The Little Book of Valuation, Updated Edition

Chapter TenBank on It: Valuing Financial Service Companies

THROUGH THE DECADES, BANKS and insurance companies have been touted as good investments for risk-averse investors who value dividends. Invest in Citigroup (CITI) and American Insurance Group (AIG), they were told, and your investment will be safe. Not only did these firms pay large and stable dividends, but they were considered safe because they were regulated. The banking crisis of 2008 revealed that even regulated firms can be guilty of reckless risk taking. While some of these firms may be good investments, buyers must do their homework, assessing the sustainability of dividends and the underlying risk.

Financial service businesses fall into four groups, depending on how they make their money. A bank makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it and from other services it offers to depositors and its lenders. Insurance companies make their income in two ways. One is through the premiums they receive from those who buy insurance protection from them and the other is income from the investment portfolios that they maintain to service the claims. An investment bank provides advice and supporting products for other firms to raise capital from financial markets or to consummate transactions (acquisitions, divestitures). Investment ...