Using DDM model to value a bank?
Is it better to use the DDM model to value a bank rather than PE?
Is it better to use the DDM model to value a bank rather than PE?
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What are your objectives? What if the bank doesn't issue a dividend?
DDM and P/E would both be along the lines of EMH theory, which for the most part has been picked apart and proven an unreliable method for arriving at 'true' value so it depends on what you are doing and why. They would certainly be the easiest and quickest methods.
But with the DDM and P/E you will never arrive at a proper valuation... if your concerned about skillset/time involved whyy don't you try FMEV method? I think that might be useful becuase you don't have to go through the whole process of highly variable DCFs, you can adjust EBITDA or whatever FCF is relevant for banks and apply a relevant multiple.
P.S. I am actually woefully ignorant though of how to value a financial institution and I know there are huge differences between the way you value the BS of a financial versus a manufacturing firm so someone please say otherwise. But I think FMEV would be useful and you can back out from there to equity value....
Multiples-based valuation always uses implicit assumptions, e.g. if you have a relatively low price multiple on earnings there must be 'something wrong' with the earnings, or you expect a low growth rate, or whatever.
Detailed modelling approaches, of which DDM is one, make these assumptions explicit, i.e. you create detailed forecasts on where income is going, what happens to the cost base and capital, etc. Therefore, if you want to get some degree of comfort with the drivers of your valuation (which granted often is based on bs assumptions...), DDM is 'better'.
I hardly think of the DDM as useful... I may need more guidance on this, but isn't the DDM just d / r - g or am I thinking of something else?
If we want to 'get comfortable' with drivers you might as well create a full operating model with with multiple scenarios that can be toggled as opposed to an abbreviated DCF that only forecasts the IS. But I don't think thats what the OP wanted, I think he wanted a down and dirty quick way to value a bank.
In this light I think the FMEV approach is used to avoid exactly the BS that goes in DCFs and the DDM, since we don't know everything and get only a 'degree of comfort' instead of pretending like we know, why don't we just arrive at an appropriate range and move on to other things i.e. financial position / BS strength? Your valuation can get bogged down in trying to understand an unpredictable income account even before other perhaps more important things should be considered...
You actually need a full blown operating model to project your dividends.... so its not just the one formula...
I, without knowing anything about banking valuation, would go with dcf APV, dcf WACC and then RIM before DDM.
Paraphrasing from Damodaran but cash flow based valuations (DCF, APV, EV/EBITDA & EBIT) are poor methods of valuing banks (excluding pure advisory firms) because capital is essentially the raw material that banks use to generate income. Also remember a bank's income statement is interest revenue minus interest expense and loan loss reserve is net interest income - no EBITDA in-between. IIRC, Damodaran does indicate that one of the primary methods of valuing a bank is via the DDM but I'm not in FIG so I don't know how it is IRL.
DCF is fine to use, but you need to do it directly at the equity level (i.e. use fcf-equity and discount at cost of equity) since interest and debt is part of a bank's operating activities. Residual Income models are also popular, since the starting point is 1.0x book value, and banks are a much more focused on their book value of equity than operating companies.
The other twist to bank valuation is that banks have to uphold specific capital ratios - tier 1 capital, tangible common equity, etc - so they are only able to pay dividends out to the extent equity remains above those thresholds.
Multiples don't work that well in today's environment. Book value multiples are used most frequently, but so many banks trade at a discount to book value because of expected future losses on their loans from 2005-2008 that it's hard to apply a group average to a single bank.
Hope that helps.
Multiples - Use P/B Valuation model - Use free cash flow to equity (or adjusted DDM): 1) Project loans and deposits growth 2)Estimate future interest rates 3)compute risk weigthed assets and equity to cover them 4) compute tier ratio and estimate your "dividend" payout possibilities based on the tier ratio you want to mantain 5) discount using CoE, don't forget that you don't unlever comprable betas
Noted. Thanks.
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apart from the above (i prefer DDM and P/B), you can also do a P/B - ROE regression - maybe look at the average roe for the last 3 years for the comp set and their latest p/b. widely used.
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