Abstract
The aim of this paper is to present a framework to bank valuation based on two generally acceptable valuation models that are not specific to banks: the model of discounted Equity Cash Flow to Equity (ECF) and the model of discounted Residual Income (RI). As emphasized by Koller, Goedhart and Wessels (pp. 663, 2005) [1] in a bestselling book on the valuation of firms, the valuation process of a financial institution is characterized by fundamental difficulties because of the peculiarities that characterize the function of banking business and also the lack of information on critical bank financial data, such as the quality of the loan portfolio. This means that estimates based on assumptions must be created for these data and in this direction this paper provides an analytical guideline. For carrying out the valuation of a financial institution, specific templates of banking accounting statements (i.e. a Balance Sheet and a Profit and Loss statement) proposed by Dermine (2009) [2] are used. The paper shows that both ECF and RI produce equivalent equity bank values. Given the recent financial crisis that has elevated the concern of banking institutions’ soundness, it is important to illustrate in practice the existing bank accepted valuation methodologies in order to form a clear framework for measuring the value of a bank and assess bank performance. The proposed framework can be applied by bank practitioners.
Highlights
The aim of this paper is to present a framework to bank valuation based on two generally acceptable valuation models that are not specific to banks: the model of discounted Equity Cash Flow to Equity (ECF) and the model of discounted Residual
The purpose of this tutorial paper is to propose an analytical guideline to bank valuation
The occurrence of recent banking crisis with contagion effects to the real economy has demonstrated the importance of valuing and assessing correctly the bank performance and in this direction this paper attempts to illustrate in practice the existing bank accepted valuation
Summary
In building a cash flow model of a bank from the outside, the Equity Cash Flow (ECF). The paper utilizes a Residual Income (RI) method in order to confirm the theoretical justification of Koller, Goedhart and Wessels (2005) [1] that both approaches lead to the same results. Both valuation models are based on discounting either future cash flows (ECF) or the periodic residual income (RI). A full income statement and a balance sheet along with an abbreviated schedule of changes in shareholder’s equity which lead to the equity cash flow, are utilized. The paper is structured as follows: Section 2 presents the procedure for the preparation of primary financial statements for valuing purposes along with the assumptions that study hypotheses.
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