Professional Documents
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Valuing Banks
A New Corporate Finance Approach
Federico Beltrame
Daniele Previtali
Palgrave Macmillan Studies in Banking
and Financial Institutions
Series Editor:
PhilipMolyneux
Bangor Business School
Bangor University
UK
The Palgrave Macmillan Studies in Banking and Financial Institutions series is
international in orientation and includes studies of banking systems in
particular countries or regions as well as contemporary themes such as
Islamic Banking, Financial Exclusion, Mergers and Acquisitions, Risk
Management, and IT in Banking. The books focus on research and practice
and include up to date and innovative studies that cover issues which impact
banking systems globally.
Valuing Banks
A New Corporate Finance Approach
FedericoBeltrame DanielePrevitali
University of Udine Luiss Guido Carli University
Italy Rome, Italy
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
xi
Contents
1 Introduction 1
References 5
References 227
Index 237
About the Authors
xvii
List of Figures
xix
xx List of Figures
xxi
xxii List of Tables
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
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.
Hamada, R.S. (1972). The effect of the firms capital structure on the systematic
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.
Koller, T.M., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and
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.
2.1.1 A
Different Role forEquity: TheRegulatory
Constraints
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
Fig. 2.2 Pillar 1 and Pillar 2 capital requirements. Source: Authors elaboration
2 Valuation inBanking: Issues andModels 11
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
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
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
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.
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:
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.
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:
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
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.
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 )
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.
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
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
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
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
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
g
b = 1 (2.19)
RoE
so that:13
g
1
Price RoE
PE = = (2.20)
EPS1 re g
In the event that the bank has not yet achieved stable growth, the PE can be split into explicit
13
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
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
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
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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.
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)
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
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
E D
WACC = rE + rD (3.1)
E +D E +D
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:
DD,Dep . iD,Dep
DD,Dep discount = (3.4)
rf
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:
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
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:
E D
WACC * = rE + iD, Dep (3.8)
E+D E+D
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
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:
E D
WACC = rE + rD, Dep (3.9)
E+D E+D
E D
WACC = rE + rf (3.10)
E+D E+D
FCFE
E= (3.11)
rE
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
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)
Thus, using equation (3.15), the FCFA can now be defined as:
from which
D rf iD, Dep
WACC * = rA 1 (3.19)
V rf
(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:
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:
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
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
Assuming a tax rate of tc, the WACC and firm value can be rewritten as:
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:
FCFA
V= (3.26)
WACC *
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
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
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.
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
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
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
FCFA1 = FCFA0 (1 + g )
Assets0
= Operating income0 (1 - tc ) - g (1 + g )
1+ g
= Operating income0 (1 - tc ) (1 + g ) - Assets0 g (3.33)
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
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
E =V D
FCFE1
E= (3.37)
rE , growth g
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
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
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
D,Non Dep
and for the long-term growth, the Terminal Value will be equal to:
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.
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:
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.
iD,Average D
rE = rA + ( rA - rf ) (3.41)
rf E
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*
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*
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
from which
ROA (1 tc ) rA
VAsset = Assets + Assets , (3.45)
rA
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
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:
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
Goodwill = D (3.51)
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
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
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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.
Benninga, S., & Sarig, O. H. (2001). http://valumonics.com/wp-content/
uploads/2014/10/Bank-valuation-Benninga.pdf.
Copeland, T., Koller, T. M., & Jack, M. (2000). Valuation: Measuring and
managing the value of companies (3rd ed.). Hoboken, NJ: Wiley & Sons.
80Valuing Banks
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
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
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
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
Bearing assets. These include all interest bearing and financial assets
producing positive flows of income from credit, financial operations
90 Valuing Banks
Other assets
Equity
Non-bearing assets
Total asset Total liabilities and equity
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
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
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
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
Table 4.7(continued)
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.
(continued)
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 105
Table 4.11(continued)
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:
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
Table 4.13 Asset-side model and simplified FCFE model (data in million)
Asset-side model
FCFE 916
Simplified FCFE model
FCFE 771
Source: Authors elaboration.
4 Measuring theCash Flows ofBanks: TheFCFA Asset-Side Approach 109
References
Beaver, W., Eger, C., Ryan, S., & Wolfson, M. (1989). Financial reporting and
the structure of bank share prices. Journal of Accounting Research, 27,
157178.
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,
32, 217228.
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
disclosures. The Accounting Review, 69, 455478.
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.
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.
( ) ( ) (
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)
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:
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)
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
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
So, we have:
V V
DD,Dep (5.6)
+ iD,Dep (1 - t c )
V
V V V
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
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
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:
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
bE 1.5
b A = = = 0.1089
D 91.27
1 + (1 - t c ) 1 + (1 - 30% )
E 5
122 Valuing Banks
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.
ri = a + b rm + e (5.12)
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:
5.3.1 P
ricing Total Risk through Implied Cost
ofCapital Metrics
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
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
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
Et [ Et +1 ] agr2
Equity valuet = + (5.19)
rE (r
E )
- g agr rE
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
Et [ Dt +1 ] Et [ Et +1 ] 0.25 0.5
R= + b = + 50% = 11.25%
Mt Bt 5 4
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
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
bj 1.5
b j,Total = = =3
r j ,m 0.5
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.
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.
(
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).
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
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).
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:
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 )
V s2
ln + r + V T
D 2
d1,2 = 2
sV T
d =d -s T
2 ,2 1,2 V
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 )
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
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:
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
DMK
ELRUnleverd = 1 - -r T
(5.47)
Ve f
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 137
ELRUL CaRV ,%
WACC = rf + ln 1 + (5.48)
1 - ELRUL
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
DD ,Dep
+ WACC - rf (1 - t c ) (5.50)
E
D
rE = WACC + WACC - rD (1 - t c ) (5.51)
E
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%):
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%
ELR UL CaRV,%
WACC = rf + ln 1 +
1 - ELRUL
0.98% 3.54%
= 3% + ln 1 + = 3.04%
1 - 0.98%
PD = N ( -d 2 ) = N ( -3.41) = 0.03%
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.
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
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
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.
3% - 1.71% (1 - 33% )
+ 285,956.691 = 299,864.26
3% - 1%
Equity is:
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:
3% - 1.71% (1 - 33% )
+ 285,956.691 = 285,161.51
3% - 1%
5 The Banks Cost ofCapital: Theories andEmpirical Evidence 145
Equity is:
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
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
VaRROA
rRN,UL (5.54)
CaRV,% =
ROA - VaRROA VaRROA
+
rf rRN,UL
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
( )
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
Equity is:
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
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5 The Banks Cost ofCapital: Theories andEmpirical Evidence 153
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
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:
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).
6.3 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
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
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
P0 (1 + g )(1 - b )
= (6.6)
E0 rE - g
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
P0 ROE1 (1 - b ) ROE1 - g
= = (6.9)
BV0 rE - g rE - g
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
EV
(6.13)
TotAssets
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
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:
(c) Calculation of the multiple for each comparable company using the growth of the
company to be assessed:
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
(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
(6.30)
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)
(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
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
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:
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.
where:
P
d=
BV Unlevered ,comparables
EV
g =
OP Unlevered ,comparables
rf - iD , Average (1 - tc )
a=
rf - g
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.
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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.
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Acquisitions, 3. ICFAI University Press.
Henschke, S., & Homburg, C. (2009). Equity valuation using multiples:
Controlling for differences between firms. SSRN 1270812.
Herrmann, V., & Richter, F. (2003). Pricing with performance-controlled mul-
tiples. Schmalenbach Business Review, 55(3), 194219.
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Leibowitz, M.L., & Kogelman, S. (1990). Inside the P/E ratio: The Franchise
factor. Financial Analysts Journal, 46, 1735.
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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
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
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.
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
(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.
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:
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:
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
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:
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
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
Risk-free rate;
Market risk premium;
Beta coefficient.
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
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
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
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:
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.
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
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.
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
8.36%
91.64%
11.41% 3.05%
6.92%
78.62%
8.93%
91.07%
Fig. 7.3 AMMComposition of the Banks firm value by CAPM Total Beta
(explicit forecast period and terminal value). Source: Authors elaboration.
11.80% 0%
7.16%
81.36%
Fig. 7.4. AMMBanks firm value breakdown by CAPM Total Beta. Source:
Authors elaboration.
8.48%
91.52%
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%
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%
21.60%
57.82%
20.58%
Fig. 7.8. DDMBanks firm value breakdown by CAPM Total Beta. Source:
Authors elaboration.
34.20%
48.61%
17.19%
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:
(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%
72.79%
Fig. 7.11 FCFE modelBanks firm value breakdown by CAPM Total Beta.
Source: Authors elaboration.
7.17%
50.61%
42.21%
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:
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.
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 7.29. 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.
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.
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
96.95%
78.24% 79.72%
21.76% 20.28%
3.05%
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
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.
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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
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