Valuing Banks and Financial Institutions

In recent periods, Bank of America's share price is trading 1.29 times its book value. 

Bank analysts and equity analysts, those involved in performing valuings of the share ownership of a financial institution, must often determine the right model or the right methodoloy to use. Often the value of the equity of a corporate balance sheet, at least the intrinsic or market value, is based on an assessment (or valuation) of the company's earnings or free cash flows (the widely acknowledged discounted-cash-flows approach). The analyst presumes the business is an ongoing concern and that cash flows can be projected and generated into perpetuity. 

There can be other ways to value the firm (liquidation value, for example), but the conventional corporate-finance approach equates shareholder value with the value of future cash flows to which owners are entitled. 

Those familiar with "discounted cash-flow" approaches to valuing companies know the historical methodology, which requires projections of operating cash flows (or free cash flows) into infinity or at least to a terminal date. And it requires determining the "cost of equity," the return required by rational shareholders relative to the returns they could receive from investing in high-grade sovereign bonds and taking into account "beta," a factor that compares the company with current equity-market returns (and volatility). The business-school textbooks refer to this as the "Capital Asset Pricing Model," or "Cap-M."

A primary challenge in this approach is tackling the challenge of projecting cash flows into an indefinite future and valuing the same cash flows. How best should an analyst project cash flows for an enterprise ten years from now? Twenty years from now?  (Valuation analysts "solve" that problem partly by assuming that a company has a "terminal value," about five years from the point of projecting cash flows. They then attempt to value the business at that point.)

Equity analysts, in turn, might seek to determine whether this approach is relevant for financial institutions, or for the most part, banks. 

Often financial institutions or entities that have financial assets on their balance sheets will be subject to a different type of valuation analysis--less of a future-cash-flows approach and more related to the values of the net assets on the balance sheet.  That would be within the category of a "relative-value" approach by observing current market-related metrics for a select group of institutions to determine the value of a specific company or institution. 

That's not to say the discounted-cash-flow approach is ignored or disregarded in the analysis of banks, broker/dealers, funds, or insurance companies. 

One common approach is a MV/BV-multiple approach.  The focus of valuing a financial institution is based on relative value based on common or expected ratios of  MV/BV (market value to book value). The book value is commonly based on "net assets," or "assets minus liabilities."

We could indeed show the discounted cash flow approach is applicable, because shareholders desire earnings and cash-flow growth for rewards.  Financial institutions generate earnings and, in various ways, generate new cash flows. Shareholders ultimately desire cash returns, whether they are received regularly (via dividends, for example) or generated when they liquidate the investment (when they sell their holdings). 

Therefore, it wouldn't be a chore approach the valuation based on cash generated from business activity.  The discount rate (expected return rate) has impact on the equity valuation. 

Yet the discount rate (tied to prevailing interest rates) also impact on the value of assets on the balance sheet of a financial institution. If the discount rate rises, cash-flow valuations fall. But similarly, if interest rates rise, the values of many of the financial assets on the balance sheet fall, too (fixed-income bonds in the investment portfolio, most notably). 

In general, a financial institution ought to be at least as worth its book value. Accountants, more now than ever in updated accounting standards, attempt to present the balance sheet of a financial institution based on the "fair value" (or something like market value) of the assets and liabilities on the balance sheet. We, too, must note that for financial institutions, there can also be the changing fair value of liabilities: "short sales," derivatives payable, e.g.

But we may consider factors that explain how and why its market value can exceed the book value (liquidation value). For valuation purposes, book value doesn't include funding sources (preferred stock, subordinated debt., e.g.) that would be considered "Tier 1 or Tier 2 capital" for the purpose of bank regulation. Book value would be equivalent to common shareholder's equity reported on the balance sheet. 

While book value is based in part on the value of net assets on the balance (assets minus liabilities), most of those assets are financial assets (investments, trading positions, loans, loans held for sale, derivatives receivable, e.g.). As mentioned, many of those financial assets are already valued (investments, trading positions, securities owned, etc.) at market value (based on fair-value accounting). For some financial assets (commercial and corporate loans), financial institutions may be permitted to account for them based on "cost," if they asset is "held to maturity." Most loans on bank's balance sheet are reported in such matter. Otherwise, the book value should reflect closely to the market value. 

Often we want MV/BV > 1.0, and we need to understand and explain when MV/BV < 1.0. Bank equity analysts like the benchmark of the financial institution's MV/BV >  2.0.  We explore factors that explain why the firm could be worth more than its book value. Some of the financial assets might be over-valued, some might be reported based on cost and not fair value or market value (loans and some investments in bonds, if they are held to maturity).  

However, if the financial institution has substantial businesses and services that are not directly linked to the balance sheet (advisory businesses, asset management businesses, other services), those factors can increase MV relative to book value. They provide revenues or fees that are in addition to the value we see on the balance sheet. Those cash flows have value that help push the MV/BV above 1.0. 

Large banks, therefore, with substantial investment-banking activities are expected to have MV/BV > 1.0 and approaching 2.0.

In November-2024, note the MV/BV ratios for some prominent financial institutions (mostly large universal banks with substantial fee-based revenue sources): 

CITIGROUP: 0.67

BANK OF AMERICA: 1.29

GOLDMAN SACHS: 1.77

MORGAN STANLEY: 2.28

JPMORGAN CHASE: 2.11

REGIONS: 1.41

PNC: 1.48

USBANCORP: 1.61

THE TRAVELERS: 2.08

In some cases, we see MV/BV < 1.0.  Often analysts and observers will argue that if the market value is less than book value, the institution's owners are better off if it is sold in parts (selling parts of the balance sheet or selling the subsidiaries or business units) than if it remains consolidated. The market may be "perceiving" or assessing that the institution combined is riskier than if the integral parts are sold off and operate separately.

For years, analysts argued the same about Citigroup. They suggested the market right-size-valued assets on the balance sheet (loans, investments, trading positions) for valid reasons. There is more risk on the balance sheet than what is implied on the accounting statements. That risk is reflected in the market value. Perhaps the market sensed the assets on the balance sheet would later be subject to write-offs or write-downs that accountants (and regulators) have not yet accounted for. 

Even as of mid-November, 2024, Citigroup continues to be valued less than book value, although its CEO Jane Fraser has worked aggressively to improve its balance sheet and shed assets and operations that were vulnerable or non-profitable, especially in its international businesses. Performance has improved over the past year, and the balance sheet is indeed stronger. Market participants may be looking for an extended track record of performance. 

For the institutions above, JPMorgan and Morgan Stanley have market values exceeding 2.0. That might be explained not just by having "cleaner" balance sheets, but also by the substantial income sources (and cash flows) from advisory businesses. Both institutions are prominent in investment banking and asset management activities. Asset management cash flows generated consistently for years to come would certainly enhance their market values. Those expected cash flows have value. 

For the past eight years, JPMorgan has generated at least $15 billion in asset-management revenues, cash flows that aren't recognizable on the balance sheet and cash flows that are highly considered in shareholder valuation. For the past 11years, JPMorgan has generated at least $6 billion in investment-banking fees, also considered in shareholder valuation. 

Goldman Sachs may be penalized, in part, because of risks and losses in its bungled effort to grow its consumer businesses. Consumer loans still reside on its balance sheet, and all potential losses from that segment may not have been flushed through. Trading income also contributes more to net revenues at Goldman (over 30% annually) than for all of its peer. Markets may account for the expected volatility in trading income and the difficulty in keeping trading income stable and predictable over the long term.  (Trading income at Goldman, meanwhile, has been at least $10 billion annually the past five fiscal years.)

In valuing an institution based on MV/BV multiples, we would normally compute the range for many similar financial institutions to determine at least (as of the moment) how the market is valuing an institution's balance sheet and the possibility of non-balance-sheet activities. And then we would determine what the right multiple to use for the specific institution we are analyzing. 

Now as for insurance companies, we might consider a cash-flow approach, but also examine the MV/BV approach because a substantial amount of the assets of an insurance company are funnelled into investments and marketable securities of which much will likely be accounted for at fair value. Accountants also require (at least for life insurance companies) that future liabilities (benefits to policy-holders) be adjusted regularly to be reported at fair value. 

The insurance business model is certainly a cash-flow business--cash inflows from premium payments and cash outflows to pay claims. (Accountants (especially IFRS accounting) are pushing to show the value of such cash flows on the balance sheet.) At the same time, the insurer's balance sheet can flucutuate daily because of market volatility in the investment portfolio. 

In the examples above, The Travelers, an insurance company, reports MV/BV = 2.08--a multiple that reflects the risks and values of an $80 billion investment portfolio, but also incorporating the high-probability future cash flows from its property-and-casualty business.

Valuation professionals will review all possible approaches before selecting what they consider they correct value of an institution. (Investment banks present that in a "football field" grid to show all possible values for a business or institution.) That means examining relative values, MV/BV, discounted cash flows, dividend models, liquidation values, and more. 

There is no one approach, but in the end, there might be favored approaches. 

Tracy Williams 

See also:

Basel III Endgame, Feb-2024

JPMorgan Acquires a Failing First Republic, June-2023

Financial Rumbles in Silicon Valley, April-2023

Deutsche Bank: Turmoil and Concern, October-2016

Dimon at JPMorgan Prepares for a New Crisis, April-2020

Easing up on Bank Stress Tests, March-2019