Why not use a DCF for a bank?
I understand that you don't use a DCF for financial institutions because the working capital and debt are deployed in different ways -- but what does that actually mean? I haven't been able to find an answer that actually explains it, although maybe it's just not clicking for me. I get that it would be hard to calculate the WACC because of all of the different debts of the bank, I get that a DDM is superior for FIs than a DCF. I understand that banks use debt differently & don't reinvest it, but I don't get what is significant about the disassociation between working capital and debt. Isn't working capital about current assets & liabilities, whereas debt for banks is typically longer term? So why is there a relationship between the two?
Think about how a bank makes money. The primary business model for most banks generates interest income on deposits. Unlike most other firms, they operate on both sides of the balance sheet, thus their Net Interest Income is sort of like their "revenue".
A DCF discounts the present value of future free cash flows starting from from revenue. For banks, the balance sheet (and working capital) drive the core business. EBITDA is worthless here because interest is the main source of income for banks.
Working capital is huge for a bank, they have tons of accounts receivables (ex. credit card income or another loan collection) and liabilities (think deposits). I don't think that there are a ton on long term assets/debt on a banks books... maybe PP&E or reserves?
Thanks so much!!
FCF is important for DCF. FCF = Net income + adjustments - change in NWC - capex. Here's why DCFs don't work for banks:
Cash flow statement. You can't tell whether an item is CFO or CFF. Theoretically, borrowing money should be CFF for regular businesses, but for banks, it's how they operate. Therefore you can't draw the difference.
NWC. Banks have customers deposits as long term liabilities, but you can never tell when customers are taking their deposit back, which immediately makes in current liabilities. The same goes for assets. Long term loans could either be defaulted or payed early. Conclusion: NWC is hard to estimate and too volatile.
CapEx . Normal businesses invest in buildings and machines to operate. Banks don't invest in those items hence this item is insignificant. It's hard to estimate.
Those are the reasons I could think of. Feel free to add anything
You use DDM for banks? Hm, I use EVA.
P.S. Dividends are super hard to forecast in my frontier market.
Assuming capital ratios do not change every year it should be fine no? As you just assume full payout of excess equity.
You do understand how a DDM works, right? You're not actually forecasting the dividends you expect the bank to pay. The "dividend" you use in the model is any net income generated above and beyond required capital. All you need to do is forecast net income and understand what the capital requirement is for the bank.
Yes, I get that.
So then you should also understand why your first comment makes no sense. If you're able to forecast the items required for a EVA model (i.e., capital invested and net operating profit), then you also have everything you need for a ddm.
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