Financial companies, including banks and insurance companies, are among the most popular investments, particularly for those who perceive them as reliable. Yet, several very big and seemingly safe institutions went down in the financial collapse of 2008. Is there a way to avoid such surprises?
In chapter nine of his book, "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," Aswath Damodaran provided answers to that question. When the book was published, his answers were particularly relevant since it came out just three years after the crash.
As usual, he starts with definitions and said financial companies fall into four groups:
- Banks: Companies that earn revenue on the spread between the interest rates they pay to bring in funds and the interest rates they collect from borrowers.
- Insurance companies: Revenue comes from net premiums collected from policyholders and from the investment portfolios maintained to service claims.
- Investment banks: Revenue earned by providing advice and support services/products to companies raising capital, as well as helping companies execute on transactions such as acquisitions and divestitures.
- Investment firms: Generate revenue by providing investment advice and portfolio management services for their clients.
The author added that consolidation had produced companies that operate in more than one of these areas. They are all subject to restrictive legislation and regulations (which can also provide competitive moats). Additionally, accounting rules differentiate between financial services and the rest of the market.
When it comes to valuing banks, investment banks and insurance companies, analysts bump up against a couple of challenges:
- It is harder to distinguish between debt and equity than other types of companies. The author wrote, “Debt to a bank is raw material, something to be molded into other products that can then be sold at a higher price and yield a profit.”
- Cash flow is harder to define than it is in other sectors, even when defined as cash flows to equity; Damodaran noted that financial companies invest in intangible assets such as brand names and human capital. As a result, their cash flow is defined in accounting statements as expenses.
Thus, Damodaran asked, and answers:
“If you cannot clearly delineate how much a financial service firm owes and what its cash flows are, how can you ever get an estimate of value? We deploy the same techniques in both intrinsic and relative valuation to overcome these problems: We value equity (rather than the firm) and use dividends, the only observable cash flow.”
When doing intrinsic valuation, several approaches are available. The first of these is the dividend discount model, in which “the value of a stock is the present value of the expected dividends on that stock.” Its formula is: Value of equity = Expected dividends next year / cost of equity – expected growth rate.
The model uses three sets of inputs to determine the value of equity:
- Cost of equity used to discount the cash flows.
- Proportion of earnings expected to be paid out in dividends. For example, the dividend payout ratio.
- Expected growth rate of the dividends over time.
Cost of equity: There are “estimation notes” to consider in making estimates of this metric:
- Using sector betas.
- Adjust for regulatory and business risk. Average beta across banks with similar business models and assign higher betas to companies with riskier business models.
- Examine the relationship between risk and growth; for example, high growth banks will likely have higher betas than mature banks.
Regarding the dividend payout ratio (number two above), Damodaran wrote of an inherent trade-off between dividends and growth. Companies that pay out large portions of their earnings as dividends have less to reinvest and will grow more slowly. In addition, there are a couple of complications worth noting: regulators impose capital constraints on banks and insurance companies, and stock buybacks must be accounted for (and should be included with dividends).
Damodaran used an October 2008 valuation of Wells Fargo (WFC, Financial) as his example, a period he pointed out was four weeks into the banking crisis.
He estimated the cost of equity at 9.6%, based on a beta of 1.20, a risk-free rate of 3.6% and an equity risk premium of 5% (cost of equity = 3.6% + 1.2(5%) = 9.6%).
Next, he ensured internal consistency by calculating return on equity. In the trailing 12 months, the bank reported an average return on equity of 17.56% but discounted that because of regulatory risks (30%) to arrive at a return of equity of 13.51%.
In the preceding 12 months, Wells Fargo had paid 54.63% of its earnings as dividends; projecting that into the future allowed him to calculate an expected growth rate of 6.13% (Expected growth rate = 13.51%(1 - .5463) = 6.13%).
Having covered the dividend discount model, Damodaran turned to a cash flow to equity model.
Because of the unconventional nature of cash flows in financial companies, the net capital expenditures and non-cash working capital are hard to identify. However, cash flows to equity can be estimated if reinvestment is defined differently.
More specifically, reinvestment by financial companies often goes into regulatory capital, which is a financial base prescribed by regulators. This, in turn, will set limits on future growth. Management of a conservative bank will hold higher capital ratios than required, and vice versa. Damodaran refers to this as the book equity capital ratio.
A third approach refers to excess return models, in which analysts look at the difference between ROE and the cost of equity. In concrete terms, this means adding the book value of equity and the expected excess return to equity investors (“Value of equity = Equity capital invested currently + Present value of expected excess returns to equity investors”).
Relative valuation provides an alternative to the intrinsic models shown above: it is based on two equity multiples: price-earnings ratios and price-book ratios. Damodaran argued there are potential complications with this approach:
- Provisions for expected bad loans. Banks with conservative management will maintain higher provisions and consequently lower earnings. On the other hand, more aggressively managed banks will report lower provisions and higher earnings.
- Earnings multiples are difficult to untangle when financial companies operate several different business lines.
Summing up, in chapter nine of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," the author has provided tools which will aid investors who are interested in financial stocks but have been reluctant to commit because they did not know how to value them.
The author: Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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