Breach of Trust: Valuing Financial Service Firms in the Post-Crisis Era
34 Pages Posted: 30 Mar 2011
Date Written: 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.
Keywords: banks, vauation, dividend discount model, regulatory capital
JEL Classification: G11, G12, G21
Suggested Citation: Suggested Citation