DCF method for Banks
Is it right to use the DCF valuation method for banks, to find out the enterprise value of the firm?
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DDM and NAV I think
Can't use DCF for banks. Use multiples and DDM.
DDM Theoretically you could derive the cashflows of a bank. But there are several problems even if you get to that point.
First of all a bank’s business is driven by the balance sheet and using the debt/deposits to generate returns on the asset side in some form of loans (the bread and butter for all banks in terms of income). Hence its impossible to split non-operational assets from operational assets, which are needed for the unlevered FCF and the EV to EqV bridge.
If you were hypothetically able to get to the levered FCF of the business, you still can’t just DCF every cashflow to the present day. Banks are extremely regulated through Basel, which expects banks always to hold a % of their core equity (CET1) against their risk-weighted assets (RWA). So there is no real concept of free cash flow even if they satisfy all payment obligations as banks need to hold capital on the balance sheet. So you usually distribute dividends above the target CET1 ratio as that is actual cash you can distribute to shareholders.
FYI also seen leverage ratios used instead of CET1 to determine the level of dividends.
This would also apply for insurance carriers as they face similar regulatory frameworks. Very different framework, implication is the same (but this varies more from region to region from my understanding)
Work in FIG myself and have never seen the leverage ratio used. Do you mean as an additional constraint or as the key driver? The former would make sense (and would be similar to MREL)
Key driver, albeit never seen it myself, was told by my associate he had seen it before. Admittedly CET1 is by far most common.
Sometimes the leverage ratio can be the binding constraint - this is usually for banks that are heavy on businesses that are not RWA intensive (mortgage lending, private banks, etc), and so the Tier 1 as a % of the total balance sheet is what they work towards when looking at capital requirements
Very succiniand well written!
Btw. Basel 3 coming, would be interesting to see how these changes affect valuations.
Have not dived deep into the new Basel framework. But how would this impact valuations vs today? From my understanding banks already disclose CET1 based on a fully-loaded basis, which should reflect the changes already. Therefore investors/public markets should already reflect this? Unless I’m missing some other material changes.
Please do some research
There are literally articles online on how to value banks
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