Financial Sector
I currently analyze the financial sector for St. Bonaventure University's Students in Money Management group. I'm running a valuation on First Niagara and am having trouble with the Dcf which I think is coming from crazy working capital projections I am getting because First Niagara has been acquiring HSBC assets for the last year causing big swings in their nwc. Any ideas on how to fix this problem?
Generally, do not use a DCF for banks/insurers. Cash flows will not paint an accurate picture, unless you go back and normalize them.
You are better off projecting operating earnings, then coming to a valuation based on a multiple of their forecast book value and/or future earnings.
The value of a Bank/Insurer is on the balance sheet. Projecting earnings is not terribly difficult. But how much capital can they deploy? How much will management deploy? And in what form? By the sound of what you just said, First Niagara is buying up HSBC assets. What impact will those have on earnings? How will this impact their loan loss reserves? You get the idea.
Thanks. I had an idea that a DCF wouldn't do much for financials because the fluctuation in their numbers were just way too high.
It isn't that you can't use a dcf; it is just that there is so much noise you need to back out to get a reasonable estimate of cash flows. You could use after tax operating earnings, and that would get you pretty close.
Some financial companies trade on Book Value (of various varieties), others on earnings, and others on cash flow. Value it a few different ways, spread comps for several multiples, figure out which are important by looking at past price movements, and then weight each value appropriately. It isn't an exaggeration to call valuation more art than science.
I should have said changes in Net working capital. I used estimations of future operating earnings and got a number that looked pretty close to what I expected to be. Thanks for the tip, I'm going to try to go back and try to get a good idea of what it trades on.
DCF models don't work for financial institutions. One of the most popular metrics for evaluating financials is the price to book ratio.
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