Why DCF is not used for banks?
Why would you not use a DCF for a bank or other financial institution? Banks use debt differently than other companies and do not re-invest it in the business-they use it to create products instead. For financial institutions, it's more common to use a dividend discount model for valuation purposes.
Most investors ignore or pass the financial industry by, largely because they don't understand the industry or valuing those companies. Using DCF's or discounted cash flow models is the tried and true method for most industries, but financials, including banks, insurance, and investment banks, are a different breed.
The main drawback of DCF analysis is that it's easily prone to errors, bad assumptions, and overconfidence in knowing what a company is actually “worth”.
Market Multiples
The market multiple approach is the simplest way to value a bank. A common multiple used by bank analysts is the Price-Earnings ratio (P/E).
- Forecasting unlevered free cash flows. ...
- Calculating the terminal value. ...
- Discounting the cash flows to the present at the weighted average cost of capital. ...
- Add the value of non-operating assets to the present value of unlevered free cash flows. ...
- Subtract debt and other non-equity claims.
EBITDA is no longer meaningful because interest is a critical component of both revenue and expenses. The balance sheet drives everything; you don't start by projecting unit sales and prices, but rather by projecting loans (interest-earning) and deposits (interest-bearing).
Growth FCFE lowers the capital, because it means that the bank is inserted into the banking business of profits that would otherwise be paid to owners as dividends.
DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate. It works best only when there is a high degree of confidence about future cash flows.
One of the most significant advantages of the DCF valuation model is that it returns the closest thing private practices can get to an intrinsic stock market value. By valuing the business based on the discounted value of future cash flow, valuation experts can arrive at a fair market value.
A DCF analysis uses a discount rate to find the present value of a stock. If the value calculated through DCF is higher than the current cost of the investment, the investor will consider the stock an opportunity. For the DDM, future dividends are worth less because of the time value of money.
How do you evaluate bank performance?
- Capital adequacy ratio (CAR) It is the measure of a bank's available capital divided by the loans (assessed in terms of their risk) given by the bank. ...
- Gross and net non-performing assets. ...
- Provision coverage ratio. ...
- Return on assets. ...
- CASA ratio. ...
- Net interest margin. ...
- Cost to income.
Introduction The valuation of a bank is an estimation of its market value in terms of money on a certain date, taking into account the factors of aggregate risk, time and income expectations.
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.
But they're not the same. The discounted cash flow analysis helps you determine how much projected cash flows are worth in today's time. The Net Present Value tells you the net return on your investment, after accounting for startup costs.
DCF Usages
WACC calculates the cost of how a company raises capital or funds, which can be from bonds, long-term debt, common stock, and preferred stock. WACC is often used as the hurdle rate that a company needs to earn from an investment or project.
As EBITDA doesn't account for the different ways a company may use debt, equity, cash or other sources to capital to finance itself, banks often use it to: compare two similar businesses. understand a company's ability to generate cash flow.
EBITDA is the cash flow that is generated by the business that is available to make loan payments. Banks look at EBITDA and compare it to the loan payment. They want to know that the business is generating more cash flow (EBITDA) than the amount of the loan payments.
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company's overall financial performance and is used as an alternative to net income in some circ*mstances.
FCFE is used in DCF valuation to compute equity value or the intrinsic value of a firm available to common equity shareholders. While doing DCF valuation, FCFF is paired with a weighted average cost of capital to maintain consistency in incorporating all the capital suppliers for enterprise valuation.
Between the FCFF vs FCFE vs Dividends models, the FCFE method is preferred when the dividend policy of the firm is not stable, or when an investor owns a controlling interest in the firm.
When should we use FCFE?
Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or more of the following conditions is present: The company does not pay dividends. The company pays dividends, but the dividends paid differ significantly from the company's capacity to pay dividends.
In contrast to using multiples for valuation, DCF makes explicit estimates of all of the fundamental drivers of business value.
Real estate investors use discounted cash flow when trying to determine a low-risk investment's value in the future when they'd want to cash out. In the investment banking world, companies can use the discounted cash flow formula to know if the value of a business is a good long-term investment, as well.
Discounted Cash Flow Analysis (DCF)
In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise.
One of the best ones is the Discounted Cash Flow method. Use it to calculate your business value based on your earnings forecasts. Moreover, you can re-run the valuation for a number of such forecasts, each with its own risk profile represented by the appropriate discount rate.
The DCF model relies on free cash flow (FCF), which is a reliable metric that reduces the noise created by accounting policies and financial reporting. One key benefit of using DCF valuations over a relative market comparable approach is that the calculation is not influenced by marketwide over or under-valuation.
When it comes to analyzing the performance of a company on its own merits, some analysts see free cash flow as a better metric than EBITDA. 1 This is because it provides a better idea of the level of earnings that is really available to a firm after it covers its interest, taxes, and other commitments.
There are a few key downsides to the dividend discount model (DDM), including its lack of accuracy. A key limiting factor of the DDM is that it can only be used with companies that pay dividends at a rising rate. The DDM is also considered too conservative by not taking into account stock buybacks.
Doesn't Consider Valuations of Competitors: An advantage of discounted cash flow — that it doesn't need to consider the value of competitors — can also be a disadvantage. Ultimately, DCF can produce valuations that are far from the actual value of competitor companies or similar investments.
The most common variations of the DCF model are the dividend discount model (DDM) and the free cash flow (FCF) model, which, in turn, has two forms: free cash flow to equity (FCFE) and free cash flow to firm (FCFF) models.
What are KPIs in banking?
Key Performance Indicators in banking operations can be defined as quantitative values used to determine how efficiently and effectively specific banking operational goals and objectives are achieved by the bank over a certain period of time. Think of them as the speedometer inside your dashboard for your bank.
The return-on-assets (ROA) ratio is frequently applied to banks because the cash flow analysis is more difficult to accurately construct. The ratio is considered an important profitability ratio, indicating the per-dollar profit a company earns on its assets.
The ideal Credit to Deposit Ratio is between 80%-90%. This means that the Bank is lending this percent from the Total deposits that it has. Lending is the main business of the bank so this ratio should be high. If the ratio is too low, it means the bank may not be earning as much as they should be.
How to Analyze Bank Statements with Pivot Tables - Calculated Fields
- Net Interest Margin = (Interest Income – Interest Expense) / Total Assets.
- Efficiency Ratio = Non-Interest Expense / Revenue.
- Operating Leverage = Growth Rate of Revenue – Growth Rate of Non-Interest Expense.
- Liquidity Coverage Ratio = High-Quality Liquid Asset Amount / Total Net Cash Flow Amount.
It is therefore unsurprising that a bank valuation will usually be conservative, sometimes 10%-20% less than the current selling prices of comparable homes.
- Fair value of the consideration transferred;
- Fair value of the acquired bank's financial assets and liabilities;
- Fair value of the acquired banks non-financial assets and liabilities;
- Fair value of any intangible assets – the most common being the core deposit intangible;
As such, a DCF analysis is useful in any situation where a person is paying money in the present with expectations of receiving more money in the future. For example, assuming a 5% annual interest rate, $1 in a savings account will be worth $1.05 in a year.
- FCF = Cash from Operations – CapEx.
- CFO = Net Income + non-cash expenses – increase in non-cash net working capital.
- Adjustments = depreciation + amortization + stock-based compensation + impairment charges + gains/losses on investments.
DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate. It works best only when there is a high degree of confidence about future cash flows.
Why is DCF better than DDM?
A DCF analysis uses a discount rate to find the present value of a stock. If the value calculated through DCF is higher than the current cost of the investment, the investor will consider the stock an opportunity. For the DDM, future dividends are worth less because of the time value of money.
Real estate investors use discounted cash flow when trying to determine a low-risk investment's value in the future when they'd want to cash out. In the investment banking world, companies can use the discounted cash flow formula to know if the value of a business is a good long-term investment, as well.
One of the most significant advantages of the DCF valuation model is that it returns the closest thing private practices can get to an intrinsic stock market value. By valuing the business based on the discounted value of future cash flow, valuation experts can arrive at a fair market value.
Banks and creditors analyze a company's positive cash flow as a means of determining how much credit to extend to a company. Cash flow loans can be either short term or long term. Cash flow financing can be used by companies seeking to fund their operations or acquire another company or other major purchase.
For now, think of free cash flow as cash available to use for things such as dividends, share repurchases, debt repayment, or reinvesting in the company. Free cash flow analysis also offers additional benefits, such as identifying problems in the income statement.
- Fair value of the consideration transferred;
- Fair value of the acquired bank's financial assets and liabilities;
- Fair value of the acquired banks non-financial assets and liabilities;
- Fair value of any intangible assets – the most common being the core deposit intangible;
But they're not the same. The discounted cash flow analysis helps you determine how much projected cash flows are worth in today's time. The Net Present Value tells you the net return on your investment, after accounting for startup costs.
One of the best ones is the Discounted Cash Flow method. Use it to calculate your business value based on your earnings forecasts. Moreover, you can re-run the valuation for a number of such forecasts, each with its own risk profile represented by the appropriate discount rate.
Thus, DCF analysis is perhaps best considered over a range of values arrived at by different analysts using varying inputs. Also, since the very focus of DCF analysis is long-term growth, it is not an appropriate tool for evaluating short-term profit potential.
