Banks, insurance companies, and other financial service firms pose particular challenges for an analyst attempting to value them for two reasons. The first is that the nature of their businesses makes it difficult to define both debt and reinvestment, making the estimation of cash flows much more messy. The other is that they tend to be heavily regulated, and the effects of regulatory requirements on value have to be considered.
This chapter begins by considering what makes financial service firms unique and ways of dealing with the differences. It then looks at how best we can adapt discounted cash flow models to value financial service firms, and looks at three alternatives—a traditional dividend discount model, a cash flow to equity discount model, and an excess return model. With each, we look at a variety of examples from the financial services arena. We move on to look at how relative valuation works with financial service firms, and what multiples may work best with these firms.
The last part of the chapter examines a series of issues that, if not specific to financial service firms, are accentuated in those firms, ranging from the effect of changes in regulatory requirements on risk and value to how best to consider the quality of loan portfolios at banks.
Any firm that provides financial products and services to individuals or other firms can be categorized as a financial service firm. We ...