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Table of Contents
INTRODUCTION ............................................................................................................... 2 BACKGROUND ...................................................................................................................2 VALUATION METHOD .................................................................................................... 4 Dividend discount model .................................................................................................. 4 Cost of equity ................................................................................................................. 5 VALUATION .......................................................................................................................7 High growth period ........................................................................................................... 8 Stable growth period.......................................................................................................... 8 Final Valuation ..................................................................................................................9 CONCLUSION .................................................................................................................. 10

INTRODUCTION
Financial service firms encompass such organizations as banks, insurance companies, investment funds, credit unions which operate in the finance industry. The finance industry includes a range of such firms which deal mainly with management of money. Financial service firms could also be broadly categorized into four groups according to Damodaran(2002): banks, insurance companies, investment banks and investment firms. Financial service firms like other nonfinancial service firms, work for profit and have to be competitive to attain growth or to even exist. Despite these characteristics financial service firms have a lot in common with other nonfinancial service firms, there are other aspects as well which make financial service firms different from other firms. For other types of firms, valuing a firm and valuing the equity in the firm can be carried out by discounting expected cash flow prior to debt payments at the weighted average cost of capital and by discounting cash flows to equity investors at the cost of equity respectively. For financial service firms, however, estimating cash flow prior to debt payments or a weighted average cost of capital is very difficult since debt and debt payments cannot be easily identified. It is therefore a must to use alternative approach to valuing such firms. Specifically, valuing financial service firms like banks and insurance companies is problematic particularly for a couple of reasons. Damodaran has pointed two of such reasons. The first one is estimating the cash flows to financial service firms is difficult, if not impossible, because the nature of their business makes it hard to define their debt and investment. The second is the fact that they are subject to regulations makes it imperative to consider the effects of such regulations on their value as well. Therefore, in this paper alternative valuation method is used to value Nordea bank which is a financial service firm and the largest financial service group in north Europe. Key financial figures, fundamentals and multiples of the bank are first calculated and anlysed as well.

BACKGROUND
Nordea was formed in 2000 through the merger of domestic banks in Denmark, Finland, Norway and Sweden under a new name Nordea. It is now the largest financial services group in Northern Europe with a market capitalisation of approximately EUR 33bn, total assets of EUR 581bn and a core tier 1 capital ratio of 10.0%. The Nordea share is listed on the NASDAQ OMX Nordic, the stock exchanges in Stockholm (in SEK), Helsinki (EUR) and Copenhagen (DKK). It has a strong performance history compared to other European banks. Figure 1 presents this comparison using DJ STOXX European banks index. Throughout the period from 2001 to 2010, Nordeas share outperformed the index which implies that its performance was above average compared to other banks. Looking at the trend also, Nordeas over time share performance has increased on average from what it was in 2001 even though there were periods the share performance deteriorated. Especially, around 2009, during the culmination of the global financial crisis, the overall all banking industry including Nordea

was to a great extent negatively affected due to increased uncertainty. The Nordea share price appreciated afterwards somewhat on the Stockholm Stock Exchange from SEK 72 to SEK 73,15. The daily closing prices listed for the Nordea share during 2010 ranged between SEK 60,30 and SEK 76,00. During 2010, the OMX Banks Index of the Stockholm Stock Exchange appreciated by 15% and Dow Jones STOXX European banks index appreciated by 27%. Since 6 March 2000, the date of the merger between MeritaNordbanken and Unidanmark, the Nordea share has appreciated 105% and clearly outperformed the Dow Jones STOXX European banks index(-49%).

Figure 1: Nordea share performance compared to other European banks

Source: Nordea annual financial report 2010

Return on Equity (ROE)


Since the valuation of Nordea bank is undertaken using equity valuation model for reasons explained in the following sections, ROE is an important parameter and looking at the level and the trend of this multiple is thus of greater importance. In fact , the two important parameters needed for valuation under this model are the cost of equity, which will estimated later, and the return on equity. ROE measures profitability from the equity investors perspective and is determined both by the companys business choices as well as regulatory restrictions. AS presented in figure 2 , ROE of Nordea bank exhibits more or less stable trend during the period. Except for 2002, it had values more than 10% and it never went up more than 25%. The high level or ROE shows that Nordea has strong capability to generate cash internally and the stability implies that we dont need to adjust it during valuation for other periods too.

VALUATION METHOD
As was stated above, Damoran(2002) pointed out that valuing financial service firms needs different framework because of the unique role debt plays in such firms, the regulatory restrictions they operate under and the difficulty of identifying reinvestment at these firms. Therefore, he suggested two general rules to deal with these features of financial service firms. The first is to just value equity directly instead of the entire firm1. The second one is to consider measures of cashflows which dont require reinvestment needs to be estimated or to redefine reinvestment that is adaptable to a financial service firm.

Dividend discount model


Given Nordea is a financial service firm and because of the unique features of such firms, I valued its equity rather than the entire firm. However, to value its equity, free cash flow to equity2 still has to be estimated first which requires estimating the net capital expenditures or non-cash working capital. But, as already stated, estimating these two components of the free cash flow to equity of financial service firms is very difficult. As presented in figure 3, Nordea pays a large proportion of its earning as dividend and stock buybacks as it is also true for other financial service firms3. The graph shows the sum of dividend payment and stock buybacks at a given year as a proportion of net income at the same year. This ratio ranges from 20% during the financial crisis in 2008 up to 140% in 2005. This indicates that considering only dividend payments during valuation will significantly under value the present value of the stock as there are large amount of stock buybacks in different years(presented in the excel sheet). Thus the payout ratio should be modified accordingly to reflect this amount.
1

He also noted that Equity multiples such as price to earnings or price to book ratios are a much

better fit for financial service firms than value multiples such as value to EBITDA.
2

Free Cashflow to Equity = Net Income Net Capital Expenditures Change in non-cash working capital (Debt repaid New debt issued) 3 Nordea clearly stated its policy of high dividend in the 2000 annual report: Nordea shall pursue a policy of high dividends. The annual level depends on market return requirements and the amount of tier 1 capital needed for development of activities. Dividend payment shall normally exceed 40% of the net profit for the year.

Ratio
1,60 1,40 1,20 1,00 0,80 0,60 0,40 0,20 0,00 1 2 3 4 5 Ratio 6 7 8 9 10

Damodaran stated three possible reasons for this. First, the financial sector in general is more mature than other sectors like telecommunications and software and thus firms in the sector are less likely to retain much of their earnings for future growth. Second, financial service firms, especially banks and insurance companies, dont need to invest as much in capital expenditures as other firms which implies that more of these financial service firms net income is paid out as dividend. The third reason is Banks and insurance companies are better known for reliable, high dividend payments as a result of which they have long been able to attract a growing number of investors and this policy is very difficult to change. Therefore, Valuation of Nordea is undertaken in this section by using dividend payments to stock holders and stock buybacks as cash flows. This estimation gives realistic result if the given firm over time pays out its free cash flows to equity as dividend. This method is appropriate for Nordea given that it pursues a policy of high dividends and large amount of stock buybacks as explained above. Since dividend discount model is one of discount cash flow models, the value of an asset is calculated using the present value of the expected cash flows (dividend + stock buybacks) generated by that asset (the stock). But in order to find present value of any expected cash flow, the rate of return which reflects the riskiness of the asset should be known first. In this valuation since dividend payments are used for valuation, the cost of equity has to be calculated first.
Cost of equity

Investors on Nordea equity, like any other investors, require a return on their investment. The cost of the firms equity is therefore the rate of return the investors require. The required return to equity investors can also be viewed as the sum of the riskless rate and risk premium which the investors need to be compensated with for taking up market risk. That means, the risk premium depends on the firms exposure to market risk. If, for example, Nordea is very exposed to market risk in a sense that its stock returns are highly correlated to the stock market upswings, then it has to pay higher risk premium. Mathematically:

Cost of equity = Riskless rate + Beta(Risk premium)

(1)

This cost of equity has to reflect the portion of the risk in the equity that cannot be diversified away by the marginal investor in the stock. And the beta measures this risk. In other words, Beta measures the exposure of the firm to market risk and it is estimated using historical data on market prices by regressing returns on the firms stock against returns on the DJ STOXX European Banks Index. Damoran argued that though the regression beta estimate is not appropriate for non-financial firms, it could be a good estimate for large and more mature financial service firms. The following regression model is therefore used: (2) Where: is Nordeas stock return in year t, estimator for Nordeas beta. is market returns in year t and b is the

The estimation result together with the regression fit is presented below = 16,05+ 1,093*
( 4,56) (0,15)

R Square=0,87

DJ STOXX European Bank

100,00 80,00 60,00 40,00 20,00 Nordea 0 -20,00 20 40 60

-80

-60

-40

-20

-40,00
-60,00

Therefore, the beta of equity of Nordea is equal to 1,09. Then given the prevailing 5-year Treasury bond rate of 4.5% as a proxy to the riskless rate and historical risk premium of 5.5%, the cost of equity can be calculated using equation (1). Cost of equity= 4.5% + 1,09(5.5%) = 10,5%

Nordea

0,00

VALUATION
An investor buys a stock in Nordea, or any other traded firm, expecting that he will earn some amount of cash flows or dividend as long as the investor still holds the stock and that he can also sell it and earn the price. Therefore, the value of any stock can be estimated using the present value of dividends in perpetuity. Thus in this section, a general valuation of Nordea is carried out using dividend discounted cash flow model where the value of SSABs is calculated via the present value of expected future cash flows on its stocks, discounted at a rate which reflects the riskiness of the cash flows. Value per share of stock = Where: =dividend per share = Cost of equity (3)

Nordeas dividends are expected to grow for five years, from 2011-2015, at high rate which is not constant forever and the growth rate will be sustainable and constant afterwards. Thus, the valuation is carried out using two-stage dividend discount model. There are a couple of characteristics of the bank and the overall banking industry which motivated the use of two stage dividend discount model. First of all, Nordea is assumed to have a little higher growth rate during the first stage because it is now in the top quartile of its European peer group in terms of total shareholder return and it has successfully defended its position and increased market shares by virtue of its financial strength, standing in the market and service delivery during the last 10 years including the global financial crisis period. However, since Nordea wont be able to sustain this higher growth rate forever, it is assumed to grow at the rate of the economy from 2015 onwards. The prime reason for this assumption is the competitive situation in the banking industry being more and more intensified year after year as many banks were able to find new financing, sometimes with the aid of government guarantees and as global players also took a renewed interest in the Nordic region, sometime in the form of new or extended local offices. Therefore, the value of Nordeas stock is estimated using two stage dividend discount model as the sum of the present values of the dividend payments during the extraordinary growth period and the present value of the terminal price. (4)

Equation (4) presents the two-stage dividend discount model adapted for valuation of Nordeas stock according to the assumptions made above. To estimate Expected growth rate of Nordeas earnings Historical growth in earnings is used Furthermore, thecorrelation between past earnings growth and expected future growth is much higher for financial service firms than it is for other firms. Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

ROE Pay out ratio Growth rate Geometric mean ROE Pay out ratio Growth rate

0,13 0,43 7,50 0,13 0,42 7,36

0,07 0,76 1,80

0,12 0,48 6,39

0,15 0,40 9,15

0,18 0,21 0,40 0,40 10,50 12,28

0,18 0,41 10,68

0,15 0,10 0,20 0,43 12,04 5,85

0,11 0,44 6,09

Stock buybacks
However, as was discussed previously, Nordea has had a significant amount of stock buybacks during the period which can ultimately affect the dividend payout ratio and change the growth rate. The dividend payout ratio is modified accordingly and it became 62%. This also changes the expected growth rate to 8%. (Calculation included in the excel sheet) (footnote: In order to be able to adjust the Companys capital structure to the capital need existing at any time and to use own shares as payment in connection with acquisitions or in order to finance such acquisitions, the Board of Directors proposes to the AGM 2011 a 10% authorisation to repurchase own shares on a regulated market where the Companys shares are listed, or by means of an acquisition offer directed to all shareholders)

High growth period


Expected Grwoth Earning Per share(EPS) Payout ratio(modified) Dividend Per share(DPS) Cost of Equity Present value Sum 2011 8,00% 0,71 62% 0,44 10,50% 0,40 1,91 2012 8,00% 0,77 62% 0,48 10,50% 0,39 2013 8,00% 0,83 62% 0,52 10,50% 0,38 2014 8,00% 0,90 62% 0,56 10,50% 0,37 2015 8,00% 0,97 62% 0,60 10,50% 0,37

Stable growth period


Since the trend of ROE was more or less stable for the last 10 years we dont need to make adjustment on it. Thus, the payout ratio will not change as well. Terminal price per share= Expected earnings per share2016*Payout ratio/(Cost of Equity-g) During the stable growth period, from 2016 onwards, Nordea is assumed to grow at the rate the economy grows which is 5% and to have beta equal to 1. As a result to calculate the terminal price per share, the cost of equity should be recalculated first to reflect the change in the rate of growth of earnings.

9 Cost of equity = 4.5% + 1(5.5%) = 10%

Thus, using the new cost of equity: Terminal price per share = =EUR 12,63 Present value of terminal price = =EUR 7,67 Graphically, this two-stage growth of Nordeas equity is presented in figure 4. The stage of extraordinary growth is presented by broken lines between 2010 and 2015 and the red lines afterward represent the stable growth period.
0,90 0,80 0,70 0,60 0,50 0,40 0,30 0,20 0,10 0,00 1 2 3 4 5 6 7 8 9 DPS 10 11 12 13 14 15 16 17 18 19 20 Growth rate

Final Valuation
The present value per share for Nordea Bank is finally computed by adding the present values of the dividends during the high growth phase and the presetent value of the terminal price. PV of dividends: high growth = EUR1,91 PV of terminal price = EUR7,63

Value per share

EUR9,5

Nordeas Stock price on 31,2011 was EUR6,97 which shows that it is undervalued.

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CONCLUSION
As a financial service firm, valuing Nordea requires using an alternative approach other than the one used to value non-financial firms. The major reasons for this are: for one thing, estimating its cash flows prior to debt payments or a weighted average cost of capital is very difficult since debt and debt payments cannot be easily identified and for the other the fact that it is, like any other financial service firms, subject to regulations makes the consideration of the effects of such regulation on the value of the firm very important.