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Breach of Trust: Valuing Financial Service Firms in the Post-Crisis Era

Aswath Damodaran

New York University - Stern School of Business

April 29, 2009

Valuing banks, insurance companies and investment banks has always been difficult, but the market crisis of 2008 elevated the concern to the top of the list of valuation issues. The problems with valuing financial service firm stem from two key characteristics. The first is that the cash flows to a financial service firm cannot be easily estimated, since items like capital expenditures, working capital and debt are not clearly defined. The second is that most financial service firms operate under a regulatory framework that governs how they are capitalized, where they invest, how much they can pay in dividends and how fast they can grow. Changes in the regulatory environment can create large shifts in value. In this paper, we confront both factors. We argue that financial service firms are best valued using equity valuation models, rather than enterprise valuation models, and with actual or potential dividends, rather than free cash flow to equity. The two key numbers that drive value are the cost of equity, which will be a function of the risk that emanates from the firm’s investments, and the return on equity, which is determined both by the company’s business choices as well as regulatory restrictions. We also look at how relative valuation can be adapted, when used to value financial service firms.

Number of Pages in PDF File: 34

Keywords: banks, vauation, dividend discount model, regulatory capital

JEL Classification: G11, G12, G21

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Date posted: March 30, 2011  

Suggested Citation

Damodaran, Aswath, Breach of Trust: Valuing Financial Service Firms in the Post-Crisis Era (April 29, 2009). Available at SSRN: http://ssrn.com/abstract=1798578 or http://dx.doi.org/10.2139/ssrn.1798578

Contact Information

Aswath Damodaran (Contact Author)
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0340 (Phone)
212-995-4233 (Fax)
HOME PAGE: http://www.damodaran.com
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