Decoding Bank Valuation
Welcome back to our weekly knowledge-share series! This week’s topic is all about banks.
Most of us are comfortable with the classic valuation methods like the DCF for an asset-heavy business. However, banks are unique in the way they are structured. As discussed in our Valuation Methods Summary article, let’s dive deeper into banks specifically and understand how their financial statements are structured and one way of conducting a very high-level, rough valuation on a bank. In this article, we will use the example of Virgin Money UK Plc.
Bank Financial Statements
This section highlights the key differences in the financial statements of banks.
Balance Sheet Essentials:
Unlike any other company, a bank’s assets are loans and loan securities, whereas liabilities are deposits and borrowings. In simple words, loans give an income to the bank in the form of interest income. Hence, they are termed as assets. On the other hand, the deposits we keep with banks have some interest charge we receive and that is an expense for the banks. That is why deposits are part of the liabilities.
Another unique aspect of a bank’s balance sheet is the capital requirement. Ideally, equity capital for any company is Assets less Liabilities. However, banks NEED TO maintain a certain level of capital. The bare minimum is CET1 (Common Equity Tier 1) capital prescribed by the regulatory authority in the bank’s jurisdiction. For EU banks, BASEL 3 norms are applied. There are further requirements to maintain Additional Tier 1 capital (AT1 capital) over the CET1 capital. Usually, banks maintain a 12-14% CET1 ratio as opposed to the regulatory minimum of 4-5% by most regulatory bodies. However, banks must always maintain the prescribed minimum. If not, then banks need to fix their books or go for government intervention in some cases.
As a side note, the CET1 Ratio is the percentage of Total CET Capital divided by the Risk Weighted Assets. Risk Weighted Assets can be looked at as loans that may not be paid off and hence, banks might have to write them off.
Net Interest Income is the Net Revenue for banks. Banks also provide services outside of lending loans and those are separated below Net Interest Income.
Cash Flow Statement considerations:
While the structure of the cash flow statement remains the same with three sections, the dividend element in Financing Activities plays a major role in assessing the bank’s financial health since that indicates excess capital with the bank (we will see this in the valuation section below). Financing Activities also show movement in capital which could be crucial depending on the CET1 ratio the bank maintains.
Dividend Discount Model
We have learnt why we cannot use a classic DCF for a bank from previous articles, simply because there are no hard assets to value in a way. Banks usually either have excess capital or dividends and hence, it is best to get a valuation using the Dividend Discount Model. However, we should consider dividends and excess capital for valuing the bank. This is because, in this model, we are valuing the maximum dividend a bank can pay theoretically. And theoretically, banks can pay full excess capital as a dividend.
Since we are concerned with the “excess capital” i.e. capital above the minimum regulatory requirement, we essentially need the beginning-of-period and end-of-period equity capital for our calculation. Since CET1 is the bare minimum a bank must maintain, we take CET1 capital amounts for our forecast.
We understand from the above explanation that CET1 capital is taken from the CET1 ratio which is dependent on Risk Weighted Assets (RWA), and RWA is further dependent on the Total Assets. Hence, in my calculation of the CET1 capital forecast for Virgin Money UK plc, I made the following assumptions:
- Total Assets Growth: an average growth from the last three years is taken as a starting point and assumed a constant growth going ahead.
- Risk Weighted Assets (RWA): assumed to stay constant at the % of Total Assets in FY23 financials.
- CET1 ratio: assumed to stay constant at the CET1 target ratio mentioned in the FY23 annual report.
- Net Income: a constant % of Total Assets based on the ROA reported in FY23 financials.
- Payout ratio: 30% constant taken from FY23 financials.
Using these assumptions, we get the forecasted value for CET1 capital at the end of each forecast year (which becomes the beginning CET1 capital for the next forecast year), Total Assets, RWA, and Net Income for each forecast period. To get the excess capital or dividend, we use the following formula:
Ending CET1 capital = Beginning CET1 capital + Net Income – Dividends or Excess Capital
From the FY23 annual report, we know that they had a 30% payout ratio (amount of capital given out as dividends). Hence, I have shown the breakdown of the excess capital and dividend components. In any case, we need to take total excess capital to get a valuation.
Now similar to a classic DCF, we need to calculate the terminal value i.e. value of the business at perpetuity (going concern). To calculate the terminal value, I have taken the last forecasted excess capital, net income growth, and cost of equity using the formula:
Terminal Value = Excess Capital*(1+g)/(r-g) where g is the net income growth rate and r is the cost of equity
Our discount rate is the cost of equity since we are calculating equity value directly (thought process: dividends are given to equity holders). I have used a classic CAPM model with a UK risk-free rate, UK equity premium, and Virgin Money’s beta.
Summing up the present values of the excess capital and terminal value, we finally get the market value which helps to get the price per share and understand if the market price is undervalued or overvalued.
market price is undervalued or overvalued.
Note, that the calculations above will give a very high-level valuation. In practice, we will forecast the financials of the bank line by line and get down to a valuation using tailored assumptions and more engineering. Ideally, economic forecasts will be considered for growth assumptions, it isn’t always constant. The above gives clarity on various components to consider in any bank valuation.
Listed Comparables and Regression Analysis
Another classic way to get a rough valuation is using listed companies. As we have understood from above, equity value and assets are at the core of a bank. Hence, we use the Return on Tangible Equity (RoTE) and Price / Tangible Book Value (PTBV) multiples for getting a valuation. Tangible equity and tangible book value figures essentially just remove the goodwill and intangibles from the total figure.
As one would approach any other listed comparable valuation, I have selected a few banks similar to Virgin Money, sifted them to get the closest matches based on multiple criteria on size, similarity of business, etc, and calculated an average for the PTBV and ROTE multiples. However, to make these robust, I have not assumed the average PTBV and ROTE as they are. The reason, in my view, is that ROTE and PTBV are related. Equity value and Price are related to each other and Net Income and TBV (Assets) are related to each other. Hence, a regression analysis would be able to better demonstrate the relationship between ROTE and PTBV among all these listed companies including Virgin Money. That would help us find an implied PTBV multiple we could use to then calculate our equity value and share price. I have done this by using the slope and intercept functions in excel, and then using the linear regression formula to calculate the implied PTBV:
y = mx + c where y is implied PTBV, m is slope, x is ROTE and c is the intercept
This may sound a little confusing to people new to statistics. But to simplify, regression just shows the relationship between PTBV and ROTE of banks in our case which helps us conclude whether the bank is providing good returns to investors, does the bank has the potential to increase its returns, and so on.
We can further plot this analysis into a graph to show where Virgin Money stands in the market and what its potential could be.
While the above analysis is a short-form version of the actual valuation analysis for a bank, I hope it helped you understand the components used for valuing a bank.
Excel version available on request for review, recommendation, or improvements.
Considering the complexity of the sector, all recommendations, corrections, or suggestions are welcome which will help me as well as the readers.
Disclaimer: This article provides a simplified overview of bank valuation methods and financial statements, with a focus on Virgin Money UK Plc. The content is for educational purposes only and not intended as financial advice. The outlined valuation techniques involve assumptions and generalizations, and real-world valuations may require a more detailed approach. Readers are encouraged to consult with financial experts and conduct thorough research before making investment decisions. The author holds no responsibility for any actions taken based on the information provided in this article.
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