[SOLVED] ACF5130 Seminar 12 Special Topics in Valuation Web

ACF5130 Financial statement analysis and business valuation

Seminar 12: Special Topics in Valuation

Valuing Financial Institutions

Importance of Financial Institutions

• Backbone of the global economy

• Intermediaries in financial markets facilitating everything from daily transactions to long-term financing for growth projects

• Economic impact

• Play a critical role in mobilising savings, allocating capital, maintaining liquidity, and stabilising the financial system.

• Integral to the implementation of monetary policy, influencing interest rates and credit availability.

• Regulatory Focus

• Subject to stringent regulatory oversight to ensure stability and protect depositors

• Individual Project Forum and weekly forums

Data: Morningstar DatAnalysis Premium

Unique Characteristics of Financial Institutions

• Regulatory Environment: Heavily regulated, impacts operational and business decisions.

• Capital Structure: High leverage, primarily funded through customer deposits

• Is debt a source of capital or something like “raw materials”

• Asset Composition: Major assets are loans and securities, which carry different risk profiles and liquidity characteristics compared to other sectors.

• Income Structure: Interest-based revenue from loans, fees from services, which are influenced by economic cycles and interest rate changes.

Valuation Challenges

• Operating vs. Investing Cash Flows: Difficulty in distinguishing cash flows related to core banking operations from those generated through investment and financing activities

• Difficult to estimate Free Cash Flows

• Difficult to measure capital expenditure

• Significant expenditure in intangible assets

• Expensed in the financial statements

• Highly volatile working capital

• Regulation

• Assumptions about growth are linked to assumptions about reinvestment

• These assumptions must pass regulatory scrutiny

• Additional risk owing to (changing) regulatory restrictions

Valuation Techniques for Financial Institutions

• DCF Valuation Approaches:

• Dividend Discount Model (DDM): Suitable for banks as they typically pay regular dividends. Focuses on the present value of projected dividends.

• Relative Valuation:

• Price to Earnings (P/E) Ratio: Comparing market value per share to earnings per share. Useful for comparing banks in stable economic conditions.

• Price to Book (P/B) Ratio: Reflects the net asset value per share, frequently used due to its relevance in reflecting the liquidation value.