Bank Investing

CHAPTER 5Valuation

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down.”

—Warren Buffett

VALUATION

Firms are valued more or else accurately at the time of birth (IPO) and at the time of death (liquidation); everything else in between is sentiment. This was a remark made by an investor to us some time back. We do not recall who it was; otherwise, we would gratefully attribute it to the individual.

We are not so sure if firms are valued accurately at the time of their birth, but that remark stirred us into thinking on what would be an appropriate valuation approach for entities, especially regulated entities, with cost of capital advantages such as banks.

What about M&A (probably a wedding event in the aforementioned investor's analogy)?

This chapter is going to look at traditional approaches to value a bank's common equity, and not the other pieces of the capital structure.

The theoretically justified approach for intrinsic valuation is to project the free cash flow to the firm and discount this using the weighted average cost of capital to obtain the total present firm value, then subtract the value of the debt to get the equity value. This approach is not applicable to banks since they use deposits for financing. Estimating the appropriate cost of capital for noninterest-bearing deposits would be an interesting academic exercise, but not ...