - t c )
D,Non Dep

V V
DD,Dep (5.6)
+ iD,Dep (1 - t c )
V

We rewrite the equation in terms of beta instead of cost of capital:

DD,Dep rf - iD,Dep (1 - t c ) DD,Non Dep


b A 1 - - tc
V rf V
E D DD,Dep (5.7)
= b E + b D,Non Dep (1 - t c ) + b D,Dep (1 - t c )
D,Non Dep

V V V

For definition, beta on deposits is zero, so that:

D r -i (1 - tc ) DD,Non Dep
b A 1 - D,Dep f D,Dep - tc
V rf V
E DD,Non Dep (5.8)
= b E + b D,Non Dep (1 - tc )
V V
120 Valuing Banks

We can now write A as:

DD,Non Dep
b E + b D,Non Dep (1 - t c )
bA = E (5.9)
DD , Non Dep iD ,Dep (1 - t c ) DD ,Dep
1 + (1 - t c ) +
E rf E

If the beta of non-deposit debt is also considered equal to zero, we can


have:

bE
bA = (5.10)
DD , Non Dep iD ,Dep (1 - t c ) DD ,Dep
1 + (1 - t c ) +
E rf E

If non-deposits are priced with the risk-free rate, we can write A as:

bE
bA = (5.11)
D iD , Average
1+ (1 - t c )
E rf

Asset beta is the beta on a loan portfolio, other earning assets, real and
servicing activities. The de-levering of non-deposit debt determines a lower
asset beta than equity beta due to a lower risk profile. The de-levering of
deposit debt determines a lower asset beta, but less proportional than non-
deposit de-levering, because we consider the value given by riskless deposits
in a manner similar to that of liquidity correction in non-financial firms.
If a bank has no deposits, the equation precisely follows the Hamada
formula. If a bank has no non-maturity debt, diluted equity beta for the
value without deposits benefits corresponds to the asset beta.
To demonstrate the use of equation (5.11) to obtain asset beta, let us
suppose bank Y with the following data:

Equity beta: 1.5;


Free risk rate: 4%;
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 121

Market risk premium: 4.5%;


Market capitalization (equity): 5;
Market value of debt: 91.27;
Deposit debt (equal to account value): 50;
iD,Dep: 2%;
D,Non Dep: 0;
Tax rate: 30%.

The cost of equity is obtained by the CAPM as:

rE = rf + b E MRP = 4% + 1.5 4.5% = 10.75%


Asset beta is:

bE
bA =
DD,Non Dep iD,Dep (1 - t c ) DD,Dep
1+ (1 - t c ) +
E rf E

1.5
= = 0.1459
41.27 2% (1 - 30% ) 50
1+ (1 - 30% ) +
5 4% 5

so that the cost of assets is equal to:

rA = rf + b A MRP = 4% + 0.1459 4.5% = 4.66%


If we do not consider the underpricing effect (iD,Dep=rf ), we can use the


classic Hamada formula as:

bE 1.5
b A = = = 0.1089
D 91.27
1 + (1 - t c ) 1 + (1 - 30% )
E 5
122 Valuing Banks

and cost of assets is:

rA = rf + b A MRP = 4% + 0.1089 4.5% = 4.49%


As one can note, the cost of assets without considering the under-
pricing deposits is lower than the cost of assets considering underpricing
deposits. This is because the liquidity generated from deposits dilutes the
risk. Hence, the first calculation of beta is the true expression of asset
risk from loans and market assets and represents the real expectations on
investments under a total diversification hypothesis. As can be seen, the
asset beta value is very low. However, this effect is in line with the nature
of bank assets, very similar to a bond instrument with low level of beta.

5.3 Pricing Total Risk


The regression models that price systematic risk state that cost of equity
is a function of systematic variables and the return based on an idiosyn-
cratic risk component that is represented by . If we use a market model,
we have:

ri = a + b rm + e (5.12)

represents the pricing of a specific component that cannot be


explained through systematic risk factors. Thus, in order to reach the
expected return on an asset, we should also take into account idiosyn-
cratic risk. In particular, this can happen when investors are not per-
fectly diversified. The perfect diversification might be a too restrictive
assumption in relation to the total portfolio diversification theory. On
the whole, several market imperfections, such as bankruptcy costs (Bris
etal. 2006) and imperfect diversification of agents (Stulz 1984; Smith
and Stulz 1985), make idiosyncratic risk costly.
As a matter of fact, high volatility of earnings entails a high degree of
firm-specific risk which, under specific circumstances, exposes investors
to insolvency or bankruptcy costs. Although this is widely acknowledged
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 123

by the literature, as previously emphasized, the most broadly accepted


approaches in the estimation of cost of capital do not take into account
the idiosyncratic component of risk but, rather, use the methods described
in the previous section. However, this is true only if investors hold a com-
pletely diversified portfolio; however, effectively, they do not (e.g. Barber
and Odean 2000; Benartzi and Thaler 2001). As a matter of fact, investors
are inclined to have a limited number of assets in their portfolios so they
are unable to be fully diversified. Goetzmann and Kumar (2008), using a
sample of more than 60,000 investors, found that more than 28% hold
just one stock, 60% hold no more than three stocks and 9% of inves-
tors hold more than 10 stocks. In these terms, according to Kearney and
Pot (2008), the number of stocks required to reduce the idiosyncratic
volatility to 5 % in a portfolio of European stocks was 166 in 2003.
Moreover, owing to the specifics of the banking business, holding bank
stocks can raise the level of idiosyncratic risk in investors portfolios and,
therefore, require an additional number of assets to reach a totally diver-
sified portfolio (Yang and Tsatsaronis 2012). The factors affecting the
lack of diversification in investors portfolios can be either endogenous
(Hirshleifer 2001), such as the lower efficiency in composition and sizing
of portfolios, or exogenous factors, for instance, institutional restrictions
(i.e. limitations in short-selling or liquidity restrictions) that may force
investors into holding an under-diversified portfolio (Merton 1987). As
a result, the issue of under-diversification should lead investors to care
not only about systematic risk, but also idiosyncratic risk, thus, requiring
higher compensation for holding additional proportions of idiosyncratic
risk (Fu 2009; Malkiel and Xu 2002).
Under-diversification becomes even more clear in case of the strategic
investor when the owner, or the relevant and influencing stockholder in a
private or publicly traded company, has a large share of its net worth invested
in the business. These concentrated investments are exposed to a high degree
of idiosyncratic risk, requiring higher returns for the equity stake held which,
in turn, implies a higher cost of equity capital (Mueller 2008).
In the banking industry, the idiosyncratic component of risk can
be related to several balance sheet ratios. Rosenberg and Perry (1978)
showed that the most important predictors on residual risk are earning
variability, leverage and accounting measures of beta.
124 Valuing Banks

On the whole, there is evidence that investors might be not fully diver-
sified and, therefore, it would be necessary to consider the idiosyncratic
risk as well when pricing expected returns on assets.
In practice, we can price total risk using two approaches:

Implied cost of capital methods (ICC);


Methods based on standard deviation.

5.3.1 P
 ricing Total Risk through Implied Cost
ofCapital Metrics

The basic assumption of implied cost of capital metrics is that investors


in the market cannot completely diversify the idiosyncratic risk away.
Therefore, the implied cost of capital in stock market prices would repre-
sent not only the pricing of systematic risk, but also a part of the specific
risk. Implied cost of capital measures are based on the direct quantifica-
tion of the cost of equity using income, dividend discount or residual
income models. In practice, the cost of equity can be estimated as the
discount rate that equals the stock market price and the expected cash
flows. Cash flows are usually based on the forecasts of analysts trying to
estimate future earnings and dividends. The most simple version of such
models is based on a dividend discount model in stable growth (Gordon
and Gordon 1997). This assumption implies that dividends are equal to
earnings:

Et [ Et +1 ]
rE = (5.13)
Mt

where rE is the cost of equity, Et[Et+1] are the expected earnings in year
t+1 and Mt is the market capitalization in year t.
Gebhardt etal. (2001), taking a different approach, extracted the cost
of equity using a residual income method by an analytical quantification
for 11 years plus a discounted terminal value as:
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 125

11 Et ( ROEt +k - rE ) Bt +k -1 Et ( ROEt +12 - rE ) Bt +11


M t = Bt + + (5.14)
(1 + rE ) rE (1 + rE )
k 11
k =1

where Bt is the book value of equity and rE is the implied cost of equity.
The numerator represents the expectations of residual incomes and the
terminal value is calculated maintaining a stable ROE at year t+12 and
a book value at t+11.
Similarly to Gebhardt et al. (2001), the Claus and Thomas model
(2001) presented a two-stage residual income model, but with a shorter
explicit period of forecast using, in this case, a stable growth model:

5 Et ( ROEt + k - rE ) Bt + k -1 Et ( ROEt + 5 - rE ) Bt + 4 (1 + g )
M t = Bt + + (5.15)
(1 + rE ) ( rE - g ) (1 + rE )
k 5
k =1

where g is set at the current risk-free rate minus 3%.


Conversely, Ohlson and Juettner-Nauroth (2005) derived cost of equity
directly using earnings and dividends, instead of residual incomes as:

Et [ Et +1 ]
rE = A A 2 + g - ( g - 1) (5.16)
Mt

where:

E [D ]
A = 0.5 ( g - 1) + t t +1 (5.17)
Mt

and

Et [ Et + 3 ] - Et [ Et + 2 ] Et Et +5 - Et [ Et + 4 ]
g = 0.5 + (5.18)

Et [ Et + 2 ] Et [ Et + 4 ]

126 Valuing Banks

in which Et [Dt+1] is the dividends expectation, is the perpetual growth


rate in abnormal earnings beyond the forecast horizon (that is, the cur-
rent risk-free rate less 3%).
Easton (2004) used the MPEG model and proposed the following
formula:

Et [ Et +1 ] agr2
Equity valuet = + (5.19)

rE (r
E )
- g agr rE

where agr2 is the abnormal growth in earnings at year 2:

agr2 = Et [ Et + 2 ] + rE Et [ Dt +1 ] - (1 + rE ) Et [ Et +1 ]

and gagr is the growth rate of those earnings. Equation (5.19) expresses
the equity value through the sum of the actualized normal earnings and
abnormal growth in earnings.
Easton exploits a modified version of equation (5.19) with gagr=0, to
extrapolate cost of equity from market capitalization:

Et [ Et + 2 ] + rE Et [ Dt +1 ] - Et [ Et +1 ]
Mt =
rE2 (5.20)

Et [ Et + 2 ] + rE Et [ Dt +1 ] - Et [ Et +1 ]
rE = (5.21)
Mt

Best practice often takes the dividend discount model with stable
growth rate for the direct quantifying of the cost of equity as:

Et [ Dt +1 ]
R= +g (5.22)
Mt

where gis quantified using the long-term growth of GDP, or using ROE
multiplied for the retention rate (b):
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 127

Et [ Et +1 ]
g= b (5.23)
Bt

According to this model, in the case of Bank Y, if we have:

Expected earnings: 0.5;


Book value: 4;
Retention rate: 50%;
Market capitalization: 5;

then, the cost of equity can be determined as follows:

Et [ Dt +1 ] Et [ Et +1 ] 0.25 0.5
R= + b = + 50% = 11.25%
Mt Bt 5 4

In the banking industry, a forward-looking approach was adopted


by Maccario etal. (2002) who extrapolated the cost of equity by using
an inflation-adjusted dividend discount model. Assuming that analysts
expectations are the best proxy of future earnings and that dividend pay-
out and growth rate are constant, the model estimates the banks cost of
equity through the reciprocal of price-earnings ratio. Despite a forward-
looking method is far more preferable than a backward-looking mea-
sure (e.g. Zimmer and McCauley 1991), this measures presents some
limitations:

Only a part of listed firms are provided with analysts forecast (Diether
etal. 2002);
These models have demonstrated having a poor predictive power and
low quality estimation (Easton and Monahan 2005).
The sensitivity to the models input represents an important shortcom-
ing (Easton 2009; Barnes and Lopez 2006);
These models are characterized by optimistic biases (Lin and McNichols
1998; Easton and Sommers 2007).
128 Valuing Banks

5.3.2 Pricing Total Risk through Standard Deviation

Equity standard deviation might be a good proxy of total risk because it is


possible to split the squared of standard deviation in the volatility of the
systematic and idiosyncratic component of risk.
Considering a market model and exploiting the properties of variance,
we can write:

s r2i = b i2s r2m + s e2 (5.24)


In these terms, the literature found a significant relation between the


total risk given by equity volatility and a banks ratios. Jahankhani and
Lynge (1980) showed as volatility is negatively related to the dividend
payout ratio, financial leverage (measured as stockholders equity divided
by total assets) and liquidity (measured by the weight on total assets).
Variability of deposits, earnings and loan losses are positively related
to equity volatility. The result on leverage is confirmed by Das and Sy
(2012). In this study equity standard deviation is negatively related to
customer deposits, securities on assets and return on average assets. In
addition, it is positively related to non-performing loans on total loans.
The most common method to price the total risk is by taking into
account a correction of beta in order to obtain a total beta:
We consider the beta of asset j:

COV ( j , m )
bj = (5.25)
VAR (m )

The total beta does not consider the diversification effect through
covariance, but consider in the numerator the standard deviation of j
and the standard deviation of the market portfolio return. To do this, we
divided the beta for the correlation index (j,M):

COV ( j , m )
rj ,M =
s j sm (5.26)

5 The Banks Cost ofCapital: Theories andEmpirical Evidence 129

bj s js m sj (5.27)
b j,Total = = =
r j ,m VAR (m ) sm

To give a simple example, if Bank Y has a correlation index of 0.5, total


beta is:

bj 1.5
b j,Total = = =3
r j ,m 0.5

and cost of equity is:

rE = rf + b E,Total MRP = 3% + 3 4.5% = 16.5%


The total beta is higher than the beta coefficient and will depend on
the correlation between the firm and the market: the lower the correla-
tion, the greater the total beta. The method states that the equity market
return is proportional to the market risk premium for a unit of risk:

rm - rf
ri - rf = si (5.28)
sm

In other words, an asset has the same Sharpe ratio of the market:

ri - rf rm - rf
=
si sm

And this is the main limitation when using the total beta, because an
asset could have a different proportion of risk premium than that of the
market.
The second method is the CaRM (Beltrame etal. 2014). It is an asset
pricing theory which has a similar structure to that of the CAPM: that
is, a risk-free rate, plus a risk premium based on a single risk factor. It is
based on three basic concepts:
130 Valuing Banks

1. the asset value is split into a certain value of assets and an uncertain
value (i.e. the CaR);
2. the totally levered approach;
3. the unlevered approach.

 e Assets Value Splits into Certain Value ofAssets


Th
andUncertain Value (CaR)
As a matter of fact, the model splits a firms assets value into two
components:

the Value Low proportion, which represents the statistically certain


part of value, with a precise interval of confidence;
the CaR proportion, which represents the part of value under risk with
a precise interval of confidence.

Therefore, we can write:

V = CaR + V low (5.29)

From these two components of the value (V), investors have different
expectations:

the required return on total value is the overall cost of capital (repre-
sented by weighted average cost of capital);
the required return on CaR is the appropriate remuneration in the case
of maximum loss;
the required return on Value Low is the risk-free rate.

Therefore, we can write:


(
V (1 + WACC ) = CaR (1 + rmax loss ) + V low 1 + rf ) (5.30)

from which:
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 131

CaR
WACC = rf +
V
( )
rmax loss - rf (5.31)

CaR
where is the CaR ratio measuring both the systematic and idiosyncratic
V
risk.
Unlike the original model, the result of equation (5.31) is not an unle-
vered cost of capital but, rather, a WACC in the presence of taxes. This is
because, in the original contribution, the authors quantified the fair value
of unlevered asset with a discount cash flow methodology and did not use
financial market data that could be affected by the value of tax-shield. In
this work, due to the availability of stock market data for listed banks we
exploited a structural model (Merton 1974) to obtain a banks firm value,
asset standard deviation and the proportion of CaR.
Beltrame etal. (2015) empirically tested the method over a panel of
141 European listed banks. In particular, the authors studied whether the
CaR ratio was significantly correlated to the systematic and idiosyncratic
risk using a two-stage regression. The results confirmed that CaR was
related to the systematic beta and to specific balance sheet risk factors
such as the change in RWA density, change in capitalization, overheads to
total assets and loan loss provision. The leverage also played an important
role in residual risk in Rosenberg and Perry (1978).
Thus, the model, unlike CAPM, allows the explicitly pricing of both
systematic and specific risk. Additionally, the model applied to bank
exploits the same quantification framework adopted by banks for mea-
suring capital requirements in relation to unexpected losses (Beltrame
etal. 2015).

The Totally Levered Approach

In the first step, to obtain the required rate on CaR we treated equity
holders and debt-holders as though they were in the same position in
terms of the risk-return profile. In particular, the amount of the maxi-
mum loss for all these investors is equal to the maximum loss for debt-
holders in a totally levered firm and with a stable asset value. Without
132 Valuing Banks

considering taxes, in a totally levered firm this implies the equivalence


between the WACC and cost of debt:

WACC = rD ,TL (5.32)


The required rate on CaR corresponds to the risk neutral rate for debt-
holders in a totally levered firm (Beltrame etal. 2014). The availability of
financial market data allows the usage of a structural model to determine
the probability of default and loss given default when debt is equal to
asset value.
In the original model (Beltrame etal. 2014), knowing a market banks
firm value and asset standard deviation, set probability of default for a
totally levered firm to 100%, in line with a structural model in which the
face value of debt is higher than its market value; the loss given default is
taken as fixed (45%).
In the present work, we exploit the Merton Model also for the calcula-
tion of expected loss rate, in two steps:
Starting from a risk-free rate, market capitalization, equity standard
deviation and face value of debt, we exploit a structural model to
find firm value, asset standard deviation and the market value of
debt (and the associated value of d1 and d2).

E1 = VN ( d1,1 ) - D1e - rT N ( d 2,1 ) (5.33)


where E1 is the initial value of market capitalization, V is the bank firm


value, D1 is the initial face value of debt and d1,1 and d2,1 are respectively:

V s
2
ln + r + V T
D 2
d1,1 =
sV T (5.34)

d 2,1 = d1 - s V T (5.35)

5 The Banks Cost ofCapital: Theories andEmpirical Evidence 133

with:

V
s E = sV N ( d1,1 ) (5.36)
E1

Increasing the face value of debt until the market value of debt is
exactly equal to the fixed bank firm value (equity value = 0). The
expected loss rate is not fixed and depends on the initial bank firm
data. The following equation must be satisfied:

E 2 = 0 = VN ( d1,2 ) - D1e - rT N ( d 2,2 )


The face debt with value equal to market value of debt is (D2):

VN ( d1,2 )
D2 = (5.37)
e - rT
N ( d 2 ,2 )

Satisfying these two equations:

V s2
ln + r + V T
D 2
d1,2 = 2
sV T

d =d -s T
2 ,2 1,2 V

the expected loss rate for a totally levered firm is:

V
ELRTL = 1 - (5.38)
D2e - rT
134 Valuing Banks

In line with the first and original approach (Beltrame etal. 2014), the
probability of default is equal to 100% and the loss given default is:

V 1
LGDTL = 1 - - rT
(5.39)
D2e N ( -d 2,2 )

where N(d2,2) is the probability of default of 100%.


Employing a structural model, we used an exponential capitalization.
Considering taxes and T = 1, the risk neutral rate (maximum loss) and
cost of debt for a totally levered bank are:

V
rmaxloss = rRN = r f - ln N ( d 2 ) + -0 rT N ( -d1 ) (5.40)
De

ELRTL CaRV ,%
rD ,TL = rf + ln 1 + (5.41)
1 - ELRTL

As one can note, this method works in an asset-side approach to deter-


mine the overall cost of capital.
Therefore, it seems that a structural model for the cost of capital, both
for the CaR proportion and expected loss rate, make the approach more
coherent with different asset standard deviation levels. In Table 5.1, we
highlight the different levels of totally levered expected loss rates for a
marginal increase of the asset standard deviation.
This metric can also be applied to quantify the cost of debt, using the
probability of default that depends on a banks rating and the appropriate
loss given default. In this case, the CaR for debt-holders is:

CaRD max D - V ;0
low

= (5.42)
D D

In general, for banks the CaR is very low because the standard devia-
tion for assets is lower than that of other firms and thus, in many cases,
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 135

Table 5.1 Totally levered expected loss rate for different levels of asset standard
deviation
Asset Final face ELR Cost of
standard value of totally debt totally
deviation d1,1 d2,1 debt (1) d,1,2 d2,2 levered CaRv% levered
0.50% 216.53 216.52 1,241.87 37.32 37.33 17.02% 1.16% 3.24%
1.00% 108.27 108.26 1,241.93 18.66 18.67 17.03% 2.30% 3.47%
1.50% 72.18 72.17 1,326.61 16.83 16.85 22.32% 3.44% 3.98%
2.00% 54.14 54.12 1,356.91 13.75 13.77 24.06% 4.57% 4.44%
2.50% 43.32 43.29 1,474.71 14.33 14.36 30.12% 5.68% 5.42%
3.00% 36.10 36.07 1,687.21 16.42 16.45 38.93% 6.78% 7.23%
3.50% 30.95 30.91 1,711.80 14.48 14.52 39.80% 7.88% 8.08%
4.00% 27.09 27.05 1,828.51 14.32 14.36 43.65% 8.96% 9.71%
4.50% 24.08 24.04 1,778.89 12.11 12.16 42.07% 10.03% 10.03%
5.00% 21.68 21.63 2,001.45 13.25 13.30 48.51% 11.09% 12.94%
Note: Firm value is 1000; risk-free rate is 3%; T is 1. The initial face value of debt
is supposed equal to 950 and the initial value of d1,1 and d2,1 is in line with
the Merton model used to obtain asset standard deviation and firm value. In
column 4 we have the final face value of debt that satisfied the firm value
equal to debt market value; d,1,2 and d2,2 are the final value in line with a
totally levered firm. In columns 8 and 9we have the proportion of CaR and the
cost of debt for a totally levered bank.
Source: Authors elaboration.

we might have a CaR for debtors equal to zero. To determine the cost of
debt, we can write:

CaRD
rD = rf +
D
(
rRN - rf ) (5.43)

If Value Low is larger than non-deposit and deposit debt, this funding
instrument must be priced through a risk-free rate. Consequently, the
CaR for non-deposit debt is:

CaRD ,Non Dep


=
( )
max DD ,Non Dep - V low - DD ,Dep ;0
(5.44)
DD ,Non Dep DD ,Non Dep

136 Valuing Banks

and rD,NonDep is:

CaRD ,Non Dep


rD ,Non Dep = rf +
DD ,Non Dep
(r
RN - rf ) (5.45)

The Unlevered Approach

The third concept is one in which the CaRM compares the cost of capital
for a totally levered firm with the cost of capital for an unlevered firm.
The common point is that both debt-holders and stockholders are remu-
nerated at a risk-free rate on a certain proportion of the asset value and at
a higher rate compensating those losses on the CaR.However, the losses
that can occur are different for debt and stockholders. As we highlighted
above, using a structural model, the loss of debt-holders is related to the
higher values of the nominal debt in respect of the market debt value. The
unlevered case states that the firms assets are financed totally by equity
capital. In order to quantify the expected loss rate, we can treat equity
and debt-holders equally, financing assets by an equal amount of nominal
debt. In other words, in respect of the totally levered firm, the condition
is not that firm value equals debt market value but, rather, that firm value
equals the face value of debt. In line with this assumption d1 is:

s V2
r + T
2
d1,2 = (5.46)
sV T

and the expected loss rate is:

DMK
ELRUnleverd = 1 - -r T
(5.47)
Ve f
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 137

Through equation (5.43) with taxes, we calculate WACC (equation


(5.31) recalculated with exponential capitalization) as:

ELRUL CaRV ,%
WACC = rf + ln 1 + (5.48)
1 - ELRUL

In Table 5.2, we highlighted the different levels of unlevered expected


loss rate, for a progressive increase of asset standard deviation.
Using equations from the WACC and rD values in Chap. 3, we can
determine the cost of equity (rE).
Using the extended WACC formula:

Table 5.2 Unlevered expected loss rate for different levels of asset standard
deviation
Final
Asset face
standard value of ELR
deviation d1,1 d2,1 debt (1) d,1,2 d2,2 unlevered CaRv% WACC
0.50% 216.53 216.52 1000.00 6.00 6.00 1.00% 1.16% 3.01%
1.00% 108.27 108.26 1000.00 3.01 3.00 0.99% 2.30% 3.02%
1.50% 72.18 72.17 1000.00 2.01 1.99 0.98% 3.44% 3.03%
2.00% 54.14 54.12 1000.00 1.51 1.49 0.99% 4.57% 3.05%
2.50% 43.32 43.29 1000.00 1.21 1.19 1.02% 5.68% 3.06%
3.00% 36.10 36.07 1000.00 1.02 0.99 1.09% 6.78% 3.07%
3.50% 30.95 30.91 1000.00 0.87 0.84 1.18% 7.88% 3.09%
4.00% 27.09 27.05 1000.00 0.77 0.73 1.30% 8.96% 3.12%
4.50% 24.08 24.04 1000.00 0.69 0.64 1.43% 10.03% 3.15%
5.00% 21.68 21.63 1000.00 0.63 0.58 1.57% 11.09% 3.18%
Note: Firm value is 1000; free risk rate is 3%; T is 1. The initial face value of debt
is supposed equal to 950 and the initial value of d1,1 and d2,1 is in line with the
Merton model used to obtain asset standard deviation and firm value. In
column4 we have the final face value of debt equal to firm value (1000); d,1,2
and d2,2 are the final value in line with the final face value of debt. In columns8
and 9 we have the proportion of CaR and the weighted average cost of capital.
Source: Authors elaboration.
138 Valuing Banks

E DD ,Non Dep DD ,Dep


WACC = rE + rD ,Non Dep (1 - t c ) + rf (1 - t c )
V V V (5.49)

DD ,Non Dep
rE = WACC + WACC - rD ,Non Dep (1 - t c )
E

DD ,Dep
+ WACC - rf (1 - t c ) (5.50)
E

If we put together deposits and non-deposit debt, we have:

D
rE = WACC + WACC - rD (1 - t c ) (5.51)
E

Considering the formula in Chap. 3 (equations 3.25 and 3.28), we can


also determine the WACC* and the cost of assets (rA).
Let us suppose that Bank Y has an equity standard deviation of 30%.
The first step is to determine the asset standard deviation with the Merton
model through the solutions to these two equations (T=1):

E = V N ( d1 ) - De - rT N ( d 2 )

5 = V N ( d1 ) - 95 e -3% N ( d 2 )

V
s E = sV N ( d1 )
E

V
N ( d1 ) 30% = s V
5

where V is the bank firm value, E is equity value, D is the nominal value
of debt, r is the risk-free rate, V is asset standard deviation, E is equity
standard deviation. d1 and d2 are respectively:
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 139

V s
2

ln + r + V T
D 2
d1,1 =
sV T

V s2
ln + 3% + V 1
95 2
d1,1 =
sV 1

d 2,1 = d1 - s V T

d = d -s 1
2,1 1 V

From this equation, the asset value is equal to 97.19, asset standard
deviation is 1.54% and market value of debt is 92.19.
The second step is to determine the CaR and WACC. We assumed
that the logarithm of the assets value is normally distributed, so we can
determine the average of the normal distribution as:

s V2 1.54%2
r
f - T + ln (V0 ) = 3% - 1 + ln ( 97.19 ) = 4.61
2 2

We can now calculate the Value Low at time 0, with a precise interval
of confidence (e.g. 1%):

,1 = f (a ) = exp m + s N (a ) = exp 4.61 + 1.54%N -1 (1% ) = 96.61


Valow -1
-1

Discounting by a risk-free rate at time 0, we have a Value Low equal to


93.75. Hence, the CaR ratio is:

CaR V - V0low 97.19 - 93.75


= = = 3.54%
V V 97.19
140 Valuing Banks

Considering a face value of debt equal to bank firm value (CaRM


unlevered approach), d1, market value of debt and ELR are:

s V2 1.54%2
r + 3% +
2 2
d1,2 = = = 1.96
sV T 1.54%

DMK = V - V N ( d1 ) - Ve - rT N ( d 2 ) = 97.19 - 97.19 N (1.96 ) - 97.19 N (1.94 )
= 93.39

DMK 93.39
ELRUnleverd = 1 - -rf T
=1- = 0.98%
Ve 97.19e -3%

Thus, the WACC is:

ELR UL CaRV,%
WACC = rf + ln 1 +
1 - ELRUL

0.98% 3.54%
= 3% + ln 1 + = 3.04%
1 - 0.98%

The third step is to determine the cost of debt. Using a structural


model, we calculate the PD as:

PD = N ( -d 2 ) = N ( -3.41) = 0.03%

The expected loss rate is:

DMK 92.19
ELR = 1 - -rf
=1- = 0.00%
De 95 e -%

5 The Banks Cost ofCapital: Theories andEmpirical Evidence 141

Risk premium for creditors is zero and cost of debt corresponds to the
risk-free rate.
Finally, the fourth step is to quantify the cost of equity as:

D
rE = WACC + WACC - rD (1 - t c )
E
92.19
= 3.04% + 3.04% - 3% (1 - 30% ) = 20.37%
5

5.4 V
 aluing Unlisted Banks through a Cost
ofCapital Comparable Approach:
APractical Example
This section concerns the application of the methodologies discussed in
this chapter in the case of unlisted banks. In particular, we show the eval-
uation of an unlisted Italian small bank using a CAPM beta comparable
approach (both classic and total beta) and an accounting version of the
CaRM.

Table 5.3 Liabilities, equity and adjusted income statementHighlights of the


small bank (data in million)
Liabilities and Equity (Highlights) 2013
Bearing liabilities 285,957
Equity 32,430
Total bearing liabilities and equity 318,386
Adjusted Income Statement (Highlights) 2013
Operating profit 6,209
Financial expenses (Interest expenses and similar charges) 4,901
Total profit (loss) before taxes 1,308
Tax expenses 432
Net profit for the year 876
Source: Authors elaborations on small bank data.
142 Valuing Banks

5.4.1 The Financial Data oftheSmall Bank

Table 5.3 presents the financial highlights of the small bank.2

5.4.2 C
 ost ofAsset Estimation through the Beta
ofComparable Banks

The bank under valuation is not listed in capital markets. Thus, we have
not the availability of stock market data useful to obtain equity betas.
To overcome the problem, we used a comparable approach exploiting
the average beta of a peer group (Table 5.4). To implement the AMM,
we purified the bank equity betas from fiscal benefits and underpricing
deposits benefits, using equation (5.11), which supposes that both non-
deposit and deposit betas are equal to zero.3

Table 5.4 Beta comparable (12-31/2013) (data in million)


Asset beta
Equity Asset corrected for
Banks beta MK CAP Debts i average beta mark-down effect
Unicredit 1.15 31,159,44 757,915,00 1.53% 0.07 0.12
Intesa San 1.16 27,809,91 497,824,00 1.51% 0.09 0.16
Paolo
UBI Banca 0.96 4,451,03 109,501,20 1.37% 0.05 0.11
MPS 0.61 2,048,94 183,161,90 2.11% 0.01 0.01
Banca 1.13 1,453,33 43,655,50 1.31% 0.05 0.12
Popolare
di Milano
Average 1.00 13,384,53 318,411,52 1.57% 0.05 0.11
Standard 0.23 14,787,63 301,155,69 0.32% 0.03 0.06
deviation
Median 1.13 4,451,03 183,161,90 1.51% 0.05 0.11
Note: In column 5 we have the return on total debt (interest expenses on total
financial debt); columns 6 and 7 present asset beta calculated using the
Hamada formula and the Hamada formula corrected for mark-down benefit,
respectively. Risk-free and tax rate are 3% and 33%, respectively
Source: Authors study on Bloomberg data.

2
This demonstration exploits the data of an existing bank.
3
Similar assumptions are made in the case of industrial firms when the classic Hamada formula is
applied.
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 143

Considering a risk-free rate of 3% and a Market Risk Premium (MRP)


of 8.8%, in line with the Italian country risk, the cost of asset for the
small bank is:

rA = rf + b A MRP = 3% + 0.11 8.8% = 3.93%


To evaluate the small banks firm value, we used a steady growth scheme
with a growth rate equal to 1% and with a unique evaluation of debt
benefits. FCFA is equal to Operating profit net of taxes at time 1 minus
the 1% asset growth, while benefits mature to debt at time 0.

Operating income0 (1 - t c )(1 + g ) - TotAssets0 g rf - iD,Average (1 - t c )


V = +D
rA - g rf - g
6,209.151 (1 - 33% )(1 + 1% ) - 318,386.474 1%
=
3.93% - 1%

3% - 1.71% (1 - 33% )
+ 285,956.691 = 299,864.26
3% - 1%

Equity is:

E = V - D = 299,864.26 - 285,956.691 = 13,907.56843

5.4.3 C
 ost ofAsset Estimation through Total Beta
Bank Comparable

Considering the standard deviation of each bank and the standard devi-
ation of market return, we exploit the value of total beta comparable
(Table 5.5).
The cost of assets is:

rA = rf + b A MRP = 3% + 0.35 8.8% = 6.08%



144 Valuing Banks

Table 5.5 Beta comparable (12-31/2013) (data in billion)


Asset total
Equity Asset beta corrected
total total for mark-
Banks beta MK CAP Debts i average beta down effect
Unicredit 3.2690 31,159,44 757,915,00 1.53% 0.19 0.35
Intesa San 3.1651 27,809,91 497,824,00 1.51% 0.24 0.45
Paolo
UBI Banca 3.6448 4,451,03 109,501,20 1.37% 0.21 0.43
MPS 4.5878 2,048,94 183,161,90 2.11% 0.08 0.11
Banca 4.0745 1,453,33 43,655,50 1.31% 0.19 0.42
Popolare di
Milano
Average 3.7482 13,384,53 318,411,52 1.57% 0.18 0.35
Standard 0.5899 14,787,63 301,155,69 0.32% 0.06 0.14
deviation
Median 3.6448 4,451,03 183,161,90 1.51% 0.19 0.35
Note: In column 5 we have the return on total debt (interest expenses on total
financial debt), columns 6 and 7 present asset beta calculated using the Hamada
formula and the Hamada formula corrected for mark-down benefit, respectively.
Risk-free and tax rate are 3% and 33% respectively
Source: Authors elaboration on Bloomberg data.

The valuation is as follows:

Operating income0 (1 - t c )(1+ g ) - TotAssets0 g rf - iD, Average (1 - t c )


V= +D
rA - g rf - g

6,209.151(1 - 33% )(1+ 1% ) - 318,386.474 1%


=
6.08% - 1%

3% - 1.71% (1 - 33% )
+ 285,956.691 = 285,161.51
3% - 1%
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 145

Equity is:

E = V - D = 285,161.51 - 285,956.691 = -795.18

Due to the high level of specific risk included in the cost of assets, the
equity value is negative.

5.4.4 C
 ost ofAsset Estimation through CaRM:
AnAccount Approach

In paragraph 5.3.2, we explained the use of the CaRM to measure a


banks firm value and asset standard deviation from a structural model. In
the same manner of small and medium-sized enterprises (Beltrame etal.
2014), we can apply the model for unlisted banks observing the ROA
of comparable banks, the ROA standard deviations of the target bank
and the loss rate. According to the previous application of the model, we
can write the banks assets value (without considering any fiscal or mark-
down benefits) as:

Operating profit low Operating profit - Operating profit low


V = Vlow + CaRV = +
rf rRN,UL


Operating profit - FaR VaR (5.52)
= +
rf rRN,UL

whereOperatingprofitlow is the certain reference of bank, Operating profit
is the average of operating profit, VaR is the difference between the average
operating profit and the certain operating profit (uncertain part of operat-
ing profit), rf is the discount factor for certain operating profit, while rRN,UL
is the discount factor for the uncertain part of operating profit.
146 Valuing Banks

We can re-express the (5.29) in terms of ROA:

ROAlow ROA - ROAlow


V = Vlow + CaRV = + TotAssets
rf rRN,UL

ROA - VaRROA VaRROA
= + TotAssets (5.53)
r r
f RN,UL

The CaR proportion can be written as:

VaRROA
rRN,UL (5.54)
CaRV,% =
ROA - VaRROA VaRROA
+
rf rRN,UL

The lack of sufficient numbers of observations for target firms neces-


sary to build a significant statistical distribution of ROA can be overcome
using the ROA statistical distribution of a panel of comparable banks.
The magnitude of ROA value at risk can be adapted standardizing ROA
standard deviation for target bank:

Table 5.6 ROA value at risk and K factors for a sample of bank in the European
Union [28] (period 20082012)
ROA data 20082012
ROA average 2.74%
ROA standard deviation 6.08%
ROA median 2.32%
ROA percentile 0.1% 47.20%
ROA percentile 1% 6.87%
ROA percentile 5% 0.00%
k 0.1% 8.22
k 1% 1.58
k 5% 0.45
Source: Authors elaboration on Bankscope data.
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 147

VaRROA ,comparables ,a confidence interval


VaRROA,target = s ROA ,target (5.55)
s ROA,comparables

VaRROA ,comparables ,a confidence interval


where is the k factor with a certain interval of
s ROA,comparables
confidence. In Table 5.6, we show the value at risk, k and ROA data for
a sample of European banks.
Considering a 1% interval of confidence and a ROA standard devia-
tion of 0.68% for the small bank, we calculate the Value at Risk as:

VaRROA,Small bank = K European sample,1% s ROA,mall bank = 1.58 0.688% = 1.0744%


According to the original approach (Beltrame et al. 2014), the risk


neutral rate is obtained using the loss rate given to the depreciation,
amortization and, in particular, the loan loss provision on Total assets:

Depreciation and Loan loss provision


Loss Rate =
Total assets (5.56)

rf + Loss Rate
rRN = (5.57)
1 - Loss Rate

Table 5.7 ROA standard deviation on comparable banks


ROA standard deviation
Unicredit 1.19%
Intesa San Paolo 1.07%
UBI Banca 1.11%
MPS 1.33%
Banca Popolare di Milano 1.31%
Average 1.20%
Source: Authors elaboration on Bankscope data.
148 Valuing Banks

Depreciation and Loan loss provision 3,352.282


Loss Rate = = = 1.05%
Total assets 318,386.474

3% +1.05%
= 4.09% rRN =
1 - 1.05%
Finally, considering an ROA average for the small bank of 1.87%, the
CaR proportion is as follows:
ROA - ROAlow 1.0744%
rRN,UL 4.09%
CaRV,% = =
ROA - VaRROA VaRROA 1.87% - 1.0744% 1.0744%
+ +
rf rRN,UL 3% 4.09%

26.2689%
= = 49.76%
26.52% + 26.2689%
and cost of assets is:


( )
rA = rf + CaR V ,% rRN - rf = 3% + 49.76% ( 4.09% - 3% ) = 3.54%

As one can note, the cost of assets through the CaRM is lower than
that calculated through an asset beta bank comparable methodology. This
is due to the low level of ROA standard deviation and the consequent
low level of risk and, in particular, of systematic risk in respect of other
comparable banks (Table 5.7).
In line with the CaRM, we also need to express the cost of debt.
Despite the fact that the CaR percentage on debt presents a high level
(around 70%)4, the expected loss rate is near zero. For this reason, we
consider risk-free debt.
Calculated as follow:
4

ROAlow
Debt - TotAsset
rf 285,957 - 26.52% 318,386.474
CaRD,% = =
Debt 285,957
= 70.47%.
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 149

Using the same assumption of the previous valuation, we re-express


the AMM imputing the cost of assets:

Operating income0 (1 - t c ) (1+ g ) - TotAssets0 g rf - iD,Average (1 - t c )


V= +D
rA - g rf - g
6,209.151 (1 - 33% )(1+1% ) - 318,386.474 1%
=
3.54% - 1%
3% - 1.71% (1 - 33% )
+ 285,956.691 = 305,198.279
3% - 1%

Equity is:

E = V - D = 305,198.279 - 285,956.691 = 19,241.5882

5.5 Conclusion
Corporate finance theory states that the higher the risk, the larger the cost
of capital must be. Cost of equity has to consider operating and financial
risk, while models for cost of debt often only include the operational risk.
In the banking industry, the most important balance sheet measures of
risk (such as leverage, credit risk measures, profitability, asset and liabili-
ties composition) are good predictors of systematic risk (measured by
the beta coefficient) and total risk (measured by equity volatility). In this
chapter, we gave two paradigms to quantify the cost of equity: the per-
fectly diversified investor and the not fully diversified investor. In respect
of traditional theory, we added the influence of idiosyncratic risk in the
cost of equity because the relative measures (such Total beta) are very
useful in mergers and acquisitions transactions and for private investors
that cannot (or do not wish to) diversify their investment portfolio. The
degree of diversification can be represented by an average of the cost of
equity in the presence and in the absence of diversification. Moreover, we
provided a measure that took into account default risk in the cost of bank
capital (CaRM) and in the cost of bank debt.
150 Valuing Banks

Lastly, we presented an asset-side valuation and we linked it with an


equity-side valuation because bank assets are the main source of risk; in
particular, the specific one. In this way, the evaluation process is more
related to banks risk like market risk and credit risk state by regulation
in order to capital adequacy. Even if banks are characterized by lower
asset beta/asset volatility and higher leverage than non-financial firms, an
asset-side valuation cannot imply an incorrect valuation in terms of cash
flows and WACC, particularly if considering the specificities of a bank,
such as the amount and the remuneration of deposits.
Thus, the chapter provided a wide range of choices for the calculation
of the cost of bank capital.

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6
Banks Asset-Side Multiples:
Profitability, Growth, Leverage
andDeposits Effect

6.1 Introduction
The main issue in the analytical valuation is the large number of assumptions
that have to be made in order to estimate expected earnings, expected
cash flows and cost of capital. Nevertheless, such discretional factors are
non-eliminable and, usually, the fundamental assumptions (i.e. growth)
are subject to a sensitivity analysis. As a matter of fact, a small variation in
basis points may imply relevant changes in firm value determining wide
ranges and, thus, the unreliability of a valuation. For these reasons, ana-
lytical methods are commonly checked with a second type of valuation
method: market multiples. As we discussed in Chap. 2, this approach
tries to generate a connection between stock market prices or a firms
assets value, and a firms financial statement variables such as earnings,
operating profit or book value. For example, if we assess the value of
Firm Alpha using earnings and we assume that the firm maintains the
same average Price to Earnings ratio of the comparable listed firms (Beta,
Gamma and Sigma) engaged in the same business, we can use the average

The Editor(s) (if applicable) and The Author(s) 2016 155


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
inBanking and Financial Institutions, DOI10.1057/978-1-137-56142-8_6
156 Valuing Banks

value of the Price to Earnings ratio and reach the value of Alpha as shown
in Table 6.1:
If Alpha presents an earnings per share equal to 0.7, Alphas target
price will be:

P . E = 5.43 . 0.7 = 3.8


PAlfa = Alfa
E Average

In general, the relative market valuation involves many types of pos-


sible multiples since the value depends on different accounting drivers,
such as assets, book value, sales, cash flows, earnings and so on.
Even in this case, we can separate market multiples according to
the approach that can be used in valuation: asset-side and equity-side.
Between these, we can make a further separation: those using income
statement variables and those built on balance sheet variables. In Table 6.2,
we can see the main market multiples used in a valuation process.

Table 6.1 Price Earnings of Beta, Gamma and Sigma


P/E
Beta 5.00
Gamma 6.50
Sigma 4.80
Average 5.43
Source: Authors elaboration.

Table 6.2 Main market multiples used in practice


Asset- side approach Equity-side approach
Income statement Enterprise value/Ebit Price/Earnings per share
Enterprise value/Ebitda Price/Cash flows per share
Enterprise value/Sales Price/Earnings per share adjusted
Balance sheet Enterprise value/Capital Price/Book value per share
employed
Source: Authors elaboration.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 157

With regard to the financial statement variables, market multiples can


be classified in three categories according to the time horizon to which
data refer and, therefore, to the scope of a valuation. In particular, market
multiples can be split into:

Current: if we use data for the last financial year;


Trailing: if we use data for the past twelve months considering quar-
terly data;
Leading: if we use forecast data (i.e. IBES).

However, since valuation is aimed at reaching a firm value which, for


definition, depends on future cash flows, the leading multiple configura-
tion would be the one better suited to a perspectival valuation. However,
again, the scope of the valuation must lead the choice of the right mul-
tiple to be used.
As far as the numerator of the multiple is concerned, generally, the data
used may be the average daily or weekly data from the last month, trimes-
ter, quarter or semester or, even, last financial year. This choice depends
on the trend of the markets and on the presence of financial stress which
may affect the stability of stock prices. In addition, the time horizon
should take into account specific anomalies such as dividends distribu-
tion, mergers and acquisitions, changes in management and so on.
As we argued in Chap. 2, bank valuation usually follows an equity-
side assessment, and academics (Damodaran 2013) and practitioners
(Franceschi 2008; Imam etal. 2008) identify price earnings (PE) and price
to book ratio (PBV) (also considered in its tangible book version (PBTV))
as the two most frequently used types of multiple in bank valuation.
With regard to price earnings, according to the theory that stock markets
reflect the discounted cash flows of an asset, it is clear that the denominator
of the ratio (earnings per share) should be forward looking. In these terms,
banks distributing more dividends, or, ceteris paribus, fast growing and cost-
less (in terms of cost of equity), should have higher PE.However, the source
and risk of earnings need to be considered when valuing banks by PE mul-
tiple. In particular, since banks are multi-business firms, not all the business
areas have the same risk-return profile so investors will be willing to pay
158 Valuing Banks

higher multiples for the more remunerable assets than for assets that are eco-
nomically marginal. This makes comparison of PE between banks difficult,
since they have different business models and asset mixes. It would be much
more reliable to break down multiples in order to catch business weights in
the overall invested capital by considering their proportion of past revenues
earned, so that risk characteristics can be taken into account in the multiple.
For these reasons and for their higher stability, the PBV and PTBV are
the market multiples more frequently used in practice for bank valuation.
The theoretical relation between ROE (i.e. its leading value driver) and
market prices is usually caught by the value map methodology which,
through an OLS regression, estimates a regression line explaining market
prices as a linear combination of ROE (see Sect. 2.2.4).

6.2 L iterature Review: TheSimilarities


Between theTarget Firm andIts
Comparables
As we have already pointed out, the market multiple method needs a set
of comparable firms. The majority of authors agree with the identifica-
tion of a sample of companies of a similar size, growth, leverage and prof-
itability to that of the target company (Bhojraj and Lee 2002; Henschke
and Homburg 2009; Herrmann and Richter 2003). Some authors, using
the DCF formulas such as the DDM, have highlighted how multiples are
dependent on the growth effect, investment opportunities, profitability
and risk (Leibowitz and Kogelman 1990; Richter 2005).
As far as the adjustments on multiples are concerned, we can split market
multiples literatureliterature not specifically related to the banking indus-
tryinto two categories. One is composed of researchers considering adjust-
ments to conform comparable firms to the target as useless and superfluous;
the other supports the opinion that adjustments regarding growth, leverage
and other operating aspects make the assessment process more robust.
The main reason why adjustments of comparables should not be made
is to be found in the connected subjectivity of corrections that make the
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 159

results of a valuation highly discretional (Bhojraj etal. 2003). Consider, for


example, the formulas used to adjust the level of growth and leverage, as in
Massari and Zanetti (2008). In both cases, it is necessary to use valuation
models holding on strong assumptions on leverage and dividends dynamic
(stability, steady growth, growth stages and so on). A small change in these
assumptions can generate a strong impact on the value of the unlevered
multiple and adjusted for growth. Such adjustments would also make los-
ing the main advantage that the market multiple method has in compari-
son with other methods: simplicity and immediacy of application.
Moreover, some authors believe that the adjustments do not sig-
nificantly reduce the typical errors of assessment. In particular, Alford
(1992), among others, believes that the adjustments regarding debt on
PE ratios reduce the accuracy of the assessment.
Conversely, other academics believe that, in order to reach an adequate
level of comparability, some specific adjustments need to be made for
the different level of growth and size of leverage (Arzac 2005; Massari
and Zanetti 2008). For example, Massari and Zanetti (2008), used dis-
counted FCFO method to adjust the asset-side multiples, and a DDM to
adjust equity-side multiples.
In the case of financial firms, especially banks, they present high levels
of similarity to their peer group in reference to size, growth and fixed
costs. The only aspect in which considerable difference can be found
between banks is in the type of business they run and their profitability.
In fact, there are several compositions of business a bank can choose (i.e.
a commercial or investment bank) that, despite the similarity in the size
or in other variables, can determine considerable differences in terms of
growth potential, cost of capital and profitability.
Usually, in the banking industry, for the reasons given above, analysts
do not provide corrections and adjustments in the market multiples,
unless in specific cases in which there are strong differences in capital
adequacy or the quality of assets levels.
Despite this, Massari et al. (2014) suggested a specific adjustment
with regard to the level of growth using a DDM as it has been made for
non-financial firms. In the next section, we highlight in detail the effect
of this adjustment on bank market multiples.
160 Valuing Banks

6.3 B
 anks Market Multiples: Feasible
Adjustments
As showed in previous chapters, the level of capitalization and the compo-
sition of funding affect the value of a bank. And they also affect profitabil-
ity. Therefore, the use of a market multiple adjusted to take into account
the overall composition of liabilities can provide a more consistent assess-
ment. This is particularly true in the case of an unlisted bank, because the
level of capitalization and the amount of deposits may be very different
from those of the listed banks that make up the sample of comparables. In
the following sections, we discuss how to take into account profitability,
growth and leverage adjustments on market multiples.

6.3.1 P
 rofitability andGrowth Adjustments
onEquity-Side Multiples

As shown in previous chapters, the value of a bank is affected by the


expected growth in terms of margins and dividends. Through the scheme
of the steady growth DDM, we highlight the direct relationship between
the growth rate of dividends (g) and the stock price:

Div1
P= (6.1)
rE - g

where Div1 is the expected dividend of next year, rE is the cost of equity
and g is the constant rate of growth of dividends that, when estimated as
fundamental growth, is equal to:

g = ROE b (6.2)

where b is the earnings retention rate. This shows that a banks profitabil-
ity in terms of return on equity plays an important role in growth because,
at the same time, it has a positive effect on dividends and a negative effect
on the denominator of the ratio by increasing the rate of growth.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 161

Theoretically, if risk is constant, a more profitable bank (in terms of


ROE) will make more efficient use of its own sources and, therefore,
it will produce a greater impact on the stock market price than a less
profitable bank. On the other hand, a change in the profit retention rate
may also have a relevant impact on value. Obviously, among comparable
banks and the target bank there could be considerable differences relative
to returns, retention rates of profit and, consequently, growth. And, at
least theoretically, it would be more appropriate to adjust the peer group
for profitability and the retention rate of the target bank.
Such adjustments can be made on PE and PBV which, as we already
pointed out, are the two market multiples widely applied in banking.
To calibrate the value of these multiples with regard to the growth level
of the target, we should:

( a) Write the multiple through a discounted cash flow method;


(b) Obtain the implied cost of capital in the multiple for each bank in
the sample;
(c) Calculate the multiple for each comparable company using the
growth of the company to be assessed.

In the case of leading PE, we:

(a) Write the multiple through a discounted cash flow method:1

P0 1- b
= (6.3)
E1 rE - g

where P0: is the stock price, E1 is the earnings per share at time 1, b is
the earnings retention rate;rE is the cost of equity and g the dividend
growth rate.
(b) Obtain the implied cost of capital in the multiple for each bank in the
sample:

1
Massari etal. (2014) propose a representation of the multiple in the event of differential growth
of the dividends.
162 Valuing Banks

1 - bcomparable
rE ,comparable = g comparable +
P0
(6.4)
E1,comparable

(c) Calculation of the multiple for each comparable company using the
growth of the company to be assessed:2

P0 1 - btarget
= (6.5)
E1,comparable adj.r E rE,comparable - gtarget

In the case of the current PE, we have: 3

(a) Write the multiple through a discounted cash flow method:

P0 (1 + g )(1 - b )
= (6.6)
E0 rE - g

where earnings at time 0 are the earnings at time 1, divided to 1+g.


(b) Obtain the implied cost of capital in the multiple for each bank in the
sample:

rE,comparable = g comparable +
(1 + g comparable )(1 - b comparable )
P0
(6.7)
E1,comparable

(c) Calculation of the multiple for each comparable company using the
growth of the company to be assessed:

P0
=
(1 + g target )(1 - b )
target
(6.8)
E1,comparable ad j.r E rE,comparable - gtarget

In the case of PBV, we have:


2
The present method (as well as for the following) assumes that the cost of capital remains
unchanged for different growth profiles.
3
In the case of the trailing version, we take the same steps.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 163

(a) Write the multiple through a discounted cash flow method:

P0 ROE1 (1 - b ) ROE1 - g
= = (6.9)
BV0 rE - g rE - g

where ROE1 is the shareholder return calculated using the expected


earnings at time 1 and the book value of equity at time 0.
(b) Obtain the implied cost of capital in the multiple for each bank in the
sample:

ROE1,comparable - g comparable
rE,comparable = g comparable +
P0
(6.10)
BV0,comparable

(c) Calculation of the multiple for each comparable company using the
growth of the company to be assessed:

P0 ROE1,target - gtarget
= (6.11)
BV0 ,comparable adg.r E rE,comparable - gtarget

6.3.2 A
 sset-Side Adjustments: Additional Bank
Market Multiples

According to the AMM and to the equity market multiples adjust-


ments, in this section we propose some asset-side multiples which
allow us to state the relative value of a bank from a firm total value
perspective.
Even in the case of the asset-side approach, it is possible to explain the
multiples we have seen so far, from either a margins or a total assets point
of view.
Considering margins, we can use the definition of operating profit
developed in Chap. 3, and easily highlight its relationship with the enter-
prise value as:
EV
(6.12)
OP
164 Valuing Banks

Using the total assets approach, we can write an asset-side version of


the price to book value as:

EV
(6.13)
TotAssets

As we described in the case of equity multiples, we can now illustrate


the steps for the growth adjustment of the target.
For the leading enterprise value to operating profit, we have:
(a) Write the multiple through a discounted cash flow method:

OP0
FCFA1 OP1 (1 - t c ) - TotAsset0 g OP1 ( 1 - t c ) - g
EV0 = = = ROA
WACC* - g WACC* - g WACC* - g
(6.14)

where OP1 is the operating profit at time 1 after the cost of funding, g is
the asset and margin growth rate; TotAsset0g is the reinvestment in capi-
tal for growth, WACC* is WACC modified to take into account the true
cost of deposits and ROA* is a profitability ratio calculated by dividing
operating profit by total assets.
Unlike the usual calculation for ROA in banking which sets as the numer-
ator the amount of the net income, in this case, we can write the operating
profit in a more consistent manner with the case of industrial firms.
As in the case with the DDM growth rate, g is given by a net ratio
of performance (ROA(1tc)) multiplied for a margin retention rate (b).
Thus, we can write:
OP0
OP1 (1 - tc ) - ROA (1 - tc ) b
EV0 = ROA = OP1
(1 - t c ) (1 - b ) (6.15)
WACC - g
*
WACC * - g
from which we can show the composition of the operating profit multiple:

EV0 (1 - tc ) (1 - b )
= (6.16)
OP1 WACC * - g
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 165

(b) Obtain the implied cost of capital in the multiple for each bank in the sample:

(1 - tc ) (1 - bcomparable )
WACCcomparable
*
= g comparable +
EV0
(6.17)
OP1,comparable

(c) Calculation of the multiple for each comparable company using the growth of the
company to be assessed:

EV0 (1 - tc ) (1 - btarget )
= (6.18)
OP1,comparable adj.WACC WACCcomparable
*
- gtarget

In the case of current enterprise value to operating profit, we have:
(a) Write the multiple through a discounted cash flow method:

EV0 (1 + g ) (1 - tc ) (1 - b )
= (6.19)
OP0 WACC * - g
(b) Obtain the implied cost of capital in the multiple for each bank in the
sample:

WACCcomparable
*
= g comparable +
(1 + g comparable ) (1 - t ) (1 - b
c comparable )
EV0
OP1,comparable

(6.20)
(c) Calculation of the multiple for each comparable company using the growth of the
company to be assessed

EV0
=
(1 + g target ) (1 - t ) (1 - b )
c target
(6.21)
OP0 ,comparable adj .WACC WACC *
comparable - gtarget

Finally, with regard to the enterprise value to assets, we have:
166 Valuing Banks

(a) Write the multiple through a discounted cash flow method:

FCFA1 OP (1 + g ) (1 - tc ) - TotAsset0 . g
EV0 = = 0
WACC - g
*
WACC * - g
ROA0 (1 + g ) (1 - tc ) - g
= TotAsset0 (6.22)
WACC * - g
from which:

EV0 ROA0 (1 + g ) (1 - tc ) - g
= (6.23)
TotAsset0 WACC * - g
(b) Obtain the implied cost of capital in the multiple for each bank in the sample:

ROA0 ,comparable (1 + g comparable ) (1 - tc ) - g comparable


WACCcomparable
*
= g comparable +
EV0
TotAsset0 ,comparable
(6.24)

(c) Calculation of the multiple for each comparable company using the growth of the
company to be assessed:

EV0 ROA0 ,target (1 + gtarget ) (1 - tc ) - gtarget


= (6.25)
TotAsset0 ,comparable adg.r WACC WACCcomparable
*
- gtarget

Although, the adjustments proposed appear theoretically correct, the
practical implementation is limited, especially if the target firm is a bank.
This is due to the following reasons:

The cost of capital (cost of equity or the WACC) could be influenced by


the different growth profiles. In contrast, for a different growth rate among
comparable banks and the target bank, the cost of capital is left constant.
The value of the bank is described by a DCF method with a constant
growth rate. In reality, the value could be determined by differently
structured of cash flows.
The complications linked to the mathematical steps remove the advantage
of simplicity and immediacy linked to the usage of market multiples.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 167

For these reasons, in order to consider the different profiles of profit-


ability (and, hence, growth) in the use of stock market multiples, we can
alternatively, in advance, select comparable banks that present growth
rates of assets, profits and dividends similar to those of the target bank, as
asserted by the literature previously outlined.
Finally, it should be emphasized as, using a single stage of growth,
in the long run all the banks in the same country should have a rate of
growth in line with the countrys GDP trend, meaning it is no longer
necessary to adjust for growth.

6.4 L everage andDeposits Effect onBank


Multiples
As is widely held regarding stock market multiples calculated on indus-
trial firms, it is possible to calculate the so-called unlevered multiple in
order to purify the target bank from the debt effect of comparables on
company value. More precisely, the price or the enterprise value is recal-
culated to reach a debt-free enterprise value, removing the value gener-
ated by tax-shields.
For banking firms, as repeatedly highlighted in previous chapters, the
advantage of debt usage is expressed not only in fiscal terms, but also with
regard to the value generated on deposits. For this reason, it is necessary adjust
the peer group for both these effects. This will make it possible to compare
the banks whose collection policy and business is different from the target.
Also, it could be particularly useful in groups in which commercial banks are
prevalent, rather than those in which investment activity is prevalent.
Depending on the constancy of debt, rather than growth, it will be
possible to reach to the unlevered multiple by certain mathematical
procedures.

6.4.1 Unlevered Multiple intheAbsence ofGrowth

For the correction of the equity-side multiple, we need to consider that the
investments will be funded entirely by equity capital and, consequently,
the numerator of a market multiple will increase in the amount of equity
168 Valuing Banks

that will replace debt. Moreover, we must take into account that the value
of equity will be reduced by the benefits on deposits and taxes.
For the PE ratio, it is necessary to adjust not only the numerator, but
also the denominator, by increasing earnings for the cost of debt, taking
into account the tax-shield4. So, we will have:5

P P nr . shares + D - DD , Dep ( rf - iD , Dep ) / rf - DD , Dep ( iD , Dep . tc ) / rf - DD , Non Dep . tc


=
E Unlevered E nr .shares + Interests expenses (1 - tc )
(6.26)

Conversely, for the PBV the denominator will be represented by the


assets, since they are entirely financed by equity:

P P nr . shares+ D - DD, Dep ( rf - iD , Dep ) / rf - DD, Dep ( iD , Dep tc ) / rf - DD , Non Dep tc


=
BV Unlevered TotAssets
(6.27)

Considering asset-side multiples, the correction of the margin multiple has


to be made in the numerator which should be adjusted by removing the bene-
fits on deposits and taxes. Therefore, the enterprise value to operating profit is:

EV EV - DD,Dep ( rf - iD , Dep ) / rf - DD,Dep ( iD , Dep . tc ) / rf - DD , Non Dep . tc


= (6.28)
OP Unlevered OP
The enterprise value to assets corresponds to the price to book value as:

P P nr . shares + D - DD,Dep ( rf - iD ,Dep ) / rf - DD,Dep ( iD ,Dep .tc ) / rf - DD ,NonDep .tc


=
BVUnlevered TotAssets
EV - DD,Dep ( rf - iD ,Dep ) / rf - DD,Dep ( iD ,Dep . tc ) / rf - DD ,NonDep . tc EV
= =
TotAssets TotAssetsUnlevered

(6.29)

4
In the event of the presence of non-operating components and extraordinary components, it
should be made other corrections in the calculation of the denominator.
5
It is assumed for the debt represented by deposits that the cost of debt is equal to the interest rate return.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 169

6.4.2 Unlevered Multiples inthePresence ofGrowth

In this section, we provide the description of the multiples in the


event it is assumed that depositsand, in general, debtgrows at a
specific rate g:

P P nr shares + D - DD,Dep ( rf - iD,Dep ) / ( rf - g ) - DD,Dep (iD,Dep t c ) / ( rf - g ) - DD,Non Dep ( rD,Dep t c ) / ( rD,Dep - g )


=
E Unlevered E nr.shares + Interestsexpenses (1 - t c )

(6.30)

P EV
=
BVUnlevered TotAssetsUnlevered
EV - DD,Dep ( rf - iD,Dep ) / ( rf - g ) - DD,Dep ( iD,Dep . t c ) / ( rf - g ) - DD,NonDep ( rD,Dep . t c ) / ( rD,Dep - g )
=
TotAssets

(6.31)

EV EV - DD,Dep ( rf - iD,Dep ) / ( rf - g ) - DD,Dep (iD,Dep t c ) / ( rf - g ) - DD,Non Dep ( rD,Dep t c ) / ( rD,Dep - g )


=
OP Unlevered OP

(6.32)

If, after having removed the debt effect from comparable banks, a dif-
ferent growth rate persists between the target bank and its comparables,
it is possible to use the equation reported in Sect. 6.3 to adjust for differ-
ent growth levels. In this case, starting from an unlevered version of the
market multiple, the implicit cost of capital in the multiple is the cost of
assets, rather than the cost of equity.

6.4.3 C
 alculating theUnlevered Multiple: APractical
Example

To demonstrate the use of unlevered multiples, we proceed to the valua-


tion of Omega Bank, which has the following characteristics:

Total assets: 45,234.6;


Total debts: 41,562.2;
170 Valuing Banks

Operating profit: 715.6;


Interests expenses: 750.9

Furthermore, based on information contained in the Bloomberg data-


base and the statistical estimates on the growth of GDP planned for Italy
by Istat, we consider:

Risk-free rate of 3.68%;


Assets and debt growth rate of 0.5%;
Tax rate of 31.4%.

The data of comparable banks are presented in Table 6.3. In order to


implement the calculation of the unlevered multiples, we assume that
the expected return of the sample banks funding is equal to the risk-free
rate. Under this assumption, the total benefit on deposits and taxes is:
D rf - Interest expenses (1 - tc )
Benefits = (6.33)
rf - g
Taking the average value and using the enterprise value to Operating
profit, we obtain the assets value as:

EV
VAssets ,( EV / OP )Unlvered = Operating Profit
OP Unlevered
= 715..6 22.40 = 16,029.4
Conversely, the Unlevered Price Earning is not used as it corresponds
to the Enterprise Value to Operating profit net of taxes. As for the
Unlevered Price to book value, we have:

P
VAssets ,( P / BV )Unlevered = TotAssets = 45,234.6 0.18
8 = 8,142.2
BV Unlevered

Making an average between the two values, we obtain a value of assets


equal to 12,085.8. The difference between the two valuations is due to
the different economic profile that one can note through the average
Table 6.3 Comparables data (12-31/2013)
Total Operating Interest P/E EV/OP P/BV
Banks MK CAP Debts assets profit expenses Benefits unlevered unlevered unlevered
Unicredit 31,158.07 795,663.70 845,838.40 4,073.60 11,604.70 670,427.67 55.97 38.39 0.18
Intesa San 29,495.00 581,225.00 626,283.00 5,037.00 7,518.00 510,431.82 29.02 19.91 0.16
Paolo
UBI Banca 4,451.00 113,060.50 124,241.80 1,691.30 1,504.20 98,388.21 16.48 11.31 0.15
MPS 2,048.90 192,942.40 199,105.40 1,736.30 3,865.80 139,884.95 46.27 31.74 0.28
Banca 1,452.70 45,708.60 49,353.30 622.80 573.10 40,532.39 15.52 10.64 0.13
Popolare
di Milano
Average 13,721.13 345,720.04 368,964.38 2,632.20 5,013.16 291,933.01 32.65 22.40 0.18
Standard 15,211.45 326,109.73 348,035.26 1,842.98 4,557.03 280,526.48 18.01 12.35 0.06
deviation
Median 4,451.00 192,942.40 199,105.40 1,736.30 3,865.80 139,884.95 29.02 19.91 0.16
Note: The benefits consider tax-shield value and deposits value calculated on total debts
Source: Authors study on Bloomberg data.
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage
171
172 Valuing Banks

ROA of the peer group and Omegas ROA: the latter is higher than the
former and, in respect of the unlevered PBV, it leads to a higher level of
assets value calculated using the unlevered EVOP. For this reason, we use
the reference obtained through PBV.
At this point, the value of the benefits of the target bank should be
added in order to reach the bank total value:

D rf - Interest expenses (1 - tc )
VBank = VAssets + = 8,142.2
rf - g
41, 562.2 3.68% - 750.9 (1 - 31.4% )
+ = 43,984.3
3.68% - 0.5%

When you consider that the face value of debt corresponds to its mar-
ket value, the equity value will be equal to:

E = VBank - D = 43,984.3 - 41,562.2 = 2,419.1

If the assessment were made considering the levered multiple, the valu-
ation by the Enterprise value to Assets would have led to a value of
43,727.6, and a value of 97,719.06 by the Enterprise value to Operating
profit. Once again, the difference between the two valuations is due to the
different level of the targets ROA compared with that of the peer group.

6.5 Conclusion
Using the market multiples valuation method, we have highlighted the
existing link between a banks firm value and certain value drivers, such as:

Operating profit;
Assets;
Debts.

Using a simple formula, we can explain a banks value generation as:


d g
VBank = Assets . + Operating Profit . + Debts . a (6.34)
2 2
6 Banks Asset-Side Multiples: Profitability, Growth, Leverage 173

where:
P
d=
BV Unlevered ,comparables

EV
g =
OP Unlevered ,comparables

rf - iD , Average (1 - tc )
a=
rf - g

Putting together the valuation achieved through asset-side multiples


cleared out of leverage with a separate evaluation of mark-down and fiscal
benefits allows us to:

evaluate the bank for its income flows, even if the profit is negative and
therefore the PE cannot be calculated. This is particularly useful, espe-
cially in the context of financial distress. In addition, the removal of
the leverage effect from the Enterprise value to Operating profit repre-
sents a more stable and sensitive valuation than that obtained with the
simple levered multiple;
present a more transparent methodology that focuses on the assets and
splits the value into the flows from assets and benefits from deposits
and taxes.

References
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of the price-earnings valuation method. Journal of Accounting Research, 30,
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Wiley & Sons.
174 Valuing Banks

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selection of comparable firms. Journal of Accounting Research, 40(2), 407439.
Bhojraj, S., Lee, C.M., & Ng, D.T. (2003). International valuation using smart
multiples. Working paper, Cornell University.
Damodaran, A. (2013). Valuing financial service firms. Journal of Financial
Perspectives, 1, 116.
Franceschi, L. F. (2008). Valuation of banks in mergers. Journal of Merger &
Acquisitions, 3. ICFAI University Press.
Henschke, S., & Homburg, C. (2009). Equity valuation using multiples:
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Herrmann, V., & Richter, F. (2003). Pricing with performance-controlled mul-
tiples. Schmalenbach Business Review, 55(3), 194219.
Imam, S., Barker, R., & Clubb, C. (2008). The use of valuation models by UK
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Leibowitz, M.L., & Kogelman, S. (1990). Inside the P/E ratio: The Franchise
factor. Financial Analysts Journal, 46, 1735.
Massari, M., & Zanetti, L. (2008). Valutazione: Fondamenti teoricie best practice
nel settore finanziario ed industriale. Milan: McGraw-Hill.
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Finanzierung und Prozessmanagement.
7
A Comparison between Valuation
Metrics ina Real Case

7.1 Introduction
The aim of this chapter is to compare some of the valuation methods
we have discussed in this book, showing the differences between the
approaches used and the correlated results.
The methods we have chosen are the DDM.EC, usually applied in
professional practice as the model for analytical cash flows; the AMM;
and an Adjusted FCFE, where the cash flows are calculated from the
FCFA and are adjusted for Excess Capital distribution. This helps in the
comparison with the dividendexcess capital approach.
The objective is to observe and discuss the differences between the
equity- and asset-side valuations of banks. The reason we decided to
apply only the AMM for the asset-side methods is because the others
we introduced in Chap. 2 do not take into account growth, or assess the
goodwill using a discretionary methodology.
In the application of these valuation methods, we also proposed the
usage of three different measures of cost of capital that are related to the
level of the investors portfolio diversification. Specifically, we run the

The Editor(s) (if applicable) and The Author(s) 2016 175


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
in Banking and Financial Institutions, DOI10.1057/978-1-137-56142-8_7
176 Valuing Banks

valuation using the CAPM for the full diversification hypothesis; while
for the under-diversification hypothesis, we used the CAPM with Total
Beta and the CaRM (see Chap. 5 for details).
In addition, we run a valuation using the basic multiples the litera-
ture has stressed as being those more frequently applied in practice (PBV,
PTBV, PE), and we added those we discussed in Chap. 6, which adopt
an asset-side approach and are derived from the AMM (Enterprise Value
on Operating Profit and PBV unlevered).
The data we used in the simulation both for the target bank and for
comparable banks are taken from real data (market stock prices and
financial statements), although we chose not to show the identity of the
bank. We made this decision because our aim is to focus the attention of
the reader on the process of valuation. The valuation and correlated data
are from 31 December 2014.
Finally, we discuss all the results obtained, highlighting the differences
in the approaches used, and the pros and cons of the asset-side model we
have presented in this book.

7.2 A
 BC Bank: Financial Statements
andBusiness Plan
ABC Bank is a European publicly listed commercial bank. The Bank closed
the fiscal year 2014 reporting the balance sheet presented in Table 7.1 and
the income statement presented in Table 7.2. The Bank is a traditional
commercial bank with more than 70 % of its assets comprising loans and
55 % being for funded by deposits. More than 60 % of the operating
income comes from the net interest margin and almost 30 % from fees and
commissions. The asset quality is one of the most relevant issues the Bank
must manage in future years.
In addition, ABC Bank has recently published its 20152019 business
plan in which the management has set the economic and financial objec-
tives the bank aims to reach within the next five years. In particular, the
Banks business plan showed ambitious targets mainly due to:
7 A Comparison between Valuation Metrics ina Real Case 177

Table 7.1 ABC Banks balance sheet (data in 000s)


Asset 2014
Cash and cash balances 398,410
Financial assets held for trading 913,272
Financial assets at fair value through profit and loss 97,444
Financial assets available for sale 6,138,287
Held to maturity investments 1,956,404
Loans and receivables with banks 1,510,766
Loans and receivables with customers 38,818,495
Hedging derivatives 32,476
Changes in fair value of portfolio hedged items (+/)
Investments in associates and joint ventures 227,733
Insurance reserves attributable to reinsurers
Property, plant and equipment 909,423
Intangible assets 440,166
of which goodwill 336,231
Tax assets 1,203,207
(a) current tax assets 160,851
(b) deferred tax assets 1,042,356
Non-current assets and disposal groups classified 2,490
as held for sale
Other assets 959,627
Total assets 53,608,201

Liabilities and equity 2014


Deposit from banks 5,726,970
Deposit from customers 30,019,376
Debt securities in issue 9,296,586
Financial liabilities held for trading 214,962
Financial liabilities at fair value through profit and loss 1,503,091
Hedging derivatives 11,478
Changes in fair value of portfolio hedged items (+/)
Tax liabilities 104,996
Liabilities included in disposal groups classified as held for sale
Other liabilities 1,350,006
Provisions for employee severance pay 196,144
Technical reserves
Provisions for risks and charges 314,452
Revaluation reserves 186,840
Reserves and Share Premium 3,231,837
Issued capital 1,443,925
Treasury shares 7,259
Net profit (loss) for the year (+/) 14,797
Total liabilities and shareholder equity 53,608,201
Source: Authors elaboration on ABC Bank data.
178 Valuing Banks

Table 7.2. ABC Banks income statement (data in 000s)


Income statement 2014
Interest income and similar revenues 948,153
Interest expenses and similar charges 306,304
Net interest margin 641,849
Fees and commission income 367,239
Fees and commission expenses 24,075
Net fees and commissions 343,164
Dividend income and similar revenues 9,635
Gain and losses on financial assets and liabilities held for trading 8,215
Fair value adjustments in hedge accounting 534
Gain (losses) on disposal and repurchase of: 81,634
(a) Loans 14,885
(b) Available for sale 96,662
(c) Held to maturity investments
(d) Financial liabilities 143
Gain and losses on financial assets/liabilities at fair value 7,076
through profit and loss
Operating income 1,077,954
Net loss/recoveries on impairment: 426,415
(a) Loans 403,815
(b) Available for sale 20,047
(c) Held to maturity investments
(d) Other financial assets 2,553
Net profit from financial activities 651,539
Premiums earned (net)
Other income (net) from insurance activities
Net profit from financial and insurance activities 651,539
Administrative costs 654,105
Net provision for risk charges 19,269
Impairment/write-backs on property, plant and equipment 21,745
Impairment/write-backs on intangible assets 13,227
Other net operating income/cost 86,090
Operating costs 622,256
Profit (loss) of associates 416
Gain and losses on tangible and intangible assets measured
at fair value
Impairment of goodwill
Gain and losses on disposal of investments 33
Total profit (loss) before tax from continuing operations 28,900
Tax expense (income) related to profit or loss from 14,103
continuing operations
Total profit or loss after tax from continuing operations 14,797
Profit (loss) after tax from discontinued operations
Net profit (loss) of the year 14,797
Source: Authors elaboration on ABC Bank data.
7 A Comparison between Valuation Metrics ina Real Case 179

a general economic recovery that will improve the growth perspectives


of the economy. Consequently, a considerable improvement of returns
from credit intermediation activity is expected. In particular, ABC
Bank foresees an increase in its loans to customers of 2.4 % for the
period 20152017, and 1.5 % in 2018 and 2019, while credit losses
are expected to decrease by 22 % from 2015 to 2017, and by 5 % in
2018 and 2019.
a relevant increase of net fee and commissions due to the development
of the private banking project that will increase assets under manage-
ment. In addition, the Bank has the aim of increasing the operating
revenues for higher value added services (i.e. factoring, consumer credit).
a remarkable reduction of the number of branches in order to squeeze
the operating costs and a global reorganization of the internal struc-
ture. This will affect the operating profit in the next five years by reduc-
ing administrative costs by 80 million.

In addition, ABC Bank foresees the RWA, Tier 1 and payout targets
presented in Table 7.3.
On the whole, the Bank foresees slow but progressive improvement
of the economy and the management has therefore decided to develop
moderate growth on the lending side. In particular, the Bank will be
more focused on the enhancement of the outstanding loans and on the
recovery of non-performing loans. Conversely, in the next five years,
ABC Bank will concentrate its efforts on asset management services,
trying to improve the capability of cross-selling and up-selling to clients.
Consistently with the managements targets, we tried to develop the
balance sheet (Table 7.4) and income statement (Table 7.5) projections
in accordance with the Banks business plan.

Table 7.3. ABC Banks Tier 1 and payouts

2014 2015 2016 2017 2018 2019


RWA ( 000s) 40,691,550 41,379,701 42,079,491 42,791,114 43,514,772 44,250,668
CET 1 11.30% 11.53% 11.76% 12.00% 12.24% 12.49%
Tier 1 Capital 4,598,145 4,770,531 4,949,380 5,134,934 5,327,444 5,527,172
( 000s)
Payout 0% 15% 25% 35% 40% 40%
Source: Authors elaboration on ABC Bank business plan.
180

Table 7.4. ABC Banks balance sheet projections (data in 000s)


Asset 2015 2016 2017 2018 2019
Cash and cash balances 398,809 399,208 399,607 400,006 400,406
Financial assets held for trading 914,185 915,099 916,014 916,930 917,847
Financial assets at fair value 97,541 97,639 97,736 97,834 97,932
through profit and loss
Valuing Banks

Financial assets available for sale 6,144,426 6,150,570 6,156,721 6,162,877 6,169,040
Held to maturity investments 1,958,360 1,960,318 1,962,279 1,964,241 1,966,205
Loans and receivables with banks 1,512,277 1,513,789 1,515,303 1,516,818 1,518,335
Loans and receivables with customers 39,750,139 40,704,143 41,681,042 42,306,258 42,940,852
Hedging derivatives 32,509 32,541 32,574 32,606 32,639
Changes in fair value of portfolio
hedged items (+/)
Investments in associates and joint 227,961 228,189 228,417 228,646 228,874
ventures
Insurance reserves attributable to
reinsurers
Property, plant and equipment 910,332 911,242 912,154 913,066 913,979
Intangible assets 440,606 441,047 441,488 441,930 442,371
of which goodwill 380,416 380,416 380,416 380,416 380,416
Tax assets 1,204,410 1,205,615 1,206,820 1,208,027 1,209,235
1. Current tax assets 161,012 161,173 161,334 161,496 161,657
2. Deferred tax assets 1,043,398 1,044,442 1,045,486 1,046,531 1,047,578
Non-current assets and disposal 2,492 2,495 2,497 2,500 2,502
groups classified as held for sale
Other assets 969,223 978,916 988,705 998,592 1,008,578
Total assets 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797
Liabilities and equity 2015 2016 2017 2018 2019
Deposits from banks 5,795,694 5,865,242 5,935,625 5,994,981 6,054,931
Deposits from customers 30,379,609 30,744,164 31,113,094 31,424,225 31,738,467
Debt securities in issue 9,580,294 9,893,603 10,095,183 10,338,708 10,403,621
Financial liabilities held for trading 221,410 228,053 232,614 200,048 210,050
Financial liabilities at fair value 1,504,594 1,506,099 1,507,605 1,509,112 1,510,621
through profit and loss
Hedging derivatives 11,707 11,941 12,180 12,424 12,672
Changes in fair value of portfolio
hedged items (+/)
Tax liabilities 107,096 109,238 111,423 113,651 115,924
Liabilities included in disposal groups
classified as held for sale
Other liabilities 1,359,320 1,382,845 1,433,338 1,318,977 1,159,752
Provisions for employee severance pay 196,340 196,536 196,733 196,929 197,126
Technical reserves
Provisions for risks and charges 314,767 315,082 315,397 315,712 316,028
Revaluation reserves 187,027 187,214 187,401 187,588 187,776
Reserves and Share Premium 3,235,069 3,238,304 3,241,542 3,244,784 3,248,029
Issued capital 1,539,812 1,629,757 1,836,774 1,969,859 2,289,393
Treasury shares 7,246 7,233 7,220 7,207 7,194
Net profit (loss) for the year (+/) 137,779 239,966 329,669 370,540 411,599
Total liabilities and shareholder equity 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797
Source: Authors elaboration on ABC Bank business plan.
7 A Comparison between Valuation Metrics ina Real Case
181
Table 7.5. ABCs income statement projections (data in 000s)
182

Income statement 2015 2016 2017 2018 2019


Interest income and similar 1,005,042 1,065,344 1,129,265 1,185,728 1,245,015
revenues
Interest expenses and similar 364,806 416,691 473,765 520,866 571,177
charges
Net interest margin 640,236 648,653 655,500 664,862 673,837
Fees and commission income 422,325 473,004 529,764 556,252 584,065
Fees and commission expense 24,798 25,542 26,308 27,097 27,910
Valuing Banks

Net fees and commissions 397,527 447,462 503,456 529,155 556,155


Dividend income and similar 10,599 11,658 12,824 14,107 15,517
revenues
Gain and losses on financial assets 9,036 9,940 10,934 12,027 13,230
and liabilities held for trading
Fair value adjustments in hedge 587 646 710 781 859
accounting
Gain (losses) on disposal and 86,339 88,520 89,450 89,922 90,376
repurchase of:
(a) Loans 10,420 8,336 7,502 7,127 6,771
(b) Available for sale 96,759 96,856 96,952 97,049 97,146
(c) Held to maturity investments
(d) Financial liabilities
Gain and losses on financial 7,083 7,090 7,097 7,104 7,111
assets/liabilities at fair value through
profit and loss
Operating income 1,137,241 1,199,789 1,265,778 1,303,751 1,342,864
Net loss/recoveries on impairment: 337,598 268,326 214,299 204,740 195,660
(a) Loans 314,976 245,681 191,631 182,050 172,947
(b) Available for sale 20,067 20,087 20,107 20,127 20,147
(c) Held to maturity investments
(d) Other financial assets 2,555 2,558 2,561 2,563 2,566
Net profit from financial activities 799,643 931,463 1,051,479 1,099,011 1,147,203
Premiums earned (net)
Other income (net) from insurance
activities
Net profit from financial and insurance 799,643 931,463 1,051,479 1,099,011 1,147,203
activities
Administrative costs 627,941 609,102 596,920 584,982 573,282
Net provision for risk charges 17,342 15,608 14,047 12,643 11,378
Impairment/write-backs on property, 21,723 21,702 21,680 21,658 21,637
plant and equipment
Impairment/write-backs on intangible 13,214 13,200 13,187 13,174 13,161
assets
Other net operating inc ome/cost 86,176 86,262 86,349 86,435 86,521
Operating costs 594,044 573,350 559,486 546,022 532,937
Profit (loss) of associates 42 46 50 55 61
Gain and losses on tangible nd intangible
assets measured at fair
value
Impairment of goodwill
Gain and losses on disposal
of investments
Total profit (loss) before tax from 205,640 358,159 492,043 553,044 614,327
continuing operations
7 A Comparison between Valuation Metrics ina Real Case

Tax expense (income) related to 67,861 118,192 162,374 182,505 202,728


profit or loss from continuing
operations

(Continued)
183
184
Valuing Banks

Table 7.5.(continued)
Income statement 2015 2016 2017 2018 2019
Total profit or loss after tax from 137,779 239,966 329,669 370,540 411,599
continuing operations
Profit (loss) after tax from
discontinued operations
Net profit (loss) of the year 137,779 239,966 329,669 370,540 411,599
Source: Authors elaboration on ABC Bank business plan.
7 A Comparison between Valuation Metrics ina Real Case 185

7.3 M
 easuring theCost ofCapital
ofABCBank
In this section, we show how to measure the cost of capital of ABC
Bank according to the following methodologies: the CaRM, CAPM and
CAPM with Total Beta. This in order to assess what the differences may be
in terms of value when investors are perfectly diversified or undiversified.

7.3.1 The CaRM

As we pointed out in Chap. 5, unlike with the CAPM, the cost of capital
quantification by the CaRM works in an asset-side approach exploiting
the assets value, asset standard deviation and market value of debt. These
data are calculated from the market capitalization, equity standard devia-
tion, face value of debt and risk-free rate.
ABC Bank is listed on the Gamma market. Considering the stock
prices from 1 January 2014 to 31 December 2014 and using a logarith-
mic return, we calculated a daily equity standard deviation of 0.031988.
There were 252 trading days for ABC in 2014 and, therefore, the annual
equity standard deviation was:

s E = 0.031988 252 = 0.5078

The market capitalization (E) and face value of debt (D) for 2014 are, respec-
tively 2,627.861 million and 46,772.463 million. Using a risk-free rate of
3.00 % that we calculated as the mean of the 10-year bonds issued in the last
month by the Zeta State, we exploited the Merton model for t=1 to obtain
the assets value for ABC, its standard deviation and the market value of debt:

E = V N ( d1 ) De r N ( d2 ) ,

( 1) 2, 627.861519 = V N d 48,175.63689 e 3% N ( d2 ) ,

where D is comprehensive of interests at the risk-free rate of 3 %.
According to the Merton model:
V
s E = sV N ( d1 )
E
186 Valuing Banks

V
0.5078 = s V N ( d1 ) ,
2, 627.861519
where:

V s
2
ln + r + V
D 2
d1 =
sV

V s V2
ln +
3% +
48,175.63689 2
d1 =
sV

d 2 = d1 - s V

From this equation, the bank firm value is equal to 49,367.321 mil-
lion. Asset standard deviation is 0.027691 and the market value of debt
is 46,739.459 million, which is similar to its nominal value.
The next step is to determine the proportion of CaR in the assets.
Assuming that asset distribution is lognormal and the distribution of
asset returns is normal, the average from returns distribution is:

s V2 0.0276912
r
f - + ln (V 0 ) = 3% - + ln ( 49,367.32144 ) = 10.836661.
2 2

Using an interval of confidence of 1 %, we showed the calculation of
the minimum reference of asset value at time 1:

,1 = f
Valow -1
(a ) = exp m + s N -1 (a ) = exp 10.836661+ 0.027691 N -1 (1% ) = 47,678.79596
At time 0, the minimum reference is:

Valow
, 0 = 47, 678.79596 e
-3%
= 46, 269.67459.

Consequently, the CaR proportion of assets is:

CaR V - V0low 49, 367.32144 - 46, 269.67459


= = = 6.27%.
V V 49, 367.32144
7 A Comparison between Valuation Metrics ina Real Case 187

Considering a face value of debt equal to the banks firm value (i.e.
the CaRM unlevered approach), d1, market value of debt (DMK) and
expected loss rate (ELR) are:

s V2 0.027691
2

r + 3% +
2 2 = 1.09724
d1, 2 = =
sV T 0.027691

DMK = V - V N ( d1 ) - Ve N ( d 2 )-r

= 49, 367.32144 - 49,367.32144 N (1.09724 )


- 49,367.32144 e -3% N (1.09724 ) = 47 , 812.81949

DMK 47, 812.81949


ELRUnleverd = 1 rf T
=1 = 0.20%
Ve 49, 367.32144 e 3%
Therefore, ABCs WACC is:
ELRUL CaRV,% 0.20% 6.27%
WACC = rf + ln 1+ = 3%+ln 1+ = 3.013%

1 - ELRUL 1 - 0.20%


According to the Merton Model the cost of debt depends on the fol-
lowing probability of default:

PD = N ( d2 ) = N ( 1.9519763) = 2.547%

Hence, the expected loss rate is:
DMK 46, 739.45992
ELR = 1 rf
=1 = 0.03%
De 48,175.63689 e 3%

And the CaR proportion of debt-holders is:

CaR D V0low 48,175.63689 46, 269.67459


= = = 3.96%
D D 48,175.63689
188 Valuing Banks

Thus, the cost of debt is as follows:

ELRD CaRD,% 0.03% 3.96%


rD = rf + ln 1 + = 3% + ln 1 + = 3.00%
1 ELRD 1 0.03%

Exploiting the WACC equation in the reduced version using the risk-
free both for short-term (including deposits) debt and long-term debt,
we obtained the cost of equity as:
E D
WACC = rE + rf (1 tc ) ,
V V

where:
D V
rE = WACC - rf (1 - t c )
V E
46,739.45992 49,367.32144
= 3.013% - 3.001% (1 - 33% ) = 20.83%
49,367.32144 2,627.861519

With regard to the effective cost of liabilities, we inverted the sec-


ond ModiglianiMiller proposition for banks in the presence of taxes to
obtain the cost of assets for an unlevered bank:
iD,Average D
( )
rE = rA + rA rf (1 tc )
rf E
,

where:
Interests expenses 306.304
iD,Average = = = 0.6549%
Total face financial debt 46, 772, 463
and rA is:

rA =
(
rE + rf (1 - t c ) iD,Average / rf ) (D / E )
(
1+ (1 - t c ) iD,Average / rf ) (D / E )
20.83%+ 3% (1 - 33% )(0.6549% / 3% ) ( 46,,739.45992 / 2,,627.861519 )
=
1+ (1 - 33% )(0.6549% / 3% )( 46,,739.45992 / 2,,627.861519 )
= 7.95%.

7 A Comparison between Valuation Metrics ina Real Case 189

7.3.2 The CAPM

As is common knowledge, the CAPM, in the original version, is based on


the following three parameters:

Risk-free rate;
Market risk premium;
Beta coefficient.

In the case of the ABC Bank valuation, as previously noted, we used a


risk-free rate of 3 % and a market risk premium of 8.8 % comprising the
5 % of historical market risk premium combined with the 3.8 % of ABC
country risk, adjusted for equity market volatility.
The beta coefficient is calculated as follows:
COV ( rABC ; rm ) 0.0000838
bE = = = 1.61
VAR ( rm ) 0.0000521

The cost of equity of ABC Bank is:
rE = rf + bE MRP = 3%+1.61 8.8% = 17.16%

The asset beta is obtained using the modified Hamada formula, which
considers the deposits benefit effect. The equation needs the market
value of debt, the market value of equity, risk-free rate, returns on debt
and tax rate. As we explained in the previous section, the cost of debt
is equal to the risk-free rate; consequently, we can consider ABCs debt
equal to zero.
bE
bA =
(
1+ ( D / E ) iD,Average / rf ) (1 - t )
c

1.61
= = 0.45
1+ ( 46,739.45992 / 2,627.861519 ) (0.6549% / 3% )(1 - 33% )

Therefore, the cost of assets is:
rA = rf + b A MRP = 3%+0.45 8.8% = 6.96%

190 Valuing Banks

7.3.3 The CAPM with Total Beta

For the under-diversification approach, we used the daily equity standard


deviation of 0.031988. Then, we corrected the beta coefficient as follows:
s ABC s m 0.031988 0.0072152
b E ,Total = = = 4.43
VAR ( rm ) 0.0000521

The cost of equity of ABC Bank, considering the total risk approach is:
rE = rf + b E,Total MRP = 3%+ 4.43 8.8% = 41.98%

ABCs beta assets with the total beta is equal to:
bE
bA =
(
1+ ( D / E ) iD,Average / rf ) (1 - t ) c

4.43
= = 1.23
1+ ( 46,739.45992 / 2,627.861519 ) (0.6549% / 3% ) / (1 - 33% )

and thus, the expected returns on asset is:
rA = rf + b A MRP = 3%+1.23 8.8% = 13.82%

7.4 V
 aluing ABC Bank: TheApplication
oftheAMM
In this section, we show how to run the valuation of ABC Bank apply-
ing the AMM.We briefly recall the valuation formula. For the period
of explicit forecast, the value of a bank is given by equation (3.39):

Vexplicit =
n
FCFAt
+
(
DD , Dept rf iD, Dep )+ D
D , Dept iD, Dep tc
(1 + rA ) (1 + r ) (1 + r )
t t t
t =1
f f

+
(D D )
,NonDepn rD, NonDep tc / rD, NonDep g

(1 + r )
t

D , NonDep

7 A Comparison between Valuation Metrics ina Real Case 191

and for the long-term growth, the Terminal Value will be equal, as in
equation (3.40):

(
AT Opn (1+ g ) - ( A g ) / rA - g DD ,Depn rf - iD,Dep / rf - g
TV = +
) ( )
(1+ rA ) ( )
n n
1+ rf

+
(
DD ,Depn iD,Dep t c / rf - g ) + (D
D )
,NonDepn rD,NonDep t c / rD,NonDep - g
,

( ) ( )
n n
1+ rf 1+ rD,NonDep

where the value of equity in time 0 can be found by netting from the
banks firm value the value of debt (other debt plus deposits) in time 0.
Bank Equity = Bank firm value Deposits ( nominal ) Other debts.

7.4.1 B
 alance Sheet Reclassification andIncome
Statement Adjustments

In Tables 7.67.8, we exhibit the balance sheet reclassification and income


statement adjustments to the business plan projections of ABC Bank,
according to the valuation framework we discussed in this chapter 4.

7.4.2 FCFA, Mark-Down andTax Benefits

According to the valuation process described in Chap. 4, the objective


of this section is to calculate the free cash flow from assets of ABC Bank.
In particular, as one can note in Table 7.9, the FCFA of ABC Bank
is negative for all years of the forecast. Basically, this is due to a double
effect: on one hand, the current low profitability of assets which is going
to be improved during the explicit forecast; on the other hand, the invest-
ments made by the Bank as a function of the forecast recovery of the
economy in future years. As a result, the current and expected low level
of operating profits is not sufficient to cover back expected investments.
However, according to the business plan, ABC Bank intends to make
a significant increase in its assets in the first three years (20152017)
Table 7.6. Balance sheet reclassification: asset and liabilities (data in 000s)
192

Asset 2014 2015 2016 2017 2018 2019


Cash and cash 398,410 398,809 399,208 399,607 400,006 400,406
balances
Loans and receivables 1,510,766 1,512,277 1,513,789 1,515,303 1,516,818 1,518,335
with banks
Loans and receivables 38,818,495 39,750,139 40,704,143 41,681,042 42,306,258 42,940,852
with customers
Financial assets 9,365,616 9,374,982 9,384,357 9,393,741 9,403,135 9,412,538
Valuing Banks

Tangible and 1,349,589 1,350,938 1,352,289 1,353,642 1,354,995 1,356,350


intangible assets
Tax asset 1,203,207 1,204,410 1,205,615 1,206,820 1,208,027 1,209,235
Other assets 962,117 971,716 981,411 991,202 1,001,092 1,011,080
Total assets 53,608,201 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797

Liabilities 2014 2015 2016 2017 2018 2019


Deposits from banks 35,746,346 36,175,302 36,609,406 37,048,719 37,419,206 37,793,398
and customers
Debt securities in 9,296,586 9,580,294 9,893,603 10,095,183 10,338,708 10,403,621
issue
Financial liabilities 1,729,530 1,737,712 1,746,093 1,752,399 1,721,584 1,733,344
Provisions for 196,144 196,340 196,536 196,733 196,929 197,126
employees
Tax liabilities 104,996 107,096 109,238 111,423 113,651 115,924
Other liabilities 1,664,458 1,674,086 1,697,927 1,748,735 1,634,689 1,475,780
Equity 4,870,140 5,092,441 5,288,008 5,588,166 5,765,564 6,129,603
Total liabilities and 53,608,201 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797
equity
Source: Authors elaboration.
Table 7.7. Balance sheet reclassification: bearing asset and liabilities (data in 000s)
Asset 2014 2015 2016 2017 2018 2019
Cash and cash balances 398,410 398,809 399,208 399,607 400,006 400,406
Loans and receivables 1,510,766 1,512,277 1,513,789 1,515,303 1,516,818 1,518,335
with banks
Loans and receivables 38,818,495 39,750,139 40,704,143 41,681,042 42,306,258 42,940,852
with customers
Financial assets 9,365,616 9,374,982 9,384,357 9,393,741 9,403,135 9,412,538
Bearing assets 50,093,288 51,036,207 52,001,496 52,989,693 53,626,217 54,272,131
Tangible and intangible 1,349,589 1,350,938 1,352,289 1,353,642 1,354,995 1,356,350
assets
Other assets 2,165,324 2,176,126 2,187,025 2,198,023 2,209,119 2,220,315
Non-bearing assets 3,514,913 3,527,065 3,539,315 3,551,664 3,564,114 3,576,666
Total assets 53,608,201 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797

Liabilities and equity 2014 2015 2016 2017 2018 2019


Deposits 35,746,346 36,175,302 36,609,406 37,048,719 37,419,206 37,793,398
Debt securities in issue 9,296,586 9,580,294 9,893,603 10,095,183 10,338,708 10,403,621
Financial liabilities 1,729,530 1,737,712 1,746,093 1,752,399 1,721,584 1,733,344
Bearing liabilities 46,772,463 47,493,308 48,249,102 48,896,301 49,479,498 49,930,364
Other liabilities 1,965,598 1,977,522 2,003,701 2,056,891 1,945,269 1,788,831
Non-bearing liabilities 1,965,598 1,977,522 2,003,701 2,056,891 1,945,269 1,788,831
7 A Comparison between Valuation Metrics ina Real Case

Equity 4,870,140 5,092,441 5,288,008 5,588,166 5,765,564 6,129,603


Total liabilities and equity 53,608,201 54,563,272 55,540,811 56,541,357 57,190,332 57,848,797
Source: Authors elaboration.
193
Table 7.8. Income statement adjustments (data in 000s)
194

Adjusted income statement 2014 2015 2016 2017 2018 2019


Interest income and similar 948,153 1,005,042 1,065,344 1,129,265 1,185,728 1,245,015
revenues
Fees and commission income 367,239 422,325 473,004 529,764 556,252 584,065
Fees and commission expense 24,075 24,798 25,542 26,308 27,097 27,910
Interests and net services 1,291,316 1,402,569 1,512,807 1,632,722 1,714,884 1,801,170
income
Valuing Banks

Dividend income and similar 9,635 10,599 11,658 12,824 14,107 15,517
revenues
Net profit (loss) from financial 83,306 88,879 92,015 93,997 95,626 97,354
operations
Profit and loss from associates 416 42 46 50 55 61
Operating income from 1,383,842 1,502,089 1,616,526 1,739,593 1,824,672 1,914,102
financial activities
Net losses/recoveries on 426,415 337,598 268,326 214,299 204,740 195,660
impairment of financial
activities
Adjusted operating income 957,427 1,164,490 1,348,200 1,525,294 1,619,932 1,718,442
from financial activities
Net premiums and incomes
from insurance activities

Adjusted operating income 957,427 1,164,490 1,348,200 1,525,294 1,619,932 1,718,442


from core activities
Administrative costs 654,105 627,941 609,102 596,920 584,982 573,282
Net provision for risk charges 19,269 17,342 15,608 14,047 12,643 11,378
Gain and losses of fair value on
tangible and intangible assets
Other net operating income/ 86,090 86,176 86,262 86,349 86,435 86,521
cost
Operating costs 587,284 559,107 538,448 524,619 511,190 498,139
Gross operating income 370,143 605,383 809,752 1,000,675 1,108,743 1,220,302
Impairment/write-backs on 34,972 34,937 34,902 34,867 34,832 34,798
tangible and intangible
assets
Operating profit 335,171 570,446 774,850 965,808 1073,910 1185,505
Financial expenses (Interest 306,304 364,806 416,691 473,765 520,866 571,177
expenses and similar charges)
Gain (losses) on disposal and
repurchase of held
tomaturity
Impairment of goodwill
Gain and losses on disposal of 33
investments
Profit (loss) after tax from
discontinued operations
Other non-recurrent costs
Non-recurrent profit (loss) 33
Total profit (loss) beforetaxes 28,900 205,640 358,159 492,043 553,044 614,327
7 A Comparison between Valuation Metrics ina Real Case

Tax expenses 14,103 67,861 118,192 162,374 182,505 202,728


Net profit for the year 14,797 137,779 239,966 329,669 370,540 411,599
Source: Authors elaboration.
195
196

Table 7.9. Free cash flow from assets (data in 000s)


ABCs free cash flow from assets 2015 2016 2017 2018 2019
Operating profit 570,446 774,850 965,808 1073,910 1185,505
Operating taxes
Effective taxes+(Marginal tax 188,247 255,700 318,717 354,390 391,217
Valuing Banks

rateInterest expenses and similar


charges)
After-taxes Operating profit 382,199 519,149 647,091 719,520 794,288
Cash ineffective transactions
Impairment/write-backs on tangible and 34,937 34,902 34,867 34,832 34,798
intangible assets
Net working capital
Cash and cash balances 398 399 399 400 400
Loans and receivables with banks 1,511 1,512 1,514 1,515 1,517
Loans and receivables with customers 931,644 954,003 976,899 625,216 634,594
Financial assets 9,366 9,375 9,384 9,394 9,403
Other assets 10,802 10,899 10,997 11,096 11,196
Other liabilities 11,924 26,179 53,189 111,621 156,439
Cash flow from financial activities 524,661 395,958 264,046 4,890 15,536
Tangible and Intangible assets
Net Tangible and Intangible assets 36,287 36,253 36,219 36,186 36,153
Free Cash Flow from Assets (FCFA) 560,947 432,211 300,266 41,076 20,616
Source: Authors elaboration.
7 A Comparison between Valuation Metrics ina Real Case 197

while, in 2018 and 2019, the pace of growth becomes lower and more
steady. Owing to the combined effect of the increasing operating profits
and the stabilization of asset growth, the Cash flow from financial activities
becomes positive in 2019 ( 15.536 million). This suggests that, in the
long term, FCFA might be expected as a positive cash flow.
In particular, to determine the long-term FCFA, we assumed that the
FCFA will grow at the same pace as assets growth and, therefore, the ter-
minal value cash flow is determined by the After taxes operating profit mul-
tiplied by the growth rate (which we fixed at 1 % close to the GDP growth
rate of the country) and netted for the assets reinvestment (i.e. total assets
less other liabilities). Therefore, the FCFAlt is equal to:

FCFA t = 794,288 (1 + 1% ) - ( 57, 848.797 - 1, 788.831) 1% = 223, 743



Therefore, the series of the FCFA for the explicit period and for the
long term are as presented in Table 7.10.
The second source of value creation is the mark-down benefit the Bank
receives from deposits. Its cash flow is measured by the amount of Deposits
for the year (as in the balance sheet reclassification, see Table 7.7), multi-
plied by the difference between the risk-free (which we fixed at 3 %) and
the effective cost of deposits of the year (Table 7.11).
The amount of the cost of deposits has been determined by subtract-
ing from the total Interest expenses for the year the amount due to non-
deposit debt. In particular, multiplying the cost of debt resulting from the
Merton model estimation (3 %) for the outstanding non-deposit debt, it
may be possible to obtain a proxy of the cost of non-deposit debt.1 The
cost of deposits in the long term is expected to grow as the average of the
previous five years (Table 7.12).
For tax benefits on deposits, they are determined by multiplying the
Deposits for the year for their effective cost, and multiplied again for the
tax rate (which is fixed at 33 %) (Table 7.13).
Conversely, the tax benefits on non-deposit debt are measured as the out-
standing Bearing liabilities other than deposits, multiplied by the expected
1
There can be other solutions for determining the cost of non-deposit debt, such as rating bench-
marks. In addition, from the perspective of an internal valuation, the effective amount of non-
deposit debt can be easily drawn. In this case, we used the Merton model estimation for internal
consistency of the valuation process we adopted.
198 Valuing Banks

Table 7.10. FCFA of ABC Bank (data in 000s)


2015 2016 2017 2018 19 LT
FCFA 560,947 432,211 300,266 41,076 20,616 223,743
Source: Authors elaboration.

Table 7.11. ABCs mark-down (data in 000s)


2015 2016 2017 2018 2019 LT
Mark-down 1,059,993 1,030,782 993,124 963,519 926,734 880,586
Source: Authors elaboration.

Table 7.12. ABCs Cost of deposits


2015 2016 2017 2018 2019 LT
Cost of deposits 0.07% 0.18% 0.32% 0.43% 0.55% 0.67%
Source: Authors elaboration.

Table 7.13. ABCs tax benefits on deposits (data in 000s)


2015 2016 2017 2018 2019 LT
Tax benefits on deposits 8,338 22,275 39,051 52,489 68,333 83,561
Source: Authors elaboration.

Table 7.14. ABCs tax benefits on non-deposit debt (data in 000s)


2015 2016 2017 2018 2019 LT
Tax benefits on 112,048 115,233 117,291 119,397 120,156 160,208
non-deposits
Source: authors elaboration.

effective cost (which is kept fixed at 3% %) and tax rate (Table 7.14). In the
long-term, the cost of non-deposit debt is expected at 4 % due to a forecast
increase in policy rates.

7.4.3 The ABC Bank Value using theAMM

The AMM value is composed of the algebraic sum of the discounted cash
flow from assets, mark-down, tax benefits netted for the outstanding debt.
At this point, since we calculated all the required data, we have merely
to discount back, at time 0, the FCFA, mark-down and tax benefits.
We reported the results of AMM for all three measures of cost of capital
we have already calculated in section 7.3: CAPM, Total beta CAPM and
7 A Comparison between Valuation Metrics ina Real Case 199

CaRM (Table 7.15). As a matter of fact, the three configuration of cost


of capital affect the present and long-term value of FCFA.
As one can note, in the explicit forecast the present value of FCFA
is negative because of the sign of the expected cash flow from assets.
Conversely, the value of mark-down ( 4,565,062) and tax benefits on
deposits ( 170,409) and non-deposits debt ( 534,471) is positive and
they are reported in Tables 7.167.18.
Table 7.15. Value of FCFA in the explicit forecast for ABC Bank (data in 000s)
2015 2016 2017 2018 2019
FCFA 560,947 432,211 300,266 41,076 20,616
Cost of capital (rA)
Full diversification
CAPM 6.96 % 6.96 % 6.96 % 6.96 % 6.96 %
Under-diversification
CAPM Total Beta 13.82 % 13.82 % 13.82 % 13.82 % 13.82 %
CaRM 7.95 % 7.95 % 7.95 % 7.95 % 7.95 %
Discounted FCFA(data
in 000s)
Full diversification
CAPM 524,446 377,793 245,381 31,383 14,726
Under-diversification
CAPM Total Beta 492,837 333,625 203,634 24,474 10,792
CaRM 519,636 370,895 238,692 30,248 14,063
Value of FCFA(data in
000s)
Full diversification
CAPM 1,193,729
Under-diversification
CAPM Total Beta 1,065,363
CaRM 1,173,534
Source: Authors elaboration.

Table 7.16. Mark-down value in the explicit forecast for ABC Bank
2015 2016 2017 2018 2019
Mark-down 1,059,993 1,030,782 993,124 963,519 926,734
Discount factor: 3.00 % 3.00 % 3.00 % 3.00 % 3.00 %
risk-free
Discounted mark-down 1,029,120 971,611 908,849 856,074 799,408
Value of mark-down 4,565,062
Source: Authors elaboration.
200 Valuing Banks

Table 7.17. Value of tax benefits on deposits in the explicit forecast for ABC Bank
2015 2016 2017 2018 2019 LT
Tax benefits on 8,338 22,275 39,051 52,489 68,333 83,561
deposits
Discount factor: 3.00 % 3.00 % 3.00 % 3.00 % 3.00 %
risk-free
Discounted tax 8,095 20,996 35,738 46,636 58,944
benefits deposits
Value of tax 170,409
benefits deposits
Source: Authors elaboration.

Table 7.18. Value of tax benefits on non-deposits debt in the explicit forecast for
ABC Bank
2015 2016 2017 2018 2019 LT
Tax benefits on 112,048 115,233 117,291 119,397 120,156 160,208
non-deposits
Discount factor: 3.00 % 3.00 % 3.00 % 3.00 % 3.00 %
Effective debt
rate
Discounted tax 108,785 108,618 107,338 106,083 103,648
benefits non
deposits
Value of tax 534,471
benefits non
deposits
Source: Authors elaboration.

Table 7.19.Value FCFA Lt


oflong-term FCFA,
mark-down and tax Full diversification
benefits for ABC Bank CAPM 2,681,615
Under-diversification
CAPM Total Beta 913,627
CaRM 2,196,098
Mark-down Lt 33,760,061
Tax Benefits on deposits Lt 3,203,583
Tax Benefits on non-deposits Lt 5,025,337
Source: Authors elaboration.

With regard to the AMM long-term value, the FCFA, mark-down and
tax benefits are as presented in Table 7.19. Specifically, they are deter-
mined assuming a growth rate of deposits equal to 0.75 %, and 1.25 %
7 A Comparison between Valuation Metrics ina Real Case 201

for non-deposit debt. Such a difference in growth rates is due to a Bank


strategy which aims at increasing the long-term funding in comparison
with short-term funding.
Summing the explicit forecast values with those of the long-term
growth, we get the enterprise value of ABC Bank, from which, by sub-
tracting the value of debt measured by the Merton model ( 46,739,459),
we get an equity value of:

2,007,351in the event that investors are fully diversified (CAPM);


367,729in the event that investors are under-diversified and we use
the CAPM Total Beta;
1,542,029in the event that investors are under-diversified and we
use the CaRM.

In Figs (7.17.6), we show the breakdown of ABC Banks firm value


in relation to the explicit forecast/terminal value, and the respective value
sources. To achieve this, we divide the figures considering the three dif-
ferent measures of cost of capital we have employed.
As one can note, valuing the Bank by using the AMM, firm value
comes mainly from the terminal value and deposits. This is because the
bank we evaluated has a very low profitability (0.65 %) compared with

8.36%

91.64%

Explicit forecast Terminal value

Fig. 7.1 AMMComposition of the Banks firm value by CAPM (explicit


forecast period and terminal value). Source: Authors elaboration.
202 Valuing Banks

11.41% 3.05%

6.92%

78.62%

Value of Assets Value of Deposits


Value of Tax Shield on deposits Value of Tax Shield on non deposits

Fig. 7.2 AMMBanks firm value breakdown by CAPM. Source: Authors


elaboration.

8.93%

91.07%

Explicit forecast Terminal value

Fig. 7.3 AMMComposition of the Banks firm value by CAPM Total Beta
(explicit forecast period and terminal value). Source: Authors elaboration.

the industry average (1.15 %) and, in addition, according to the business


plan, the Bank expects to grow considerably in terms of new investments.
The combination of these factors makes ABCs FCFA negative for the
entire explicit forecast period. Incidentally, the recovery trend that can be
observed in the FCFA statement suggests that the Bank will return to a
positive value of assets in the long-term.
In addition, it is important to observe how, through the AMM, we can
understand how the value spreads out over the Bank.
7 A Comparison between Valuation Metrics ina Real Case 203

11.80% 0%

7.16%

81.36%

Value of Assets Value of Deposits


Value of Tax Shield on deposits Value of Tax Shield on non deposits

Fig. 7.4. AMMBanks firm value breakdown by CAPM Total Beta. Source:
Authors elaboration.

8.48%

91.52%

Explicit forecast Terminal value

Fig. 7.5 Composition of the Banks firm value by CaRM (explicit forecast
period and terminal value). Source: Authors elaboration.

7.5 V
 aluing ABC Bank: TheApplication
oftheDDM
In this section, we run the valuation of ABC Bank following the DDM.
EC described in Chap. 2.
According to the DDM, cash flows for shareholders are composed by
those coming from dividends and those from excess capital distribution
(see Table 7.20).
204 Valuing Banks

11.52% 2.12%

6.99%

79.38%

Value of Assets Value of Deposits


Value of Tax Shield on deposits Value of Tax Shield on non deposits

Fig. 7.6 AMMBanks firm value breakdown by CaRM. Source: Authors


elaboration.

Dividends are measured in relation to the forecast net incomes and


payout ratios disclosed by the Bank. On the other hand, the excess capi-
tal distribution is determined by the difference of the Available common
equity Tier 1 and the Target common equity Tier 1 the bank decided to hold
in the forecast period. Conversely, from 2016 to 2019, the excess capital
distribution can be measured as the difference between the Cumulated
excess capital over the years.
The long-term cash flow for shareholders is measured considering the
Net Income of 2019, increased by the expected growth rate; minus the
capital requirements due to the long-term growth of the RWA (fixed at
1 %, equal to the expected growth of assets in AMM). With regard of
the growth rate of dividends, in order to allow comparability between
the models, we estimate the required equity growth supposing an asset
growth of 1 %, a deposit growth of 0.75 % and a non-deposit debt
growth of 1.25 %. Results require a long-term growth rate of equity equal
to 2.05 %. On the whole, the long-term hypothesis is that the Bank will
distribute all the net income after having covered the regulatory capital
requirements. Therefore, the perpetual dividend is calculated as follows:

DIVlt = 411.599 (1+ 2.05% ) - ( 44.693.175 - 44.250.668 ) 11% = 371.361



Table 7.20. ABC shareholders cash flow
Forecast period 2014 2015 2016 2017 2018 2019 LT
Net income 14,797 137,779 239,966 329,669 370,540 411,599 420,037
Payout % 0% 15 % 25 % 35 % 40 % 40 %
Dividends 20,667 59,992 115,384 148,216 164,640
Adjustment for 755 1,719 2,321 3,408
Excess capital
Total net 14,797 117,112 180,730 216,004 224,645 250,368 371,361
adjusted income
RWA 40,691,550 41,379,701 42,079,491 42,791,114 43,514,772 44,250,668 44,693,175
Available 4,598,145 4,770,531 4,949,380 5,134,934 5,327,444 5,527,172
common
equity T
Tier 1% 11.30 % 11.53 % 11.76 % 12.00 % 12.24 % 12.49 %
Target common 4,069,155 4,220,730 4,376,267 4,535,858 4,699,595 4,867,573
equity tier
Tier 1% 10.0 % 10.2 % 10.4 % 10.6 % 10.8 % 11.0 % 11.0 %
Cumulated Excess 549,802 573,113 599,076 627,849 659,598
capital
Distributed Excess 549,802 23,311 25,963 28,773 31,749
capital
EUR 6M forward 0.18 % 0.21 % 0.45 % 0.58 % 0.81 %
Tax rate 33 % 33 % 33 % 33 % 33 %
Adjustment for 755 1,719 2,321 3,408
Excess capital
7 A Comparison between Valuation Metrics ina Real Case

distribution
Source: Authors elaboration.
205
206 Valuing Banks

Discounting back the cash flow of dividends and excess capital, we can
directly measure the value of equity of the Bank. In Table 7.21, we report
the synthetic table of the valuation by the DDM in relation to the differ-
ent levels of cost of capital.
In Figs 7.77.9, we show the value breakdown obtained by the
DDM valuation in relation to the different cost of capital methodology
employed.
As one can note, the weight of excess capital and terminal value is
relevant and, together, they bear on total equity value by almost 80 %.
Generally, in this case, it is important to think about the nature of cash

Table 7.21. DDM valuation and the Cost of capital of ABC Bank
DDM Excess capital
CAPM Payout 17,640 43,705 71,748 78,664 74,583
Distributed 469,274 16,983 16,144 15,271 14,383
Excess
capital
Terminal 1,113,360
value
Total equity
value
1,931,754
CAPM Payout 14,556 29,760 40,315 36,474 28,536
total Distributed 387,239 11,564 9,071 7,081 5,503
beta Excess
capital
Terminal 157,068
value
Total equity
value
727,168
CaRM Payout 17,104 41,090 65,407 69,534 63,924
Distributed 455,021 15,967 14,717 13,499 12,327
Excess
capital
Terminal 727,110
value
Total equity
value
1,495,699
Source: Authors elaboration.
7 A Comparison between Valuation Metrics ina Real Case 207

27.54%

57.63%

14.82%

excess capital dividends terminal value

Fig. 7.7. DDMBanks firm value breakdown by CAPM. Source: Authors


elaboration.

21.60%

57.82%
20.58%

excess capital dividends terminal value

Fig. 7.8. DDMBanks firm value breakdown by CAPM Total Beta. Source:
Authors elaboration.

34.20%

48.61%

17.19%

excess capital dividends terminal value

Fig. 7.9 DDMBanks firm value breakdown by CaRM. Source: Authors


elaboration.
208 Valuing Banks

flows we are discounting back, which are hard to forecast (dividends)


and, somehow, figurative (excess capital). In addition, we do not have any
kind of information on value creation sources.

7.6 V
 aluing ABC Bank: TheApplication
oftheFCFE Model
In this section, we run the valuation of ABC Bank using an FCFE
approach. In this case, we compare the FCFE not synthetically deter-
mined from the net income as is common practice (see Chap. 2)
but,rather, we obtain the cash flow to equity from the FCFA scheme
(see Chap. 4). Specifically, from the FCFA, we take into account
the cash flows generated by the liabilities side and the excess capital
distribution. In this way, we are able to compare the DDM approach
with that of FCFE calculated with the FCFA scheme. In Table 7.22,
we report the explicit forecast period of cash flows to equity of
ABCBank.
With regard to the long-term cash flow to equity, we made the
assumption that the Banks cash flow to equity is the net income
after having covered the equity reinvestment. In particular, we
assumed that equity will grow at 2.05 % in the long term, as in the
DDM method. Consequently, the long-term cash flow for share-
holders is measured considering the Net Income of 2019, increased
by the expected growth rate; minus the equity requirements due, for
the major part, from the long-term growth of RWA. Therefore, the
FCFElt is equal to:

FCFElt = 411.599 (1 + 2.05%) (6.129.603 2.05%) = 294.380.



Discounting back the cash flows from equity, we can directly measure
the value of equity of the Bank. In Table 7.23, we report the synthetic
table of the valuation by the FCFE model in relation to the different
levels of cost of capital.
Table 7.22 Cash flow to equity of ABC Bank
Forecast period 2015 2016 2017 2018 2019 LT
Free Cash Flow from Assets 560,947 432,211 300,266 41,076 20,616
(FCFA)
Financing operations
Interest expenses 339,540 349,191 355,427 361,809 364,109
and similar charges on
non-deposit debt
Interest expenses and 1,085,259 1,098,282 1,111,462 1,122,576 1,133,802
similar charges on
deposits at risk-free rate
Deposits * (rfi)i 1,059,993 1,030,782 993,124 963,519 926,734
is Interest expenses on
deposits/Deposits
Interest expenses and 120,386 137,508 156,343 171,886 188,489
similar chargesMarginal
tax rate
Deposits 428,956 434,104 439,313 370,487 374,192
Other financing sources 291,889 321,690 207,886 212,710 76,673
other than deposits
Non-recurrent profit (loss)
Excess capital distribution 549,802 23,311 25,963 28,773 31,749
FCFE adjustment of Excess 755 1,719 2,321 3,408
capital distribution
Free Cash Flow to Equity 465,280 66,955 53,754 219,593 75,902 294,380
7 A Comparison between Valuation Metrics ina Real Case

(FCFE)
Source: Authors elaboration.
209
210 Valuing Banks

Table 7.23. FCFE valuation and the cost of capital of ABC Bank
FCFE model
CAPM Discounted 72,142 32,346 18,350 102,508 21,545
FCFE
Excess capital 469,274 16,432 15,075 14,039 12,839
Terminal value 882,567
Total equity 1,512,833
value
CAPM Discounted 59,531 22,025 10,311 47,530 8,243
total FCFE
beta Excess capital 387,239 11,189 8,471 6,509 4,912
Terminal value 127,783
Total equity 574,682
value
CaRM Discounted 69,951 30,411 16,728 90,610 18,466
FCFE
Excess capital 455,021 15,449 13,743 12,409 11,004
Terminal value 608,610
Total equity 1,202,501
value
Source: Authors elaboration.

6.78%

34.88%

58.34%

fcfe excess capital terminal value

Fig. 7.10 FCFE modelBanks firm value breakdown by CAPM. Source:


Authors elaboration.

In Figs 7.107.12, we show the value breakdown obtained by the


FCFE valuation in relation to the different cost of capital methodology
employed.
Even in this case, the major part of value comes from excess capi-
tal and terminal value, while FCFE contributes just a very small part.
In particular, comparing the FCFE value breakdown with that of the
4.97%
22.24%

72.79%

fcfe excess capital terminal value

Fig. 7.11 FCFE modelBanks firm value breakdown by CAPM Total Beta.
Source: Authors elaboration.

7.17%

50.61%
42.21%

fcfe excess capital terminal value

Fig. 7.12 FCFE modelBanks firm value breakdown by CaRM. Source:


Authors elaboration.

DDM, one can note how the contribution of FCFE is lower than that of
dividends. In this sense, it might be useful to verify the internal consis-
tency of managements target payout ratios and the available cash flows.

7.7 V
 aluing ABC Bank: TheApplication
ofMarket Multiples
For the market multiples valuation, we first selected a comparable group
for ABC Bank. In particular, we took the peer group of the Bank, con-
sidering the listed banks in the same index. Since the number of the
212 Valuing Banks

comparable banks was limited, we first kept the peer group as it was,
and then we ran the same simulation filtering for the size and, therefore,
obtaining a more restricted peer group.
Since we had no precise information about the expected growth for
the comparable banks, we decided to use the asset-side multiples without
growth.
The other assumptions and adjustments we made are:

The tax rate is equal to 33 %;


Risk-free rate is 3 %;
Euribor rates follow the expectations as in the DDM;
The earnings used for ABC Bank are the expected earnings in 2015
according to its business plan;
The expected return of the sample banks funding is equal to the risk-
free rate;
The benefits consider tax-shield value and deposits value calculated on
total debts;
The financial statements data are adjusted for minorities.

7.7.1 Equity-Side Approach: PBV, PTBV, PE

Applying the market relative methods to the peer group we selected, we


obtained the multiples presented in Table 7.24.
As one can see, notwithstanding that we used geometric mean,
the standard deviation of the multiples is relevant so that, in order to
obtain a more reliable measure of ABC Bank value, we used median
values.
The value of ABC Bank is determined applying the multiple to relative
financial data (Table 7.25).
Conversely, in the restricted sample in relation to the relative size of
ABC Bank, the multiples are as shown in Table 7.26.
In this case, considering the geometric mean, the ABC Bank relative
value would be equal to the data given in Table7.27.
7 A Comparison between Valuation Metrics ina Real Case 213

Table 7.24. Market multiplesEquity side approach, full sample


PBV PTBV PE
Bank D 0.40 0.35 n.s.
Bank F 0.44 0.37 53.73
Bank G 0.87 0.84 18.69
Bank H 0.91 0.88 30.66
Bank I 0.53 0.51 72.09
Bank L 0.58 0.57 25.07
Bank M 0.63 0.54 14.36
Bank N 0.45 0.26 n.s.
Bank O 0.55 0.42 23.03
Bank P 0.33 0.30 6.97
Geometric mean 0.52 0.44 19.28
Standard deviation 0.18 0.21 21.10
Median 0.54 0.46 24.05
Source: Authors elaboration.

Table 7.25. Relative value ABC BankEquity-side approach, full sample


PBV PTBV PE
Relative value ABC 2,629,876 2,058,381 3,313,588
Source: Authors elaboration.

Table 7.26. Market multiplesEquity side approach, restricted sample


PBV PTBV PE
Bank F 0.44 0.37 53.73
Bank G 0.87 0.84 18.69
Bank I 0.53 0.51 72.09
Bank L 0.58 0.57 25.07
Geometric mean 0.57 0.53 31.78
Standard deviation 0.19 0.20 24.98
Median 0.56 0.54 39.40
Source: Authors elaboration.

After having calculated the ABC Bank value using the plain market
multiples, we now focus on a modified version of the multiples, making the
adjustments proposed in Massari etal. (2014), which are aimed at control-
ling for extraordinary components and for the excess capital in respect of the
regulatory requirements. In particular, we made the following adjustments:
214 Valuing Banks

Table 7.27. Relative value ABC BankEquity side approach, restricted sample
PBV PTBV PE
Relative value ABC 2,896,278 2,444,296 4,378,249
Source: Authors elaboration.

1. Price to Book Value and Price to Tangible Book Value:


(a) Market capitalization is netted of the amount of excess capital,
which is measured by the difference between the amount of Tier 1
ratio at 31 December 2014, less the target Tier 1 ratio as for ABC
Bank (see DDM Excess capital valuation Sect. 7.5).
(b) Book value of equity is netted for the same amount of excess capital
that is used for the adjustment of the numerator.
2. Price earnings:
(a) Market capitalization is netted for the excess capital, which is mea-
sured by the difference between the amount of Tier 1 ratio at 31
December 2014, less the target Tier 1 ratio as for ABC Bank (see
DDM Excess capital valuation Sect. 7.5).
(b) Earnings are normalized for the extraordinary components and
netted for the figurative return (at the Euribor rate used in DDM
Excess capital valuation Sect. 7.5) of the distributed capital.
According to such adjustments, the new equity-side market mul-
tiples are shown in Table 7.28.
The new relative value of ABC Bank considering the full sample is
given in Table 7.29.
If we restrict the valuation for the size variable, we obtain the fol-
lowing multiples (Table 7.30) and relative value of ABC Bank
(Table 7.31).

7.7.2 Asset-Side Approach: EV/OP andP/BVun (EV/A)

For the asset-side valuation using market multiples, we used the Enterprise
Value unlevered on Operating Profit (EVun/Op) and the unlevered ver-
sion of the Price to Book Value, which is equivalent to the Enterprise
Value on Asset (P/BVun). Since we had no precise information on the
7 A Comparison between Valuation Metrics ina Real Case 215

Table 7.28. Adjusted market multiplesEquity-side approach, full sample


Adj PBV Adj PTBV Adj PE
Bank D 0.49 0.45 n.s.
Bank F 0.39 0.30 n.s.
Bank G 0.86 0.83 12.65
Bank H 0.88 0.83 23.81
Bank I 0.44 0.41 7.09
Bank L 0.59 0.58 12.53
Bank M 0.59 0.49 13.08
Bank N 0.36 0.10 n.s.
Bank O 0.47 0.30 n.s.
Bank P 0.30 0.27 6.02
Geometric mean 0.48 0.32 10.27
Standard deviation 0.19 0.24 6.10
Median 0.48 0.43 12.59
Source: Authors elaboration.

Table 7.29. Relative adjusted value ABC BankEquity-side approach, full sample
Adj PBV Adj PTBV Adj PE
Relative value ABC 2,081,043 1,691,625 1,722,304
Source: Authors elaboration.

Table 7.30. Adjusted market multiplesEquity-side approach, restricted sample


Adj PBV Adj PTBV Adj PE
Bank F 0.39 0.30 n.s.
Bank G 0.86 0.83 12.65
Bank I 0.44 0.41 7.09
Bank L 0.59 0.58 12.53
Geometric mean 0.52 0.46 10.00
Standard deviation 0.21 0.23 3.17
Median 0.51 0.49 12.53
Source: Authors elaboration.

Table 7.31. Relative adjusted value ABC BankEquity-side approach, restricted


sample
Adj PBV Adj PTBV Adj PE
Relative value ABC 2,362,038 1,906,738 1,368,605
Source: Authors elaboration.
216 Valuing Banks

expected growth rates of the peer group, we decided not to take it into
account. Therefore, we employed the multiples described in Sect. 6.4.1.
The asset-side multiples for the peer group are reported in Table 7.32.
Even in this case, due to the high standard deviation of the sample we
used the median values. In order to measure the relative value of ABC Bank:

For the EVun/Op, we had to multiply its median value for the expected
operating profit of ABC Bank and then add the debt benefits (formula
(6.33)), and net for the outstanding debt measured by the Merton model.
For the P/BVun, we had to multiply its median value for the total asset
of ABC Bank and then add the debt benefits (formula (6.33)), and net
for the outstanding debt measured by the Merton model.

The relative value of ABC Bank is reported in Table 7.33.


Considering the restricted sample, the asset market multiples and the
relative value of ABC Bank is showed in Tables 7.34 and 7.35.
In addition, we applied the adjustments suggested by Massari et al.
(2014) with regard to equity-side multiples to the asset-side approach we
adopted. In particular, for:

Table 7.32.Market EVun/Op P/BVun


multiplesAsset-side
approach, full sample Bank D n.s n.s
Bank F 66.05 0.29
Bank G 14.76 0.20
Bank H 23.14 0.32
Bank I 16.25 0.28
Bank L 17.17 0.27
Bank M 19.25 0.30
Bank N 72.57 0.34
Bank O 59.67 0.27
Bank P 16.75 0.25
Geometric 23.19 0.27
mean
Standard 24.43 0.04
deviation
Median 19.25 0.28
Source: Authors elaboration.
7 A Comparison between Valuation Metrics ina Real Case 217

Table 7.33.Relative EVun/Op P/BVun


value ABC Bank
Asset-side approach, Relative value ABC 2,865,215 6,130,824
fullsample Source: Authors elaboration.

Table 7.34.Market EVun/Op P/BVun


multiplesAsset-side
approach, restricted Bank F 66.05 0.29
sample Bank G 14.76 0.20
Bank I 16.25 0.28
Bank L 17.17 0.27
Geometric mean 19.74 0.25
Standard deviation 25.01 0.04
Median 16.71 0.27
Source: Authors elaboration.

Table 7.35. Relative value EVun/Op P/BVun


ABC BankAsset-side
approach, restricted Relative value ABC 3,144,828 5,023,644
sample Source: Authors elaboration.

EVun/Op: we corrected the numerator for the excess capital, while the
operating profit is adjusted for the minor earnings to capital distribu-
tion. In this case, we did not make adjustments for extraordinary items
because operating profit is already net for such a variable;
P/BVun: we adjusted the numerator and the denominator of the excess
capital.

The adjusted asset-side multiples of the peer group and the relative
value of ABC bank in the full sample is reported in Tables 7.36 and 7.37.
Finally, using the combination between the adjusted market multiples
and the restricted sample (Table 7.38), we obtained the relative value of
ABC Bank as given in Table 7.39.
As one can note, the asset version of the multiple is considerably higher
than the value obtained with operating profit. This is due to the notably
higher level of the peer groups operating profits than those of ABC Bank.
As a matter of fact, if we divide the operating profits for the total assets of
the peer group and ABC Bank, we obtain a Return on Asset of the former
at 1.04 %, while ABC Banks is equal to 0.67 % (Table 7.40).
218 Valuing Banks

Table 7.36.Adjusted Adj EVun/Op Adj P/BVun


market multiples
Asset-side approach, Bank D n.s. n.s.
fullsample Bank F 64.89 0.29
Bank G 14.46 0.20
Bank H 21.92 0.31
Bank I 15.36 0.26
Bank L 17.24 0.27
Bank M 18.83 0.29
Bank N 70.92 0.33
Bank O 57.15 0.26
Bank P 16.54 0.24
Geometric 22.59 0.27
mean
Standard 23.81 0.04
deviation
Median 18.83 0.27
Source: Authors elaboration.

Table 7.37.Relative Adj EVun/Op Adj P/BVun


adjusted value ABC
BankAsset-side Relative value ABC 2,629,935 5,959,368
approach, full sample Source: Authors elaboration.

Table 7.38.Adjusted Adj EVun/Op Adj P/BVun


market multiples
Asset-side approach, Bank F 64.89 0.29
restricted sample Bank G 14.46 0.20
Bank I 15.36 0.26
Bank L 17.24 0.27
Geometric mean 19.26 0.25
Standard deviation 24.63 0.04
Median 16.30 0.27
Source: Authors elaboration.
7 A Comparison between Valuation Metrics ina Real Case 219

Table 7.39.Relative Adj EVun/Op Adj P/BVun


adjusted value ABC
BankAsset-side Relative value ABC 2,872,500 4,792,896
approach, restricted Source: Authors elaboration.
sample

Table 7.40.Operating 31/12/2014 ROA (%)


profit on total asset
31December 2014, Bank D 0.04
fullsample Bank F 0.45
Bank G 1.35
Bank H 1.40
Bank I 1.70
Bank L 1.58
Bank M 1.54
Bank N 0.47
Bank O 0.45
Bank P 1.47
Arithmetic mean 1.04
ABC Bank 0.67
Source: Authors elaboration.

Consequently, when we use the multiple methodology we are assum-


ing the profitability of ABC Bank in relation to the assets average assets
of the peer group, which in this case is almost double. Therefore, the asset
version of the multiple overestimates the value of ABC Bank.
In order to solve this problem, we run a value map between the P/
BVun and ROA.In this way, we can use a different estimator. Eliminating
the outliers of the sample and using ABC Banks current ROA, we obtain
new equity values of ABC Bank as given in Table 7.41.
Then, using ABCs expected level of ROA, equal to 1.08 %, we obtain
the new equity values as given in Table 7.42.
In conclusion, it is useful to point out the difference in terms of value
distribution that originates from the comparison between AMM and the
adjusted asset multiples in the full sample and adjusted version (Fig. 7.13).
As one can note, in this case there is a different ratio between the value
of assets and debt benefits. As a matter of fact, through multiples we use
the peer group level profitability in relation to assets which is greater than
that of ABC Bank. As a consequence, this attaches greater value to assets
in relation to debt benefits.
220 Valuing Banks

Table 7.41. ABC Bank Full sample Normal Adjusted


byvalue map regression,
current level of ROA Current ABCs ROA 0.67 % 0.67 %
P/BVun 0.185 0.182
ABC Bank equity value 1,439,552 1,284,624
Source: Authors elaboration.

Table 7.42. ABC Bank Full sample Normal Adjusted


byvalue map regression,
expected ROA Expected ABCs ROA 1.08 % 1.08 %
P/BVun 0.223 0.222
ABC Bank equity value 3,401,971 3,350,329
Source: Authors elaboration.

96.95%

78.24% 79.72%

21.76% 20.28%

3.05%

AMM (Capm) EVun/Op (adj) full P/Bvun (adj) full


value of assets value of debt benfits

Fig. 7.13. EVun/Op (adj)Banks firm value breakdown. Source: Authors


elaboration.

7.8 Conclusion: Comparing Valuation Methods


In Table 7.43, we report all the results of the valuation models we used in
the case of ABC Bank. In addition, they are compared with the market
capitalization of the Bank at 31 December 2014 (Table 7.44).
In the following bullet points, we resum the main evidences of the
analysis:
7 A Comparison between Valuation Metrics ina Real Case 221

Table 7.43. Comparison between valuation methods for ABC Bank


Analytical methods Data in 000s
AMM DDM.Ec FCFE
Full diversification
CAPM 2,007,351 1,931,754 1,512,833
Under-diversification
CAPM total beta 367,729 727,168 574,682
CaRM 1,542,029 1,495,699 1,202,501
Equity market multiples
Full sample
PBV 2,629,876
PBV (adj) 2,081,043
PTBV 2,058,381
PTBV (adj) 1,691,625
PE 3,313,588
PE (adj) 1,722,304
Restricted sample
PBV 2,896,278
PBV (adj) 2,362,038
PTBV 2,444,296
PTBV (adj) 1,906,738
PE 4,378,249
PE (adj) 1,368,605
Asset market multiples
Full sample
EVun/Op 2,865,215
EVun/Op (adj) 2,629,935
P/BVun 6,130,824
P/Bvun (adj) 5,959,368
Restricted sample
EVun/Op 3,144,828
EVun/Op (adj) 2,872,500
P/BVun 5,023,644
P/Bvun (adj) 4,792,896
Value map
Current ABCs RoA 1,439,552
Current ABCs RoA (adj) 1,284,624
Expected ABCs RoA 3,401,971
Expected ABCs RoA (adj) 3,350,329
Source: Authors elaboration.
222 Valuing Banks

Table 7.44. Comparison between valuation methods for ABC Bank in relation to
market capitalization
Analytical methods Difference versus market capitalization (%)
AMM DDM Ec FCFE
Full diversification
CAPM 23.61* 26.49 42.43
Under-diversification
CAPM total beta 86.01 72.33 78.13
CaRM 41.32 43.08 54.24
Equity market multiples
Full sample
PBV 0.08***
PBV (adj) 20.81*
PTBV 21.67*
PTBV (adj) 35.63
PE 26.09
PE (adj) 34.46
Restricted sample
PBV 10.21**
PBV (adj) 10.12**
PTBV 6.99**
PTBV (adj) 27.44
PE 66.61
PE (adj) 47.92
Asset market multiples
Full sample
EVun/Op 9.03**
EVun/Op (adj) 0.08***
P/BVun 133.30
P/Bvun (adj) 126.78
Restricted sample
EVun/Op 19.67*
EVun/Op (adj) 9.31**
P/BVun 91.17
P/Bvun (adj) 82.39
Value map
Current ABCs RoA 45.22
Current ABCs RoA (adj) 51.12
Expected ABCs RoA 29.46
Expected ABCs RoA (adj) 27.49
Note:***<or>5%; **<or>15%; *<or>25%
Source: Authors elaboration
7 A Comparison between Valuation Metrics ina Real Case 223

With regard to analytical methods, AMM, DDM and FCFE report


very similar results. In the opinion of the authors, this points out the
ability of the AMM to provide an alternative bank valuation method-
ology that is far more useful than DDM, because it allows the analysis
of where the value is created (cash flow from assets, mark-down and
tax benefits).
The AMM reports a result that is slightly higher than the other models
when the CAPM and CaRM are employed for cost of capital. This is
due to the funding benefits, which are separately assessed and high-
lighted as a relevant value source.
The generation of value in the AMM method derives, in particular, from
deposit benefits. The assets value represents only a very low proportion
of the total value. And this is due to the low level of ROA of the Bank
(0.67 % current and 1.08 % expected), and because the explicit forecast
period FCFA is negative. The negative sign of FCFA, in turn, is due to
the growth expectations of new investments, which erode the total cash
flows from assets.
The FCFEs results report lower valuations than AMM, even if they
represent, respectively, a direct and an indirect method. However, this
is not the case, because, in the reconciliation between the asset-side
method (AMM) and the equity method (FCFE), the cost of equity has
not been adjusted for growth effect, thus reporting a proxy result of
the intrinsic value. Converseley, the AMM method does not need a
direct adjustment on the rate as the cost of assets is an elementary rate
and, generally, is more theoretically solid than the stable cost of equity.
In other words, the direct and indirect methods are equivalent only in
the event of a steady state.
FCFE and AMM differences could also be due to misalignments
between the mechanism of excess capital distribution and asset growth
along the forecast period.
As occurred in the analytical valuation, the asset-side version of market
multiples reported higher values than the equity-side method. This is
because the asset multiples separately value the benefits of funding.
The extreme value given by the P/BVun is due to ABC Banks current
profitability of assets being lower than that of the peer group.
224 Valuing Banks

Considering the under-diversification hypothesis, the values we


obtained by the usage of the CaRM are less punitive than the CAPM
total beta.
In relation to ABCs market capitalization, notwithstanding the limits of
the study and the discretional component of every valuation (which,
however, we tried to overcome by making the same structural assump-
tions), it transpired that the AMM and DDM are not a very good
approximation of the market value of equity. In this sense, the AMM
seems to work better than DDM.However, a further reason why we are
not able to speculate on the predictive power of the two models is because
the imperfect efficiency of markets and their endogenous dynamics do
not allow us to understand whether the models are incorrect, or market
prices are under- or over-estimated in relation to their intrinsic value.
Looking at the market valuations, a lower level of error can be noted
between the relative value of the Bank and its market capitalization.
Obviously, this is due to the fact that multiples use market data to
appoint a relative value to the Bank and, thus, incorporate the specific
dynamics of markets. In this case, the multiples that work better are
EVun/Op, PBV and PBTV.In particular, considering the bank-specific
adjustments and the wider representativeness of the full sample, the
EVun/Op seems to be the more precise multiple.

Finally, after having applied the AMM to a real case, we highlighted


the following pros and cons:

Pro (1): The model allows better analyze than the DDM, where the
value is generated in the business. Assets and liabilities contribute to
the final value in a different manner and it could be very important to
assess which business source contributes to the overall profitability and
cash flows. In particular, debt is a great source of value in banking and
the AMM appoints value to it.
Pro (2): The usage of the rA as a cost of capital is an elementary rate
that is independent from growth, debt and taxes and, consequently,
does not need any adjustment. Therefore, the asset-side approach
might represents a more reliable method than a steady cost of equity.
7 A Comparison between Valuation Metrics ina Real Case 225

Pro (3): The model is easily applicable and does not require any black
box estimation, simply a different setting and valuation approach.
Con (1): The results of the model strongly depend on growth forecasts,
and, in particular, in relation to debt expected evolution, both in terms of
stock and its correlated cost. This requires particular attention being paid to
forecasts, because too much discretion might lead to incorrect estimation.

In conclusion, future research on the AMM should concern further


deep empirical investigation, in terms of understanding how to limit its
variability in relation to different scenarios and, in addition, to undertake
tests of its statistical validity and predictive power.

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Index

A CAPM, 207
ABC Bank CaRM, 207
AMM application, 1901, 2235 cash flow, 205
balance sheet reclassification, valuation and cost of capital,
192, 193 206
CAPM, 2013 FCFE application
CaRM, 203, 204 CAPM, 210, 211
cost of deposits, 197, 198 CaRM, 211
FCFA, 197200 cash flow to equity, 209
free cash flow from assets, 196 cost of capital, 210
income statement adjustments, income statement, 178
1945 market multiples application
mark-down benefit, 1979 asset-side approach, EV/OP
tax benefits, 199, 200 and P/BVun, 21420
balance sheet, 177, 1801 assumptions and adjustments,
business plan, 179 212
cost of capital equity side approach, PBV,
CAPM, 18990 PTBV, PE, 21120
CaRM, 1858 statement projections, 1824
DDM application tier 1 and payouts, 179

Palgrave Macmillan, a division of Macmillan Publishers Limited 2016 237


F. Beltrame, D. Previtali, Valuing Banks, Palgrave Macmillan Studies
in Banking and Financial Institutions, DOI10.1057/978-1-137-56142-8
238 Index

Adams, M., 37 asset-side approach, 446


Alford, A.W., 159 current enterprise value to
analytical valuation, 155 operating profit, 165
Arbitrage Pricing Model, 113 enterprise value to assets,
asset-based model, 278 1656
asset beta, 120, 121 leading enterprise value to
Asset Mark-down Model (AMM), 2, operating profit, 1645
58, 6770, 738 target firm, 1667
ABC Bank, 1901, 219, 2245 cash flow, 169
balance sheet reclassification, charge-offs, 145
192, 193 contingent claim, 37
CAPM, 2013 DCF models, 1923
CaRM, 203, 204 debt role, 124
cost of deposits, 197, 198 discretional factors, 155
FCFA, 197200 equity beta, 1157
free cash flow from assets, 196 equity role
income statement adjustments, capital adequacy, 101
1945 capital constraint, 11
mark-down benefit, 1979 focus on capital, 8
tax benefits, 199, 200 national regulation, 11
asset return (ROA), 75, 1458 potential restrictions, 910
asset-side approach, 446 regulation, 8, 11
current enterprise value to RWAs, 89
operating profit, 165 equity-side approach, 424
enterprise value to assets, 1656 excess returns, 237
leading enterprise value to FCFA, 79
operating profit, 1645 leverage, 11722
target firm, 1667 leverage and deposits effect
asset standard deviation, 137 unlevered multiple
associates, 87 (unlevered multiple)
available for sale (AVS), 86 LLPs, 145
market multiples, 1567
literature, 15860
B market valuation
Baker, M., 53 BHC, 367
bank valuation Gordon Growth model, 34
AMM, 6770, 738 PBV, 33, 36
asset and mixed-based models, price earnings ratio (PE), 313
2731 PTBV, 33, 36
Index 239

Modigliani-Miller propositions, cash flow, 169


4654 Cash Flow to Equity Model (CFE),
absence of taxes, 702 223
presence of taxes, 723 certain value of assets and uncertain
NAV methodology, 38 value (CaR), 1301
price earnings, 156, 157 totally levered approach, 1316
pricing systematic risk, 1145 unlevered approach, 13641
profitability and growth WACC, 139
adjustments Chen, N., 113
PBV, 1623 Choi, J.J., 114
PE, 1612 Claus, J., 125
small banks vs. large banks, 116 Cosimano, T.F., 53
specifics of, 12 cost of capital
with taxation and growth, 637 beta of comparable banks, 1423
with tax benefits, 613 CaRM, 1459
WACC, 47, 51, 53 financial risk, 112
without taxation and growth investors/non-diversified
debt different from deposits, investors, 1123
presence of, 5961 pricing systematic risk, 1134
medium long debt, absence of, banking industry, 1145
569 equity beta, 1157
Basel Accord, 10, 11 leverage, 11722
Basel framework, 8 pricing total risk
bearing assets, 8990 (pricing total risk)
bearing liabilities, 90 small bank, 141
Beltrame, F., 131 total beta bank comparable, 1435
Benninga, S., 43 volatility, 111
cost saving approach, 50
credit rating agencies (CRAs), 5960
C
Calomiris, C.W., 36
Capital Asset Pricing Model D
(CAPM), 53, 115 Damodaran, A., 43
ABC Bank, 189, 190 Das, S., 117, 118, 128
Capital at Risk Model (CaRM), debt, 124
12930 debt securities in issue, 88
ABC Bank, 1858 deposits from banks and customers, 88
asset return (ROA), 1459 discounted cash flow (DCF) models,
cash and cash balance, 84 1923
240 Index

Dividend Discount Model (DDM) IAS compliant bank, 85


ABC Bank liabilities, 8891
CAPM, 207 Macro-class of assets and
CaRM, 207 liabilities, 86
cash flow, 205 income statement
valuation and cost of capital, 206 IAS compliant bank, 92
Dividend Discount Model with the operating income, 945
Excess Capital adjustment reclassification, 93
(DDM.EC), 1923, 27 incomes to cash flows
FCFA to FCFE, 96, 98
operating profit, 97
E Intesa San Paolo Bank
Easton, P., 126 assumptions, 107
Elliott, D.J., 52 balance sheet, 1002
empirical evidence, 117 FCFA and FCFE, 106
Enterprise Value unlevered on financial assets, 99
Operating Profit (EVun/ income statement, 1035
Op), 216, 217, 220 macro-classes of assets and
equity, 89, 91 liabilities, 101
equity-side approach, 424 free cash flow to equity (FCFE), 178
expected loss rate (ELR), 1878 ABC Bank
CAPM, 210, 211
CaRM, 211
F cash flow to equity, 209
fair value to profit or loss (FVTPL), cost of capital, 210
86 French, K.R., 115
Fama, E.R., 115 Fundamental Valuation Formula
Feltham, G.A., 24 (FVF), 29
Ferretti, R., 43
financial assets, 85
financial liabilities, 88 G
Floreani, 118 Gebhardt, W., 1245
forward-looking approach, 127 Goetzmann, W., 123
free cash flow (FCFA) asset-side Gordon Growth model, 34
approach, 456
asset-side model and simplified
FCFE model, 1089 H
balance sheet Hakura, D.S., 53
asset side, 847, 8990 Hamada, R.S., 118, 1212
Index 241

hedging derivatives, 87, 88 loan loss provisions (LLPs), 145


held for trading (HFT), 86 loans and receivables with banks and
held to maturity (HTM), 867 customers, 845
Lynge, M.J., 128

I
implied cost of capital methods M
(ICC), 1247 Maccario, A., 127
Information and Communication mark-down, 501
Technology (ICT), 16 market multiples
Internal Capital Adequacy Assessment ABC Bank
Process (ICAAP), 10 asset-side approach, EV/OP
International Accounting Standard and P/BVun, 21420
Board (IASB), 15 assumptions and adjustments,
International Financial Reporting 212
Standards (IFRS), 15 equity side approach, PBV,
Intesa San Paolo Bank PTBV, PE, 21120
assumptions, 107 Massari, M., 107, 159, 213, 216
balance sheet, 1002 Merton, R.C., 37, 45, 1856
FCFA and FCFE, 106 MPEG model, 1267
financial assets, 99 multifactors models, 115
income statement, 1035
macro-classes of assets and
liabilities, 101 N
Net Asset Valuation (NAV), 278
net working capital, 16
J
Nissim, D., 36
Jahankhani, A., 128
non-bearing assets, 90
Juettner-Nauroth, B., 125
non-bearing liabilities, 91
non-eliminable risk, 113
K
Kashyap, A.K., 52
Kearney, C., 123 O
Kumar, A., 123 Ohlson, J.A., 24, 125
Omega Bank, valuation, 16972

L
leverage and deposits effect, P
unlevered multiple Perry, P.R., 116, 123, 131
unlevered multiple Pot, V., 123
242 Index

Preda, S., 77 Sy, A.N.R., 117, 118, 128


price earnings ratio (PE), 314
Price to Book Value (P/BVun), 216,
217 T
price to book value (PBV), 33, 34, tangible and intangible assets,
36 87
price to tangible book value (PTBV), tax assets, 87
33, 34, 36 tax liabilities, 88
pricing total risk, 1223 Thomas, J., 125
ICC, 1247
standard deviation, 12830
certain value of assets and U
uncertain value (CaR), 1301 under-diversification, 123
totally levered approach, 1316 Union European of Accounting
unlevered approach, 13641 Experts (UEC) model,
provisions for employee severance 289
pay, 88 unlevered multiple, 16972
absence of growth, 1678
presence of growth, 169
R
residual income models (RIMs), 237
return on equity (ROE), 256 V
risk weighted assets (RWAs), 89 Vander Vennet, R., 117
Rosenberg, B., 116, 123, 131
Rudolf, M., 37
W
weighted average cost of capital
S (WACC), 134
Sandri, S., 43 CaRM, 1858
Sarig, O.H., 43 medium long debt, absence of,
small banks 567
CAPM and CaRM, 141 Modigliani-Miller propositions,
vs. large banks, 116 712
standard deviation, 12830 tax benefits, 613
certain value of assets and unlevered approach, 13741
uncertain value (CaR), 1301 Wrgler, J., 53
totally levered approach, 1316
unlevered approach, 13641
Supervisory Review Evaluation Z
Process (SREP), 10 Zanetti, L., 159

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