Industry Specific Valuation:

Banks & Financial Service Firms

Presented by: Antoni Tris, MBA, CFA

Jakarta 2015

1
Introduction
 General Value Creation Process
Investment
Decision
Cash in assets for
operation
Company/ Financing Creditors
Firm/ Decision
Cash is invested by
Enterprise investors in form of
capital Shareholders
Operating
Decision
Return/Cash generated
from operating assets
Operating & = Debt & Equity
Investment Assets Financing

Cash Flow: Cash Flow to Firm = Cash Flow to Capital Providers

Value: Enterprise Value (EV) = Market Value of Invested Capital (MVIC)

3B
Financial Service Firms – Introduction

• Definition of financial service firm: any firm that provides financial products
and services to individuals or other firms.

• Classification of financial service business

Four groups of f financial service firms from the perspective of how they make
their money:
‒ Bank: makes money on the spread between the interest it pays to
depositors and the interest it charges lenders, and from other services it
offers to depositors and its lenders.
‒ 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.
‒ E.g. Helping corporation & government to raise capital in the market.
‒ Investment firms: provide investment advice or manage portfolios for
clients.
‒ Insurance companies: make their income in two ways
o through the premiums they receive from those who buy insurance
protection; and
o from the investment portfolios that they maintain to service the claims.
4
Banking Business – Introduction
A bank’s primary purpose is financial intermediation:
• Accept deposits: Usually short-term in nature with relatively quick interest rate adjustments,
• Make loans: Variety of maturities with fixed and variable rates
• Make money through an interest rate spread and by charging for services provided

Activity:
Commercial Gathering Deposits Making Loans • Maturity-transforming
Banking Money
activity or Asset Liability
Management
• Credit Risk
Interest Expense Interest Income Management

• Underwriting & placement of

Securities Fee and
Investment • Securities brokerage Commission Income
Banking & • Corporate advisory
Asset Mgt • Portfolio/Asset Management

• Proprietary Trading Trading Income

Private Services to Wealthy Individual:

Fee and
Banking • Financial/Banking advisory
Commission Income
• Portfolio/Asset Management
5
Corporate & Investment Bank’s Business model

CLIENT’S COVERAGE
•Corporate
•Institutions
•Banks
•Energy &
•Industries
Commodities •Origination
•Trade Finance •Corporate Finance
•Export Finance CORPORATE & INVESTMENT •Cash Management
•Project Finance BANKING •Equity, debt, interest,
•Syndications FX, Sales & Trading
•Structured
Finance
BOOK MANAGEMENT
•Credit
•Sales
•Hedging
Characteristics of Financial Service Firms
Financial service firms operate under strict regulatory constraints.
Regulatory General forms of regulations:
Constraints • Maintaining regulatory capital ratios;
• constrained on where they can invest their funds;
• controlled by the regulatory authorities on entry of new firms and
mergers between existing firms.
Differences • Mark to Market: recording assets at fair value,
in Accounting • Loss Provisions and smoothing out earnings.
Rules ‒ The most difficult problem: Determining the quality of Loans

• Debt is raw material, not capital.

• The definition of what comprises debt is murkier with a financial
Difficulty in
service firm than it is with a non-financial service firm.
defining Debts
• Degree of financial leverage: tend to use more debt in funding their
businesses and thus have higher leverage

Estimating • Financial service firms invest primarily in intangible assets such as

cash flows is brand name and human capital. Their investments often are
difficult categorized as operating expenses in accounting statements.
• If working capital = current assets -/- current liabilities, a large
proportion of a bank’s balance sheet would fall into these categories.7
Changes in this number can be both large and volatile and may have
no relationship to reinvestment for future growth
 VALUATION PROCESS –
FUNDAMENTAL APPROACH

Understand
the Business

Macroeconomic
Analysis
Analysis &
Select Make/
Industry
Normalization Perform
Valuation Recommend
Analysis of Financial Valuation Decision
Method(s)
Statements
Company
Analysis

Input Financial Valuation

Statement
Analysis 8A
Analysing Performance of Banks
Framework for Analyzing Performance of Banks

CAMELS

Capital adequacy is a reflection of the inner strength of a bank, which would stand it in
Capital Adequacy good & during the times of crisis.
• Common Ratio: CAR (Capital Adequacy Ratio), Leverage Ratio
Asset quality is high loan concentrations that present undue risk. The asset quality rating
Asset Quality is a function of present conditions and the likelihood of future deterioration or
improvement based on economic conditions, current practices and trends.

Management Management's ability to identify, measure, monitor, and control the risks of the bank’s
activities, ensure its safe and sound operations, and compliance with applicable laws and
Quality regulations.

Ability to earn an appropriate return on its assets which enables bank to fund expansion,
Earnings remain competitive, and replenish and/or increase capital.

This represents Asset/liability management , reflecting the process of evaluating,

Liquidity monitoring, and controlling balance sheet risk (interest rate risk and liquidity risk).

Sensitivity to market risk is a complex and evolving measurement area, covering

Sensitivity assessment of interest rate and commodity price risk exposures. Sensitivity to market
risk can cover ever increasing territory.

10
Balance Sheets – Banks

• Cash and Due From Banks (DFB): Vault cash, deposits held at the Central Bank and
other financial institutions.
• Investment Securities: Bonds, notes, and other securities held to generate return and
help meet liquidity needs.
• Loans: Generate most of interest income; highest default risk.
• Other assets: Fixed assets, prepaid expenses, and others.
11
Balance Sheets – Banks

• Savings and time deposits often represent the bulk of interest-bearing

liabilities.
• Purchased liabilities (rate-sensitive):
- Central Bank Funds Purchased (Borrowing from Central Bank).
- Repurchase agreements
- Other borrowings less than one year
• Subordinated notes and debentures: Notes and bonds with maturities over
one year.
• Equity Accounts: Ownership interest in the bank.
- Common and preferred stock listed at par
- Additional Paid In Capital: Surplus account represents the amount
of proceeds received by the bank in excess of par when it issued the
stock
- Retained earnings equals accumulated net income not paid out as
cash dividends

12
 Income Statements – Banks

• Net interest income is interest income minus

interest expense.
- Interest income: interest income and fees
earned on loans and leases, deposits held at
other institutions and securities.
- Interest Expense: interest paid on deposits,
Repos, other borrowings, and sub. notes and
debentures
• Provision for Loan Losses
- Noncash expense representing funds put
aside to prepare for bad loans
• Noninterest income:
• Noninterest Expense:
- Service charges: Fees for
maintenance, overdraft, stop - Personnel expense: Salaries and benefits
payments - Rent and depreciation on equipment
- Others: Investment banking, - Other operating expenses: Utilities, Deposit
Insurance commission fees, insurance premiums
etc

13
 Analyzing Bank Performance with Financial Ratios

• Profit ratios
– Return on equity: ROE = NI/E (net income after taxes/total equity)
– Return on assets: ROA = NI/TA (net income after taxes/total assets)
– Other profit measures
Net interest margin
NIM = (Total interest income - Total interest expense)/Total assets

Decomposing ROE

Average assets
ROE = ROA ×
Average equity

ROE = Profit margin × Turnover × Leverage

Net income Revenue Average assets

ROE = × ×
Revenue Average assets Average equity
Analyzing Bank Performance with Financial Ratios
 Analyzing Bank Performance with Financial Ratios
• Risk ratios
Asset quality
- Provision for loan loss ratio = PLL/TL (provision for loan losses/total loans and
leases)
- Loan ratio = Net loans/Total assets
- Loss ratio = Net charge-offs on loans (gross charge-offs minus
recoveries)/Total loans and leases
- Reserve ratio
= Reserve for loan losses (reserve for loan losses last year
minus gross charge-offs plus PLL and recoveries)/Total loans and leases
- Nonperforming ratio = Nonperforming assets (nonaccrual loans and
restructured loans)/Total loans and leases
Operating efficiency (cost control)
- Wages and salaries/Total expenses
- Fixed occupancy expenses/Total expenses
– Liquidity: Temporary investments ratio
= (Fed funds sold, short-term securities, cash, trading account
securities)/Total assets
Analyzing Bank Performance with Financial Ratios

• Risk ratios
– Capitalization
Leverage ratio
Total equity/Total assets
Total capital ratio
(Total equity + Long-term debt + Reserve for loan
losses)/Total assets
Note: book values and market values likely are different and yield
different results.
Capital Adequacy Ratio
• Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the
adequacy of their capital keeping in view their risk exposures.
• Banking regulators require a minimum capital adequacy ratio so as to provide the
banks with a cushion to absorb losses before they become insolvent.
• Formula:

• Risk-weighted exposures include weighted sum of the banks credit exposures

(including those appearing on the bank's balance sheet and those not appearing).
The weights are determined in accordance with the Basel Committee guidance for
assets of each credit rating .
• Capital consists of:
– Tier I Capital: Actual contributed equity plus retained earnings.
– Tier II Capital: Preferred shares plus 50% of subordinated debt
Capital Adequacy Ratio - Example
Calculate capital adequacy ratio i.e. total capital to risk weighted exposures ratio for
Small Bank Inc. using the following assumptions:

The bank's Tier 1 Capital and Tier 2 Capital are $200,000 and $300,000 respectively

Solution
Banks's total capital = 200,000 + 300,000 = $500,000
Risk-weighted exposures = $1.5×0% + $15×10% + $8×20% + $6×10% = $3.7 million

If the national regulator requires a capital adequacy ratio of 10%, the bank is safe.
However, if the required ratio is 15%, the bank might have to face regulatory actions.
Banking Financial Ratios

Source: Massari, et.al. p.102

Analysing Business Plan for a
Bank
Assessing Business Plan

Purpose of Analyzing Bank’s Business Plan

1. Assessing its sustainability;
2. Highlighting areas of potential inconsistency.

Broad Category of Analysis

1. Status quo analysis:
Assessing whether the current recorded amount of some key on
& off balance sheet items requires potential adjustments.
2. Internal consistency
Evaluate whether the forecasts included in the business plan are
internally consistent
3. External consistency
Assessing whether the business plan is consistent with external
factors.

22
Status Quo Analysis
Objective:
Investigate whether the recorded amount of some key on & off balance sheet items
needs to be adjusted to better reflect the current situation & expected evolution of the
business.

Status Quo Analysis & Potential Adjustments include:

1. Analysis on the Asset Quality:
• Loan Portfolio analysis:
→ Analysis on Loan Reserve Provisioning may require additional provision.
• Toxic & Illiquid Assets analysis:
→ Analysis on adequacy of reserve and/or write-off

2. Analysis on Impairment of Goodwill and intangible assets

3. Analysis on Adequacy of Bank Capitalization
Analyze whether Bank’s capital meets regulatory requirements and market
expectation.

23
Status Quo Analysis

24
Internal Consistency Analysis
Objective:
Evaluate whether the forecasts and connections among different elements included in
the business plan are internally consistent.

Main Categories of Internal Consistency Analysis:

1. Consistency between forecasts and historical data

2. Consistency between P&L items and Balance Sheet items

3. Consistency between the asset and liability sides of the Balance Sheet

4. Consistency between financial & operating forecasts

25
External Consistency Analysis
Objective:
Evaluate whether the business plan is consistent with external factors:
Whether macroeconomic trends & expected development in the competitive
landscape are properly reflected.

Main Categories of Analysis:

1. Macroeconomic outlook
→ GDP growth, inflation & interest rates influence any bank’s financials such as:
net interest income, loan growth, the value of securities owned by bank.

2. Competitive landscape
a. Strategic positioning of the bank to understand its main strengths and
weaknesses compared to peers.
b. Evolution of competitive pressure as a result of expected change in
competitive landscape such as industry consolidation
c. The expected performance of peers to be used as a reference to check
the reliability of business plan assumptions

3. Business Plan vs. Market Consensus

26
Valuation of Banks
Overview

28
Overview

29
Overview

30
Overview

31
Overview

32
Issues in Valuing Banks & Financial Services Firms

Aspects of Bank’s Financial Structure which have impact of on

valuation
• Banks are highly leverage entities, while such high degree of financial leverage is rare
for non-financial companies.

• Core business for banks is to transform money collected from depositors into
financing products for other clients. Therefore, Debt is raw material, rather than
source of capital.
‒ For non-financial companies, financing, investment and operating decisions
can be made independently.

• Banks are heavily regulated all over the world.

‒ Financial service firms are often constrained in terms of where they can
invest their funds.
‒ Banks and insurance companies are required to maintain regulatory capital
ratios. They cannot expand beyond their means and put their claimholders or
depositors at risk.
‒ This regulatory capital control affect dividend policy and the recourse to
capital market.

33
Valuing Financial Service Firms
Non Financial Financial Valuation Implications
Companies Companies
Financing & Operating Financing & Operating • Valuation is Equity-side (DDM, equity DCF, equity
Decisions are separate Decisions are multiples).
integrated • Relevant cost of capital is cost of equity

Financial structure Mandatory minimum • Dividend/cash flow should reflect capital

decisions are (usually) capital requirements requirements
free • Multiples adjusted in case of severe excess/deficit
capital

High degree of Leverage is structurally • Cost of equity (beta) should not be adjusted for
variation in capital high & consistent leverage
structure, but across similar financial
extremely high institutions
leverage is rare

Financing, investment Financing, investment • Net income (+change in regulatory capital) is the
and operating and operating activities free cash flow to equity.
activities separate are integrated and
equivalent

34
Valuing Financial Service Firms & Free Cash Flow
Free Cash Flow to the Firm
(FCFF)
= EBIT (1- Tax rate) + Non Cash
Charges – Capital Expenditure –
Increase in Working Capital for
Operation
= Net Income + Non Cash Charges
+ Interest (1-Tax rate) – Capital
Expenditure – Increase in
Working Capital for Operation
Computing FCFF from Statement of Cash Flows
= Cash Flow from Operations +
Interest (1-Tax rate) – Capital
Expenditure
Free Cash Flow to Equity
(FCFE)
= [EBIT (1- Tax rate) + Non Cash
Charges – Capital Expenditure –
Increase in Working Capital for
Operation]- Interest (1-Tax rate)
+ Net borrowing
= Net Income + Non Cash Charges
– Capital Expenditure – Increase
in Working Capital for
Operation + Net borrowing
FCFF - Interest (1-Tax rate) +
= Net borrowing
35
Valuing Financial Service Firms

Income Approach:
• It is difficult to measure Free Cash Flows to the Firm (FCFF) as well as Free Cash
Flows to Equity (FCFE) for Financial Service Firms:
‒ difficulty in defining debt
‒ difficulty in estimating net capital expenditures or non cash working capital .

• Income Approach to valuing Financial Service Firms:

‒ Dividend Discount Models
‒ Present Value of Excess Returns or Future Economic Profit
• When valuing Financial Service Firms, use levered beta from comparable companies.
No need to unlevered and then relevered the beta.

Relative Valuation (Market Approach):

• Firm value multiples cannot be easily adapted to value financial service firms.
‒ difficulty in defining debt
‒ difficulty in estimating net capital expenditures or non cash working capital .

• Appropriate multiples to analyze financial service firms are equity multiples:

‒ Price Earnings Ratios
‒ Price to Book Value Ratios

36
Approaches to Valuing Financial Service Firms
Valuation Approaches

Decision on what
Income Market Asset method(s) to apply
Approach Approach Approach depends on:
• Purpose of
valuation (M&A,
Investment
• Dividend Discount • Multiples from • Net Asset Value recommendation)
Model (DDM) Fundamentals • Nature &
• Discounted Cash • Market Multiples complexity of
Flow to Equity (GPCM – Guideline financial
• Present Value of Publicly Listed institution
Excess Returns or Multiples) • Availability of
Future Economic • Deal Multiples internal & external
Profit (Excess (M&A Multiples) data
Return Model) • Valuer’s time &
resources

37
Valuation using Income
Approach
Generic DCF Valuation Model
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Inco me/EPS Firm is in stable growth:
cash flows Gro ws at constant rate
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Equity: Value of Equity
Length of Period of High Gr owth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

•Formula:
V =  [CFt/(1+Cost of Capital)t ]

39B
Generic DCF Valuation Model

40B
Generic DCF Valuation Model

41B
Income approach
Discount rate – Cost of Equity

Cost of Equity

Build up of
Capital asset pricing model
specific risk

Ke = Rf + β [ E(Rm) - Rf ] + α + Ssp

Risk free Equity market Small stock

rate risk premium premium

Beta Company specific

(systematic risk) risk

42
Income approach
Discount rate – Cost of Equity

Risk free rate (Rf)

• No totally risk free asset in existence; Risk in government debt in most developed
economies can be used as proxy
• Need to match cash flow period
Equity market risk premium (E (Rm) – Rf)
• Compensates investors for higher risk of the equity market
• Higher risk markets are compensated with a higher premium
• Expected compensation – typically not directly observable
Alpha – Company specific risk (α)
• Investors are not always rational or diversified
• Common risk includes small stock premium, early stage investment, country risk
and dependency risk (customer, key personnel, etc)

© 2015 Deloitte Southeast Asia Ltd 43

Income approach
Discount rate – Cost of Equity
3) Beta (β)
• Development of CAPM and beta is based on portfolio theory
• Systematic (or market) risk – non-diversifiable risk (eg. economic growth,
interest rates, foreign exchange, commodity risk, etc)
• Market risk ≠ project risk or specific asset risk
• Regression of the returns on an asset against the market. Length of
estimation period: 2- 5 years
(Bloomberg default – measured weekly over 2 years)
• For Banks, use Industry Beta rather than historical beta of the bank
analyzed (if listed).
• “Industry” should include only companies comparable to the bank
being analyzed
• The following Gearing affecting beta computation – unlevering and re-
levering IS NOT APPLICABLE FOR VALUING BANKS
BL = BU ( 1 + ( 1 – t ) ( D / E ) )
44
Cost of Equity - Required Rate of Return Models

Expanded Build-Up
CAPM
CAPM Approach
Rf Rf Rf

Βi(equity risk premium) Βi(equity risk premium) Equity risk premium

Small stock premium Small stock premium

Company-specific risk Company-specific risk

Industry risk premium

Re = Rf + b. (Rm - Rf)
Example: Required Return Models

Risk-free rate 1.00 %

Equity risk premium 6.00 %

Beta 1.50 %

Small stock premium 4.00 %

Company-specific risk premium 1.50 %

Industry risk premium 1.20 %

Example: Required Return Models

Expanded Build-Up
CAPM
CAPM Approach
Rf = 1.00% 1.00% 1.00%

B*ERP =1.50(6%) 1.50(6%) 6.00%

Ssp = - 4.00% 4.00%

Apha = 1.50% 1.50%

Industry Risk Premium 1.20%

= 10.00% = 15.50% =13.70%

Dividend Discount Models (DDM)

General version of DDM:

Where,
DPSt = Expected dividend per share in period t
ke = Cost of equity
g = Constant Growth in Perpetuity period
Gordon Growth model (One Stage
DDM): Value per share
A special case where the expected growth of equity in =
rate in dividends is constant forever. stable growth

DPSn+1 = Payout Ratio x Net Incomen (1-t)(1-g/ROE)

Constraints:
• g max = Nominal Economic Growth
• Value Driver formula may be used if dividend is derived from Net Income:
ROE = Net Incomen+1 /Book Value of Equity
Where:
g/ROE = Retention Ratio = 1 – Dividend Payout Ratio
 Sustainable g = Retention Ratio x ROE
48
Dividend Discount Models (DDM)

Normalizing Dividend:
• Check whether current dividend is consistent with the past behavior of the bank and
with the industry.

• Normalizing Dividend: consider either the historical company average payout ratio or
current industry payout ratio, and apply it to the company's expected earnings.

Treatment of Excess (Deficit) Capital:

Excess (Deficit) Capital = (Optimal Tier 1 Capital - Actual Tier 1 Capital) x RWA.
RWA = Risk Weighted Assets

• Treatment 1:
Equity Value = Excess (Deficit) Capital + DDM Valuation
• Treatment 2:
Future Dividends (in one or more years) will be increased in case of excess
capital and decreased in case of deficit capital until the bank capital converges on
the optimal level.

49
Summary - Dividend Discount Models (DDM)
Dividend Payout Ratio

Earning ROE
Growth Rate
Growth

Sustainable g = Retention Ratio x ROE

Sustainable g = (1 – Dividend Payout Ratio) x ROE

Cost of Equity
• Use average Beta from Comparable: No need to
unlevered & re-levered beta
• High Growth banks have higher beta
• As growth decreases, beta and cost of equity also
decrease
50
 DDM: Illustration
Valuing Wells Fargo in 2008 during market crisis
Information for the year 2008: Scenario 2 – return to average
• Total Dividend = USD 6,034 million
• Payout Ratio = 76% Normalized Net Income
• ROE = 16.67% = Book Value of Equity x Normalized ROE
• Book value of equity = USD 47,628 = 47,628 x 18.91%
million = 9,006 million
Additional Information:
• Average ROE 2001-2007 = 18.91%
Dividend Payout Ratio = 1 – g/ROE
• Cost of Equity = 9% = 1 – 3%/18.91%
• Stable growth rate = 3% = 84.14%

Scenario 1 – using 2008 figures Value of Net Income x Payout Ratio

equity =
Value of equity = 6,034/(9%-3%) Ke - g
= 100,567 million
9,006 x 84.14%
=
9% - 3%

= USD 126,293 million

(Source: Aswath Damodaran)
51
DCF Valuation Model - FCFE Model for BANKS

52B
DCF Valuation Model - FCFE Model for BANKS

Other Method to Estimate FCFE:

• Characteristics of banks:
‒ Financing and investment are key elements of bank core activity & cannot be
effectively disentangled from the bank’s comprehensive income.
‒ Implication: Net Income can be used s a gross proxy of FCFE.
‒ Banking capital regulation imply that net income generated cannot be freely
distributed to shareholders but a portion (or all) of it has to be retained by bank
to meet regulatory capital requirement.
• FCFE for bank could be formulated as:
FCFE = Net Income ± Equity Investment in Regulatory Capital
± Planned Change in Equity Capital

Equity Investment in Regulatory Capital is the difference between total equity

capital held by bank at the time t-1, and then to be held by the bank at time t on the
basis of the target Tier 1 ratio and of the expected RWA.
‒ It is advisable to use not just the minimum regulatory capital, but rather a
“market” level consider appropriate by investors given specific market
condition.
Planned Change in Equity Capital refers to the planned (if any) capital increased or
reductions.

53B
DCF Valuation Model - FCFE Model for BANKS

Equity Value:
Similar to DDM, equity value obtained using FCFE DCF is:
Equity Value = Excess (Deficit) Capital + DCF Valuation

Alternative 2:
Excess (deficit) capital is incorporated into the expected FCFE either as a one-off
or by spreading it over several years.

54B
Income approach: Economic profit (Excess Return)
method

Accounting Profit vs Economic Profit (Excess Return)

Accounting approach Economic profit approach

Revenue
Revenue Operating
profit
Operating
NOPAT
profit Opex
COGS
Tax
Economic
Opex Net profit profit
Invested
capital
Capital
Interest & charge
tax Cost
of capital

55
Income approach: Economic profit (Excess Return)
method
Concept of economic profit
Economic Profit (EP) or Excess Return calculates the net operating profit
after taxes minus a charge for the opportunity cost of the capital invested

EP = NOPAT – Capital Charge

Where:
NOPAT = Net Operating Profit After Taxes
Capital Charge = WACC x Invested Capital
Invested Capital = Net Fixed Assets + Net Working Capital

Alternative calculation of Economic Profit:

EP = Net Profit – (Equity x Cost of Equity)

= (ROE – Cost of Equity) x Equity

56
Income approach: Economic Profit (Excess Return)
method

T
EP
Value
Invested
Capital 
 1 (1  r )


Applied to Equity
Value of Equity = Equity Capital currently invested + PV of Expected Excess
Returns to Equity investors

57
Income approach: Economic Profit (Excess Return)
method

• Similar to DDM & FCFE DCF, if there is Excess (Deficit) Capital, then:
Equity Value = Excess (Deficit) Capital + Excess Return Valuation

• If there is stable presence of Excess Capital, ROE may reduce. If this is the case, ROE
should be adjusted accordingly:
Equity Value = Excess (Deficit) Capital + Excess Return Valuation

Adjusted Net Income – [EXC x Rf x (1-t)]

ROE Book Value of Equity – EXC

Where:
• EXC = excess capital
• Rf = risk free rate
• T = corporate marginal tax rate

58
Valuation using Market
Approach
Relative Valuation (Market Approach)

Formula
Subject Company
Fundamental Variable Multiple of Comparable
Companies
Balance Sheet variable
V or Multiples from transactions
Selected level of involving similar companies
Maintainable Earning

(1) Guideline Publicly Traded Company

• Value indication: non-controlling
value
• Value standard: market value
(2) Guideline M&A Company
• Value indication: controlling value
• Value standard: market value
&/or investment value
Relative Valuation
Main Considerations
Three Main Issues to be Considered in Relative Valaution:
1. Comparables.
• Reasonable set of criteria to select comparables:
‒ Operational Characteristics: The Business Model (such as: investment bank vs.
commercial bank, customer, etc), Geographical Scope
‒ Financial characteristics: The Size, Performance/Profitability, Growth Potential,
accounting/reporting standard
• Comparables can be obtained from Publicly Listed Companies (Guideline Publicly
Listed Comparables) or from M&A transactions (Guideline or Comparable
Transaction Method).

2. Meaningful Price: share prices should not be biased.

• Some possible price distortion: market illiquidity & inefficiency, specific
market/corporate features that might influence price.
3. Valuation Multiple(s) choice: Which multiple to use?.
• Appropriate multiples to analyze financial service firms are equity multiples.
• While the numerator (share price) should refer to the price as of valuation date or
current share price, the denominator could be Current, Trailing or Forward:
• Current refers to earnings for the last yearly period.
• Trailing refers to earnings for the last 12 months period.
• Forward refers to expected earnings over the next or subsequent year.
 Market Approach
Comparable Transaction Method – M&A Transaction Multiple

• Comparable transaction method values a company by reference to other sale transactions of similar
businesses
• The trick is to find the right comparable transactions and to look for the relevant information required.
Issues to consider:
– As in comparable company analyses, look for acquisitions of companies with comparable
operational and financial characteristics
– Time Horizon of the M&A Transaction: Recent transactions are a more accurate reflection of the
values buyers are currently willing to pay than are acquisitions completed in the distant past.
This is because market fundamentals are subject to dramatic change over periods of time. In
addition, cyclical businesses will trade at widely different valuations at the peak and ebb of a
cycle.
– Payment Method: “Cash for Share” or “Share for Share” & other deal terms
– Control Premium & Synergies may exist in M&A transaction.
• Multiples should be based on the latest public financial information available to the Acquirer at the
time of the acquisition

62
Relative Valuation (Market Approach) for BANKS

Formula

Subject Company Multiple of Comparable

Fundamental Variable Companies

V Book Value of Equity or Multiples from

Maintainable Net Profit transactions involving
(NPAT) similar companies

• Appropriate multiples to analyze financial service firms are equity multiples:

‒ Price Earnings Ratios
‒ Price to Book Value Ratios
• Issues to consider:
‒ Differences is growth opportunities, risk profile or business mix will affect
multiple of a specific bank.
‒ There is an implicit assumption in using market multiple: stock market values
correctly the shares of comparable companies

63B
Guideline Public Company Method
Relative Value and Fundamentals
Gordon Growth Model of DDM:

Value per share

of equity in =
stable growth

P = Dividend1/ (ke – g)

P = [Net Income1 x dividend payout ratio]/(ke – g)

P/E = dividend payout ratio/(ke – g)
P/BV = P/E x ROE

ROE = Net Income/Book Value of Equity

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 Valuation Multiple from Fundamentals
Equity Multiples
Value of Stock = DPS 1 /(ke - g)

PS= Net Margin (Payout ratio) (1+g)/(r-g)

PE=Payout Ratio/(r-g) PBV=(ROE – g)/(r-g)
PBV1=ROE x Payout
PE=f(g, payout, risk) PS=f(Net Margin, payout, g, risk)
ratio x (1+g)/(r-g)

PBV=f(ROE,payout, g, risk)

Firm Multiples

V/FCFF=f(g, WACC)
Value/FCFF=(1+g)/(WACC-g)

(Source: Aswath Damodaran) Value of Firm = FCFF 1 /(WACC -g)

66C
Valuation Multiple & Fundamentals

67C
Valuing INSURANCE COMPANIES
 VALUATION PROCESS –
FUNDAMENTAL APPROACH

Understand
the Business

Macroeconomic
Analysis
Analysis &
Select Make/
Industry
Normalization Perform
Valuation Recommend
Analysis of Financial Valuation Decision
Method(s)
Statements
Company
Analysis
Insurance Business – Introduction
Insurance companies can be seen as facilitators of risk transfer:
• Insurers’ Role: Risk Pooling (Packaging Risk) & Diversifying Risks (Risk Spreading),
• Two important features of Insurance Business:
‒ Insurance Business Activities:
‒ Underwriting insurance policies (assessing the acceptability of risks, the contractual
terms of coverage, and the premium to receive)
‒ Billing & collecting Premium
‒ Investigating & Settling Claims
‒ Premium from policyholders are paid up-front, while possible payment for claims take
place after a certain period of time.

Business model of insurance companies consist of two distinct but interrelated activities:
1. Technical Insurance operations: Management of Premiums & Claims:
Net Premiums
-/- Claims and related expenses
-/- Client acquisition costs
= Return on Underwriting & Claim Management

2. Investment of the collected Premiums:

Dividends, Interest & Gains from Investments
-/- Expenses related to investments
= Return on Investments

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Insurance Business – Introduction
Segmentation of Insurance Business by Products

Life & Health • Life insurance policies primarily refer to death benefits or to life-contingent
annuities.
• Health insurance contract provide economic protection against disability or
medical expenses.

Property & • Property insurance is insurance protecting against property (car, house,
business)
Casualty • Casualty insurance protect against liabilities for losses brought about by injury
to other people or damage to their property.

Reinsurance • Reinsurance is the insurance of insurance risks.

Issues Specific to Insurance Business

• Accounting and financial reporting for Insurance business
• Regulations for Insurance, including regulatory capital for Insurance
companies.

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Approaches to Valuing Insurance Companies
Valuation of Insurance Valuation Approaches
Companies does not
differ substantially
from the valuation of
banks.
• The structure and Equity-side Equity-multiple Asset
logic of valuation is Income Market Approach
the same, but Approach Approach
• The definition of
regulatory capital is • Dividend Discount • Multiples from • Net Asset Value
industry-specific Model (DDM) Fundamentals • Appraisal Value
and country- • Discounted Cash • Market Multiples
specific. Flow to Equity (GPCM – Guideline
• Additional valuation • Present Value of Publicly Listed
approach ad hoc for Excess Returns or Multiples)
Insurance Future Economic • Deal Multiples (M&A
Companies: Profit (Excess Multiples)
Appraisal Value Return Model)
Approach, which Note: Specific Industry
represent Actuarial multiple for Insurance
Appraisal Valuation include:
Price/Premiums
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Valuation of Other Financial
Companies
Some Financial Companies & Approaches to Valuing
Them

Bank and insurance valuation techniques can be used in most circumstances to other financial
companies.

Consumer • Consumer Financing/Multifinance Companies mostly provide financing for the

customers of retailers or wholesalers.
Financing
• Multifinance Companies should be valued using the same approaches seen
Companies for banks:
‒ Equity side DCF models;
‒ Equity-side multiples, with P/E and P/BV generally being the most
accurate.

Leasing • Leasing Companies provide financing by leasing: they purchase specific

machinery or equipment and they lease it to business,
Companies • Leasing Companies are somehow closer to insurers than to banks from a
valuation standpoint because portfolio of leasing contracts is similar to a
portfolio of insurance policies..

74
Some Financial Companies & Valuation Approaches
• Asset Management Companies professionally manage
Asset
Management
investment in various securities (shares, bonds and other
Companies securities) and assets (e.g. real estates) for institutional or private
individual investors.
‒ In general, income of the managing company is based on
a fixed fee and/or on a fee based on the performance of
the invested fund.
• In the asset management industry, there are three key distinct
and separate legal entities:
‒ Asset Management Company manages investors’ pool of
fund by investing into securities and assets on behalf of
the investors.
‒ The Fund under management which contains the portfolio
of securities and assets owned by Investors. P/NAV (Net
Asset Value) is the leading approach to value funds.
‒ Custodian bank who hold the portfolio of securities and
assets on behalf of the Fund.

75
Some Financial Companies & Valuation Approaches

Asset Management Companies (AMC) in Mutual Fund

(Reksadana)

OJK
(Otoritas Jasa Keuangan)

76
Some Financial Companies & Valuation Approaches

Asset • Asset management company is not different from a non-financial

Management company.
Companies ‒ It can be valued using asset-side valuation approaches
such as:
‒ Enterprise DCF (DCF using FCFF)
‒ Asset-side multiples such as EV/EBITDA
‒ Since the performance of the Asset Management
Company depends on the managed fund and the fund is
influenced by economic cycle, care should be taken for
the terminal value estimation when using DCF.
‒ “Normalized” mid-cycle dividend, cash flows, or
excess returns should be considered.
‒ Specific multiple for asset management company is
P/AUM (AUM stand for Asset Under Management)

77
References
• Aswath Damodaran, Breach of Trust: Valuing Financial Service Firms in the postcrisis era, April
2009.
• Copeland, Tom, Tim Koller and Jack Murin.2000. Valuation: Measuring and Managing the
Value of Companies. 3rd edition. John Wiley & Sons, Inc.
‒ Chapter 21 discussed Valuing Banks
• Jean Dermine, Bank Valuation with an Application to the Implicit Duration of non-
Maturing Deposits, Faculty & Research Working Paper, Insead, December 2008.
• Massari, Mario, Gianfranco Gianfrate, & Laura Zanetti, The Valuation of Financial
Companies, Wiley, 2014

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