Value and Capital Management: A Handbook for the Finance and Risk Functions of Financial Institutions

Chapter 5Valuing Financial Services – The Theory

The last two chapters made the case that Business RAPMs are not generally used for strategic decision making, in large part due to the lack of a clear link with share value, and that they often do not make theoretical sense, especially in the way that capital and the cost of capital are measured. Both issues can lead to wrong decisions, including over-investing in value-destroying businesses and under-investing in businesses which create value.

Counterbalancing these criticisms is the observation that New Business RAPMs continue to have a substantial tactical impact on some firms' pricing and underwriting decisions and that both New Business and Investment RAPMs are directly linked to shareholder value.

This leads to an obvious question. Can we integrate New Business and Investment RAPMs into a valuation framework that makes sense for banks and insurers, with a direct link to shareholder value? The answer is yes, if we go back to fundamentals.

What Determines Share Value? Market Multiples, Roe And Growth…

As Figure 5.1 illustrates, the difference between Total Shareholder Return (TSR) of top-quartile and bottom-quartile firms can be substantial. During the period from 1995 to 2002, the top quartile of the largest 50 banks in the USA managed to quadruple their market value in a little over 5 years, while the bottom-performing firm did not even double its market value over the same period.

Figure 5.1 US bank TSR, 1995–2002