Valuing Financial Service Firms

Banks, insurance companies and other financial service firms pose particular challenges for an analyst attempting to value them for two reasons. The first is the nature of their businesses makes it difficult to define both debt and reinvestment, making the estimation of cash flows much more difficult. The other is that they tend to be heavily regulated and the effects of regulatory requirements on value have to be considered.

We begin by considering what makes financial service firms unique and ways of dealing with the differences.

Categories of financial service firms

Any firm that provides financial products and services to individuals or other firms can be categorized as a financial service firm. We would categorize financial service businesses into four groups from the perspective of how they make their money.

A bank makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it, and from other services it offers it depositors and its lenders.

Insurance companies make their income in two ways. One is through the premiums they receive from those who buy insurance protection from them and the other is income from the investment portfolios that they maintain to service the claims.

An investment bank provides advice and supporting products for other firms to raise capital from financial markets or to consummate deals such as acquisitions or divestitures.

Investment firms provide investment advice or manage portfolios for clients. Their income comes from advisory fees for the advice and management and sales fees for investment portfolios.

With the consolidation in the financial services sector, an increasing number of firms operate in more than one of these businesses. For example, Citigroup, created by the merger of Travelers and Citicorp operates in all four businesses. At the same time, however, there remain a large number of small banks, boutique investment banks and specialized insurance firms that still derive the bulk of their income from one source.

In emerging markets, financial service firms tend to have an even higher profile and account for a larger proportion of overall market value than they do in the United States. If we bring these firms into the mix, it is quite clear that no one template will value all financial service firms and that we have to be able to be flexible in how we design the model to allow for all types of financial service firms.

What is unique about financial service firms?

Financial service firms have much in common with non-financial service firms. They attempt to be as profitable as they can, have to worry about competition and want to grow rapidly over time. If they are publicly traded, they are judged by the total return they make for their stockholders, just as other firms are. In this section, though, we focus on those aspects of financial service firms that make them different from other firms and consider the implications for valuation.

Debt: Raw Material or Source of Capital

When we talk about capital for non-financial service firms, we tend to talk about both debt and equity. A firm raises funds from both equity investor and bondholders (and banks) and uses these funds to make its investments. When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity.

With a financial service firm, debt seems to take on a different connotation. 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 General Motors, something to be molded into other financial products which can then be sold at a higher price and yield a profit. Consequently, capital at financial service firms seems to be more narrowly defined as including only equity capital. This definition of capital is reinforced by the regulatory authorities who evaluate the equity capital ratios of banks and insurance firms.

The definition of what comprises debt also seems to be murkier with a financial service firm than it is with a non-financial service firm. For instance, should deposits made by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between a deposit and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid to depositors, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

Financial service firms are heavily regulated all over the world, though the extent of the regulation varies from country to country. In general, these regulations take three forms. First, banks and insurance companies are required to maintain capital ratios to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are often constrained in terms of where they can invest their funds. For instance, until recently, the Glass-Steagall act in the United States restricted commercial banks from investment banking activities and from taking active equity positions in manufacturing firms. Third, entry of new firms into the business is often restricted by the regulatory authorities, as are mergers between existing firms.

Why does this matter? From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints. There might also be implications for how we measure risk at financial service firms. If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, which can have an effect on value.

Reinvestment at Financial Service Firms

In the last section, we noted that financial service firms are often constrained by regulation in both where they invest their funds and how much they invest. If, as we have so far in this book, define reinvestment as necessary for future growth, there are other problems associated with measuring reinvestment with financial service firms. Note that in Chapter 10, we consider two items in reinvestment – net capital expenditures and working capital. Unfortunately, measuring either of these items at a financial service firm can be problematic.

Consider net capital expenditures first. Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are categorized as operating expenses in accounting statements. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation. With working capital, we run into a different problem. If we define working capital as the different between current assets and current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth.

As a result of this difficulty in measuring reinvestment, we run into two practical problems in valuing these firms. The first is that we cannot estimate cash flows without estimating reinvestment. In other words, if we cannot identify net capital expenditures and changes in working capital, we cannot identify cash flows either. The second is that estimating expected future growth becomes more difficult, if the reinvestment rate cannot be measured.

Taken from Investment Valuation by Aswath Damodaran (Second edition)