Valuation of FIG between FCFE or Dividend Discount Model?
in the FIG industry because of capital regulatory ratios such as Tier 1 capital, I have always been more comfortable with using the DDM as it allows us to find out the cash that a bank can pay to shareholders while taking into consideration the Tier 1 Capital requirement.
Let's look at FCFE.
FCFE = NI + D&A - chg in WC - CAPEX - chg in Debt (Principal Repaid - Principal Issued)
I am hesitant about the FCFE as
1) chg in WC can be large, deposits and short term loans 2) CAPEX (Inv in computers, offices) is not reflective of reinvestment (Banks are balance sheet driven, it depends how much loans they issue to drive their top line)
these metrics might not be the best to gauge the true FCFE, and FCFE does not take into account the regulatory ratios. remain cash available to equity holders might have to be retained in the Balance Sheet to satisfy the Basel-pillar 3 disclosures.
Would appreciate an expert opinion.
For banks. insurance companies, and the like you tend to use a DDM. Dividends are essentially used as a proxy for FCF, since it can be difficult to put a clear definition on what cash vs debt actually is, since the business generates money based on the spread between borrowing and lending. The idea is that dividends being paid is money that is "disposable" (read: the bank doesn't need it to operate, doesn't need to hold onto it in retained earnings, and can pay it out to shareholders), so it is a fair proxy to FCF.
FCFE is generally used in place when the institution has unpredictable dividends, or if the company has an investor with significant influence/control over the firm, since dividends can be influenced by said individual.
For investment managers they are basically just EBITDA companies, so you use a DCF or a multiple the same way you would with any other more traditional valuation.
Excellent response, thank you for sharing your perspective. It is most helpful.
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