Understanding Bank Valuation: An Application of the Equity Cash Flow and the Residual Income Approach in Bank Financial Accounting Statements

Abstract

The aim of this paper is to present a framework to bank valuation based on two generally acceptable valuation models that are not specific to banks: the model of discounted Equity Cash Flow to Equity (ECF) and the model of discounted Residual Income (RI). As emphasized by Koller, Goedhart and Wessels (pp. 663, 2005) in a bestselling book on the valuation of firms, the valuation process of a financial institution is characterized by fundamental difficulties because of the peculiarities that characterize the function of banking business and also the lack of information on critical bank financial data, such as the quality of the loan portfolio. This means that estimates based on assumptions must be created for these data and in this direction this paper provides an analytical guideline. For carrying out the valuation of a financial institution, specific templates of banking accounting statements (i.e. a Balance Sheet and a Profit and Loss statement) proposed by Dermine (2009) are used. The paper shows that both ECF and RI produce equivalent equity bank values. Given the recent financial crisis that has elevated the concern of banking institutions’ soundness, it is important to illustrate in practice the existing bank accepted valuation methodologies in order to form a clear framework for measuring the value of a bank and assess bank performance. The proposed framework can be applied by bank practitioners.

Keywords: Banks, Valuation, Accounting Statements, Cash Flow to Equity, Residual Income

JEL Classification: G21, M41