Valuation of banks: Alternative approaches

Abstract

Historically private sector banks have experienced better valuation ratios than public sector banks. The differences in valuation ratios cannot be explained fully by difference parameters such as ROA and NPA/advances. The differences in these parameters are not very significant. These mixed interpretations with respect to bank valuations, along with unique business model of banks pose certain challenges in terms of valuing the business correctly. Banks unlike normal firms primarily operate on both the sides of balance sheet actively seeking profits not only in lending but also in raising capital. Each asset and liability class of banks has unique characteristics and warrants different attention in terms of valuation approach. Each asset class has different term structure approach with different discount rate. Also value of deposit and Loan is quite huge as compared to other items in balance sheet. These challenges therefore warrant a different approach to valuing a bank business model compared to other types of firm. Various approaches can be considered while valuation. These include discounted cash flow valuation, dividend discount approach and relative valuation. Each of these approaches suffers some shortcomings in terms of correctly predicting and accounting of various parameters such as maturity, duration and effect of changing interest rates. Also discounting factors used in general DCF models such as cost to equity and weighted average cost of capital cannot be taken directly to discount the cash flows in case of banks. In case of relative valuation techniques, price to book value becomes an important indicator of valuation especially in banks as their entire income and expenditure is related to the book value of assets. But again, it becomes difficult to compare book value estimates of one bank with other due to their varying credit risks. Closer look at each assets and liabilities class separately will enable the better understanding of the banks value. In this context, market value method is primarily based on the principle that the market value of a bank’s equity is the difference between the market value of assets and the market value of liabilities. Of course each asset / liability class is influenced by parameters such as time to maturity, contractual interest rates, deposit rates etc. Therefore each asset / liability class is dealt with separately. On the asset side of the balance sheet, items such as cash and balances with RBI and other banks have been taken at book values. Primary reason being, cash balances / balances with RBI are readily available for liquidations and do not earn / earn small interest. Loans and advances represent the significant portion of the balance sheet and act as prime income generator for the banks. Market value of loan portfolio is calculated based on the principle for discounting of future cash flows. Since there are loans with variable maturities, we use maturity baskets data available in balance sheet as proxy to understand the exact composition of loan portfolio of the bank. Future cash flow form a loan portfolio will depend on the average lending rate. Here we adopt the term structure approach for calculating the appropriate discounting factor. Term structure data corresponding to different maturities is taken as the discounting rate for loans with respective maturities. We can adopt similar methodology for valuing the deposits. Here future cash outflows from the banks will depend on the coupon rate on deposits and maturity patterns. Again term structure approach can be used for discounting the cash flows.