Updated: Oct 27, 2020
Banks, investment banks, insurance companies and financial services firms can be different from the rest of the normal companies we generally value. The nature of these businesses is generally different from other businesses as they are heavily regulated and defining debt, reinvestment, capex, working capital and cash flows can be difficult. The following is an overview of banks business model, value drivers, regulation, risks and valuation methodologies.
How does a bank earn money and what is the business model?
Banks generally earn income from the interest on their mortgage, personal, credit card, business and government and other loan portfolios to clients, their investment securities as well as non-interest income items related to fees including deposits, credit cards, advisory, underwriting, mutual funds, investment management and custodial, insurance, commission, trading, foreign exchange other than trading, and other. Hence, there are two parts to banks revenues: interest income and non-interest income.
Operating costs at banks include non-interest expense items such as human resource, occupancy costs, computer and office expenses, advertising, professional fees, business expenses, and other. These costs are both fixed and variable.
Another important expense item on banks’ income statements is provision for credit losses (PCL). PCL is an amount charged or credited to income to adjust the allowance for credit losses to the appropriate level, for both performing and impaired financial assets. Provision for credit losses for loans and acceptances and related off-balance sheet loan commitments is included in the provision for credit losses line on the consolidated statement of income. Provision for credit losses for debt securities measured at fair value through other comprehensive income or amortized cost is included in gains (losses) from debt securities measured at fair value through other comprehensive income (FVOCI) and amortized cost, net. PCL’s are generally calculated as a percentage of the average beginning and ending loan balances and this percentage is determined based upon the management’s opinion and estimate of borrowers’ financial conditions, ability to service the debt and macroeconomic conditions of the market. Consequently, PCL represents the anticipated credit losses for loans and is an expense item. The unanticipated portion is absorbed by general capital reserves. Net charge-offs, which is the charge-off (or write-off of debt which has become delinquent) net of recoveries, is forecasted as a percentage of loan’s beginning balance. Allowance for loan losses is a contra asset account on the balance sheet that is netted against the gross loan amount. Allowance for loan losses increases by the amount of PCL and decreases by net-charge offs.
One of the biggest expenses on the income statement of a bank is interest expenses on deposits, securities sold short or lent, subordinated indebtedness and wholesale funding. Wholesale funding is treated as the revolving credit facility of the bank.
Depreciation and amortization of intangible assets is another expense item on bank’s income statement. Bank’s are taxed just like any other company based on the jurisdiction they are incorporated in. Preferred shareholders and non-controlling interest take their share of the earnings prior to distribution of a portion of earnings to common shareholders as dividends.
What is different about bank’s balance sheet?
Bank’s balance sheet is generally marked to market and financial assets are recorded at or near fair market value (FmV). Debt to bank is more like raw material and a source of capital. For instance, deposits that are recorded under liabilities on a bank’s balance sheet, are what bank lends to clients against and there is little distinction between deposits and the debt that is issued by the bank. Defining capital for banks is different since borrowed funds are an important part of the daily operations and hence capital is defined more narrowly, including only equity capital. Consequently, regulatory authorities evaluate equity capital ratios for banks and insurance companies.
Securities, loans, cash, derivative assets, land, equipment, deferred tax assets and other assets are recorded under the asset side of the bank’s balance sheet and deposits, obligations related to securities, derivative liabilities, acceptance, unsecured wholesale funding, secured borrowing and other liabilities are recorded under the liability side of the balance sheet. Equities comprise of preferred equity, common equity, retained earnings, contributed surplus, accumulated other comprehensive income and non-controlling interest.
How are banks regulated?
Banks are heavily regulated worldwide. Regulators control the banking industry in three ways: first, they require banks to maintain certain limits for common equity tier 1 capital ratio (CET1), tier 1 capital ratio, tier 2 capital and total capital ratio (in Canada); second, they restrict financial services firms in terms of where they can invest and their investments; third, entering the market for new participants is restricted and regulated as there could be mergers between existing firms. The regulatory body in Canada is OSFI (Office of the Superintendent of Financial Institutions) and the targets set by this regulatory body prior to COVID-19 were as follows: CET1 10%, Tier 1 capital ratio 11.5%, total capital ratio 13.5%. As of March 2020, in response to the pandemic, these targets have all been lowered by 1%. The regulatory capital at a bank should never fall below the required levels or the bank existence is put at risk.
These regulations will certainly affect value; hence reinvestment for the purpose of equity valuation and free cash flow to equity calculation for bank is defined as the change in the level of regulatory capital as defining net capex and working capital for banks as a proxy for reinvestment is challenging. Reinvestment is necessary for growth, and the higher the growth rate of a bank, the higher the reinvestment rate and the lower the free cash flow to equity.
What are some banking industry specific performance metrics, financial measures, value measures, liquidity and asset quality measures?
Due to the nature of financial services industry and regulation, a different set of industry specific metrics are used for the purposes of performance measurement.
Financial measures include efficiency ratio, loan loss ratio, return on equity or ROE, net interest margin, net interest margin on interest earning assets, return on assets or ROA, total shareholder return or TSR, loan to deposit ratio, and PCL as a percentage of loans.
Value measures include dividend yield, dividend payout ratio and price to book ratio. P/B ratio is the most important relative valuation metric for banks since financial assets and book equity are marked to market and have regulatory implications. ROE is an important driver of value and it is important to stay equity focused in bank valuation and the risk measures should include regulatory risks.
Liquidity and asset quality measures include risk weighted assets (RWA), capital ratios including CET1 ratio, tier 1 capital ratio and total capital ratio, leverage ratio, liquidity coverage ratio or LCR.
For the definition of these terms please refer to the Banking Financial Model Terms and Description.
What risks do banks face in their operations?
Banks face a variety of risk factors including market risk, credit risk, liquidity risk and operational risk. Accordingly, the risk weighted assets (RWA) which is the proxy for calculation of capital ratios is broken down into three categories of market risk, credit risk and operational risk.
What are the drivers of value in the valuation model of a bank?
The drivers of value at a bank, just like any other firm, is cashflow, growth and risks. Financial services firms and banks can be opaque as they do not provide enough information about the assets and the quality of assets. As accountants mark the assets to market value, regulators try to keep banks in check through regulatory capital ratios, and net capex and working capital are not meaningful definitions for banks, many industry practitioners use the dividend discount model (DDM) to value banks. However, when we use the DDM, we trust that the banks are paying what they can truly afford to pay as dividends and post 2008, this could be a questionable approach. Hence the most suitable approach is to determine the ‘potential dividends’ or the true equity cashflows as free cash flow to equity or “FCFE” under the intrinsic value approach. Other methods include relative valuation and residual income valuation.
What are the three methods to value a bank?
The three methods as explained below include: intrinsic valuation, relative valuation, and residual income approach.
Intrinsic Valuation: under the intrinsic value framework, we discount the estimated equity cash flows or FCFE at the cost of equity of the firm. The cost of equity is defined as the risk-free rate plus the beta of the bank (measure of relative risk to market) times the market equity risk premium. FCFE is defined as net income less the reinvestment in the bank. Reinvestment in a regulated bank is defined as what the bank would have to put in its regulatory capital since without regulatory capital, the bank can not grow. The change in the regulatory capital year over year is defined as reinvestment and total regulatory capital is defined as RWA times the total capital ratio. In a high growth bank, the regulatory capital grows faster; in an undercapitalized bank, regulatory capital increases more rapidly as there is a deficit to meet. In both cases, the reinvestment rate would be higher and free cash flow to equity would be lower.
Free cash flow to equity is defined as:
And valuation is equal to:
Terminal value of cash flow, FCFE_term, is defined under the perpetuity approach:
Relative Valuation: under the relative value framework, as banks are equity focused and financial assets are marked to market and have regulatory implications, we need to remain equity focused. Therefore, the best ratio to use in pricing banks and financial services firms is price to book value of equity (P/B) as book value of equity is tied to regulatory capital. The drivers of P/B are risk, ROE and growth. Hence a bank with a high P/B, low growth rate, high risk and low ROE is overvalued and a bank with a low P/B, high growth rate, low risk and high ROE is undervalued. Since valuation is forward looking, it is best to use the forward earning multiples.
Residual Income Approach: under the residual income framework, we add the value generated by the bank due to the excess return (ROE) over bank’s cost of equity, to the bank’s current book value of equity. As the bank approaches the terminal year in valuation, ROE converges to cost of equity or r_e. The period throughout which this convergence happens includes a high growth period (usually five years), a convergence period of maybe three or more years depending on the bank and the stage of its life cycle, and the term year. In this multi-stage model, terminal value is usually zero since ROE equals cost of equity or r_e.
Valuation is equal to: