I have recently been trying to build out my experience and knowledge base regarding financial companies. Historically, I have tried to avoid the financial sector because of the intricacies of valuing financial companies, and the hangover from the financial crisis.
Regardless, I have recently taken a new interest in the sector because, in a widely overvalued market, financial stocks are some of the only assets that appeared to be appropriately or attractively valued right now.
A big problem
The problem I have faced is placing a value on financial companies. Unlike other businesses, which are easy to value based on their cash flows, it is challenging to determine cash flows for a financial company.
It is particularly challenging to determine the capital spending of a financial enterprise.
Typically, financial companies don't have any substantial capital spending. Instead, they spend on educating and developing their staff, which is booked as an operating expense. This means we don't really know how much the company needs to invest to maintain its current level of growth.
Working capital changes further complicate the picture because banks and other large financial institutions rely on debt to run their businesses. This means sizeable working capital changes, which distort operating cash flow figures.
My research on this topic has lead me to the work of Aswath Damodaran, professor of finance at the Stern School of Business at New York University, who is often called a modern-day Benjamin Graham for his work on valuation.
The valuation conundrum
In 2009, Damodaran published a paper on the problems of valuing financial services companies.
The paper highlighted the problems with trying to estimate banks' cash flows as well as other factors, such as the cost of debt, regulations and book value.
Book value for large banks is particularly tricky and unreliable as a measure of value because of the process of marking assets to market. The method of mark-to-market account presents two issues for analysts. First, even if there is an active market from which market prices are extracted, "markets can make mistakes and these mistakes will then be embedded in the book value."
Second, in many cases, asset values are marked to market "based not upon an observable market price, but upon models used by the appraiser," which means there's a " tendency to overstate values and a lag in recognizing changes in those values."
The dividend method
So what is the best method for investors to use to value financial services companies?
Damodaran recommends investors concentrate on dividends because they are observable and quantifiable.
He also advises focusing on valuing the equity rather than the company because the cost of equity for a financial services company is easy to understand, while the cost of data can be extremely volatile and difficult to estimate. In particular, he notes:
"Capital expenditures and working capital, which are required inputs to estimating cash flows, are often not easily estimated at financial service firms. In fact, much of the reinvestment that occurs at these firms is categorized under operating expenses. To estimate cash flows to equity, therefore, we either have to use dividends (and assume that what is not paid out as a dividend is the reinvestment) or modify our definition of reinvestment."
There are plenty of drawbacks to using the dividend method. For example, a simple dividend growth model ignores the quality of the company and there's also a risk that analysts will overstate a company's dividend growth potential.
However, given the fact it is so difficult to understand how much cash a bank is generating and how much it needs to reinvest to maintain its current rate of growth, Damodaran argues this could be the most straightforward method for analysts to use without getting bogged down in unpredictable and confusing cash flow data.
This is just the beginning of what I believe will be a long process in evaluating how best to go about valuing financial services businesses. I thought it might be interesting to document at least part of the process.
Read more here:
- Joel Greenblatt's Views on Concentrated Investing
- Using Warren Buffett's Preferred Method to Value Zoom Video Communications
- Time to Buy Gold Miners as Gold Prices Skyrocket
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