Balance Sheet Driven Companies
What is a balance sheet driven company? Why is the valuation of balance sheet driven companies different from other companies?
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Banks and other lending firms are 'balance sheet driven companies'. They use the capital (balance sheet) available to them and lend it to other companies or individuals. In the case of a bank, it takes in deposits and gives out loans. The different forms of loans and deposits are referred to as interest-earning assets (loans) and interest-bearing liabilities (deposits). The interest rate at which the banks lends money is greater than the interest it pays on deposits (obviously), the difference is the interest margin (the greater the better for the bank - currently very narrow for most banks due to low interest rate environment). Two issues arise when valuing banks or balance sheet driven companies: 1) Cash flows cannot be easily estimated, since items like capital expenditures, working capital and debt are not clearly defined. 2) Banks operate in a regulatory framework which requires them to hold a certain amount of capital to cover for potential losses, determines how they can invest their capital and the room for growth of their loan book. Because debt does not mean the same for banks as it does for non-financial services companies, equity or book value multiples are more appropriate than enterprise value based ones. Your most commonly used metrics are Return on (Tangible) Equity and Price to (Tangible) Book. In a market based valuation, you would use regression analysis to arrive at a P/(T)B multiple based on the banks forecast Ro(T)E. Banks need to account for their minimum or target capital requirements. The most common approach to intrinsic valuation is taking the forecast the dividends the bank can pay out in the future and discounting them to their present value, similarly to how you would discount the future cash flows of a company, and add its terminal value to arrive at an intrinsic value. Damodaran has published a paper on this ("Valuing Financial Service Firms") if you're looking for more detail.
To add on, equipment rental and other such businesses could also be considered "balance sheet companies." These types of companies have their own metrics related to fleet management and utilization.
Thank you so much for the reply, cleared up many things for me.. What I wanted to know is, what is the opposite of "balance sheet driven companies"? For example, why is a manufacturing company not a "balance sheet driven company"? Because they also use the assets(balance sheet) available to them in order to make money, do they not?
And also regarding the valuation models, is there a go to method when banks divident payout history is wayward and hard to predict. In my work, my supervisor has gotten us to forecast the future EPS and discount them into present (plus the terminal value) to obtain the fair price of a company but I do not think it makes a lot of sense. Once again, thank you!
Balance sheet driven is another way to say 'capital driven'. I see why you would say a manufacturing (or any other non-lending company) also is balance sheet driven as it uses its assets to generate revenue. These businesses could be more accurately described as 'inventory / production / manufacturing' driven, as they take raw materials and produce something out of it. These are not 'on the balance sheet' however. The balance sheet merely reflects their book value which changes as they go from raw materials to finished goods and to goods sold. Banks and other lenders however actually use exactly what's on the balance sheet - money. They move it from one pocket to another. Their added value is the risk they take on (therefore the regulatory requirements to have enough capital reserves). For dividend based valuation purposes, banks often state a target capital ratio in presentations or annual reports. In your model, build up the capital to the company's target ratio using your projected net income. Assume the company pays out whatever is left after deducting its retained earnings needed to achieve its target capital. If you can't identify the company's target capital ratio, use the minimum requirement or compare to peers who have stated target ratios (often well above minimum requirements). Your historical dividend payout is irrelevant. Using EPS (or net income for that matter) only works if the company is sufficiently / perfectly capitalised, that is it's able to pay out 100% of its earnings to shareholders. The approach is flawed, however, in the sense that you either assume there will be no loan book growth or a deteriorating capital ratio. Neither is desirable.
Thanks again. One last question, what do you mean by a target capital ratio? Do you mean Capital Adequacy Ratio (Tier one capital/Risk weighted assets)?
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