CHAPTER 15How to Value a Bank1

The requirement to measure current and future (expected) profitability and thus the ability to determine the value of a firm is not just a concept of recent years, but rather one that has evolved over the past two and a half centuries. As early as 1776, Adam Smith describes, in his epic tome The Wealth of Nations, how the owner of capital will always invest in those projects that provide a return over and above his cost of capital, and will refrain from investing in anything that does not at least meet his cost. In addition, his return should compensate for any risk he takes.

In the late nineteenth and early twentieth centuries, the ownership structure of companies started to change, and management and ownership of the corporation became increasingly segregated. This, combined with the general increase in company size, resulted in a situation where the ability to provide an accurate valuation for a company became more and more important.

Although the management often owns shares in the company, the average shareholder, or owner of the capital, has only limited control over the management of the firm he invests in, especially when it comes to large companies. Beyond the shareholders' annual general meeting, his control is limited to voting with his feet: if he is not convinced the company is run very well, the only choice he has is to sell his shares. Having said that, institutional investors are becoming more vocal when it comes to company performance ...

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