I've been looking up on how one would go about valuing a bank, as I'm currently tasked to do so and I have zero clue. I read that a lot of analysts use the DDM, but in a somewhat different manner. Instead of using the payout ratio to forecast dividends, they calculate the maximum dividends a bank could "theoretically" pay without dropping below the tier 1 ratio - then they discount these using COE. Can someone explain the logic as to why this gives one the value of the bank? And if it's inaccurate, how should one set up a DDM instead?
The steps I found go along: 1. Forecast net income and assets 2. Identify how much of assets are risk-weighted 3. Forecast SHE by multiplying minimum tier 1 ratio to net income 4. Beg SHE + Net Income - DIVIDENDS = End SHE 5. Discount Dividends & find a terminal value
Can't elaborate on the procedure, as I am not too familiar. The logic behind it? I'll give it a shot.
Banks are bank-holding corps. These are regulated by the fed. The world blew in 2008, so to prevent it from happening again, banks need to put more of their own capital and abide by a bunch of regulations. As RWAs grow, so does the amount of money the bank itself puts in. It's sort of intuitive & it's called moral hazard - tons of money you dont own but manage means more risks taken by the bank.
Theoretically, banks have to mantain the tier-one capital ratio (SHE). Dividends flow out of the equity, reducing SHE. You can only pay out so many dividends before the SHE drops below the required capital ratio, so you use this max amount, as opposed to the net income of the bank, as dividends. The more net income that comes from increasing RWAs, the less dividends the investors receive, as more capital needs to be kept.
What if the bank has a fixed dividend policy, would that affect the valuation? I'm assuming it won't because you're discounting the dividends they "could" pay anyway and not what they actually pay out. But I'm not too sure.
Your explanation is more or less correct in theory. World world asset multiples are the most common pricing mechanism.
I highly recommend trying to find a sample model or just getting a course if it's that important. Modeling a bank is dramatically different than modeling other types of companies and revolves around forecasting your balance sheet assets and yield on each category, while having controls that prevent it from showing dividends that would put them below their capital requirements. You can't simply adapt an EBITDA based model to a bank and get anything halfway realistic and it takes a lot of time to learn.
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