The guide says it's because fin institutions are highly levered and they do not re-invest debt in the business and instead use it to create products. Also, interest is a critical part of a bank's business model and working capital takes up a large part of their balance sheet.
What exactly does this mean? Is there a better answer to this?
And what are some good reasons why you would not use a DCF? Other than having unpredictable/unstable cash flow and for financial institutions.
Thanks.
Valuing Financial Institutions and Banks
Understanding why financial institutions groups are different from traditional coverage groups is key. This is because the companies are different from traditional cash flow driven companies.
The financial institutions group offers advisory to many diffrent financial firms
These firms include:
- Banks
- Insurance Companies
- Financial Technology Companies
- Asset Managers
- Diversified Financial Companies
- Securities Firms
- Other Specialty Finance Firms
In this way the financial institutions groups are unique because of the unique asset classes involved, similar to energy and real estate.
Specifically, FIG client assets can include:
- loans
- investments
- cash
- securities
WallStreetPlayboys:
Basically, FIG companies "borrow money" (i.e., source capital) cheaply and then "lend money" (invest that capital) expensively. Much (though not all) of their income is generated by the spread between those two rates of return.
Additionally, because of the sources of some of their capital (largely individual consumers), there is strict regulation surrounding what kind of assets FIG companies can and cannot hold on their balance sheet, and in what quantities.
valuation using dividend discount model
Solidarity:
DDM - Dividend Discount ModelTraditional banks have to maintain a certain level of liquid assets, which means that at any given time, they have to be above threshold levels for several capital ratios (i.e. in case depositors withdraw all deposits, liquidity sources disappear, etc). Thus, traditional net income (and therefore FCF) is a pretty bad place to start.
- You should start with net interest income, which is essentially the bank's gross margin (think interest income as revs, interest expense as COGS... this should be intuitive).
- Next, look at a bank's non-interest expense (fixed costs, rent, and the biggest part--comp expense). You also have to keep in mind that the bank has to keep making loans to make money (its "assets" are earning), so there are certain ratios that your model should be maintaining (asset/loan ratios, assets/equity, etc.).
- Now, after mandatory debt repayment, reserves, and all the jazz, you should get to a net-income-like figure, but more accurately, it's "excess capital available for distribution." That's the "dividend" that gets paid out in the DDM / Gordon Model.
- Like every PV method, it works the same way as a DCF. Of course, there are other quick-and-dirty methods you can apply; comps, price-to-book-value ratios, deposit premiums, etc.
I glossed over some of the fuzzier aspects, but this should be a reasonably accurate overview. Recently, I think there were some pretty laughable rumors of a Bank of America sale, but just for a second--think about the complexity of that model. Take your traditional banking model, latch on an investment banking business, mortgages, credit cards, etc... It would SUCK to be the analyst modeling that one. The complexity of this model is also the reason that people say FIG is more sophisticated than other industry groups.
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