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Valuation Methods for Banks: An Empirical Comparison of Intrinsic Valuation


Methods for Banks

Research · May 2015


DOI: 10.13140/RG.2.1.4194.4483

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Valuation Methods for Banks

Bachelor Thesis
IUBH School of Business and Management
Campus Bad Honnef · Bonn
Mülheimer Straße 38
53604 Bad Honnef
Germany

International Management
Valuation Methods for Banks:
An Empirical Comparison of Intrinsic Valuation Methods for Banks

Florian Leister

Supervisor: Professor Dr. Isselstein

Date of submission: October 13, 2014


Valuation Methods for Banks

ACKNOWLEDGMENT
I would like to thank my girlfriend for being patient and for supporting me, not just
during my thesis. I would like to thank my dog for taking care of my breaks. Furthermore, I
would like to thank my parents for giving me the opportunity to study what and where I want.
Finally, I would like to thank Professor Franz Isselstein for giving me feedback, support and
for keeping me on track during this thesis.

i
Valuation Methods for Banks

ABSTRACT
Bank valuation methods differ from valuation methods for non-bank companies in
several aspects. Therefore, the following study compares several intrinsic valuation
approaches to examine whether there is a method that is superior over another. For this
comparison 44 European banks have been analyzed with up to eleven valuation methods. The
calculated values were then compared to the respective stock prices over time to assess the
explanatory power of the model. This study starts with a description of bank regulations and
their impact on bank valuations and continues with an overview of valuation approaches. In
the last section, the thesis applies several valuation models and provides descriptive statistics
to compare these approaches. In the end, this thesis shows the advantages and disadvantages
of each model and provides a framework for the selection of valuation methods. The
comparison showed not one clear superior model but it differentiates between weaker and
stronger models.

Keywords: Bank Valuation, Discounted Cash Flow, Intrinsic Valuation, European Banks,

   

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Valuation Methods for Banks

TABLE OF CONTENTS
Acknowledgment ........................................................................................................................ i  
Abstract ...................................................................................................................................... ii  
Table of Contents ...................................................................................................................... iii  
List of Figures ............................................................................................................................ v  
List of Appendices .................................................................................................................... vi  
List of Abbreviations ............................................................................................................... vii  
1. Introduction ............................................................................................................................ 1  
1.1. The Importance of Valuation ......................................................................................... 1  
1.2. Intrinsic Value ................................................................................................................ 1  
1.3. What Drives Value? ....................................................................................................... 2  
1.4. Specifics of Bank Valuation........................................................................................... 4  
1.5. Bank Regulation ............................................................................................................. 5  
2. Literature Review................................................................................................................... 7  
2.1. Recent Studies ................................................................................................................ 7  
2.2. General Assumptions About the Market ........................................................................ 7  
2.3. Intrinsic Valuation .......................................................................................................... 8  
2.3.1. The Two-Stage Dividend Discount Model............................................................. 9  
2.4. Relative Valuation ..................................................................................................... 9  
2.4.1. P/E Ratio............................................................................................................... 11  
2.4.2. P/BV Ratio ........................................................................................................... 12  
3. Input Factors ........................................................................................................................ 13  
3.1. Estimating Input Factors .............................................................................................. 13  
3.2. The Capital Asset Pricing Model ................................................................................. 14  
3.2.1. Beta factor ............................................................................................................ 14  
3.2.2. Risk Free Rate ...................................................................................................... 17  
3.2.3. Risk Premiums ..................................................................................................... 17  
3.2.4. Estimating Growth ............................................................................................... 20  
3.3. Normalizing Fundamentals ..................................................................................... 22  
4. Examination of Different Valuation Methods ..................................................................... 23  
4.1. Methodology ........................................................................................................... 23  
4.2. Database Validity and Reliability ............................................................................ 24  
4.2.1. Assumptions ......................................................................................................... 24  
4.3. Application and Comparison........................................................................................ 27  

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Valuation Methods for Banks

4.3.1. Constant Dividend Payments with Expected Growth Rate Normalized .............. 28  
4.3.2. Constant Dividend Payments Stable Growth Period 4% ..................................... 30  
4.3.3. DDM, Average Dividends of Previous 4y Grow with Normalized Growth Rate 31  
4.3.4. Two-stage DDM; Dividends Grow with Expected Growth Rate and 4% in
Perpetuity........................................................................................................................ 33  
4.3.5. Discounted Cash Flow with Cash Flow to Equity ............................................... 34  
4.3.6. Excess Return Model............................................................................................ 37  
4.3.7. DCF Considering Reinvestment in Regulatory Capital ....................................... 39  
4.3.8. Other DCF Varieties ............................................................................................. 41  
5. Limitations ........................................................................................................................... 42  
6. Conclusion ........................................................................................................................... 43  
Declaration of Authenticity...................................................................................................... 45  
References ................................................................................................................................ 46  
Appendix .................................................................................................................................. 49  

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Valuation Methods for Banks

LIST OF FIGURES
Figure 1. Line chart, Government bond interest rates with ten years maturity. Source: Eurostat
.......................................................................................................................................... 19

Figure 2. Share Price of Deutsche Telekom AG. Source: Deutsche Telekom AG retrieved 7th
October 2014.................................................................................................................... 26

Figure 3. Line chart, Constant dividend payments with expected growth rate normalized,
valuation applied for 2012 ............................................................................................... 28

Figure 4. Line chart, constant dividend payments with expected growth rate normalized,
valuation applied for 2013 ............................................................................................... 29

Figure 5. Boxplot, constant dividend payments with expected growth rate normalized and
valuation for 2013 ............................................................................................................ 30

Figure 6. Line chart, constant dividend payments stable growth period 4% valuation applied
for 2013 ............................................................................................................................ 31

Figure 7. Line chart, dividend discount model average dividends of previous 4 years grow
with expected growth rate normalized, valuation applied for 2013................................. 32

Figure 8. Boxplot, DDM with average dividends of previous 4 years and Valuation for 2014.
.......................................................................................................................................... 32

Figure 9. Line chart, two-stage dividend discount model, dividends grow with expected
growth rate and 4% in perpetuity, valuation applied for 2013 ........................................ 33

Figure 10. Line chart, cash flow to equity model with net income of 2013,valuation applied
for 2014 ............................................................................................................................ 35

Figure 11. Boxplot, cash flow to equity model and net income of 2013, valuation applied for
2014.................................................................................................................................. 36

Figure 12. Boxplot, cash flow to equity model and average net income of previous 4 years,
valuation applied for 2014. .............................................................................................. 36

Figure 13. Boxplot, excess return model, valuation applied for 2014. .................................... 38

Figure 14. Line chart, excess return model, valuation applied for 2014 ................................. 39

Figure 15. Line chart, net income discount with AOCI, valuation applied for 2014 .............. 41

Figure 16. Boxplot, net income discount with AOCI, valuation applied for 2014. ................. 42

   

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Valuation Methods for Banks

LIST OF APPENDICES
Appendix A. Income Sources for European Banks, 1988-2007 (Koller et al., 2010, p. 744) . 49

Appendix B. Phase-in arrangements Basel III capital requirements (Accenture, 2012). ........ 50

Appendix C. Table, Beta factors of Deutsche Bank AG as of 1st January 2014..................... 51

Appendix D. Income breakdown by business segments Deutsche Bank AG (Deutsche Bank


AG, 2014) ........................................................................................................................ 52

Appendix E. WACC for Microsoft. (Gardner et al., 2010, p. 36) ........................................... 53

Appendix F. Table, net income as of bank and year in million. Source: Morningstar.com .... 54

Appendix G. Table, Price/ Earnings Ratio............................................................................... 55

Appendix H. Table, Price to Book Value Ratio....................................................................... 56

Appendix I. Table, Cost of Equity ........................................................................................... 57

Appendix J. Table, Return on Equity....................................................................................... 58

Appendix K. Table, Retention Ratios. ..................................................................................... 59

Appendix L. Pie chart, total income by branch operations for Svenska Handelsbanken 2013.
.......................................................................................................................................... 60

Appendix M. Constant dividend payments with expected growth rate normalized and
valuation for 2012. ........................................................................................................... 61

Appendix N. Constant dividend payments stable growth period 4% and valuation for 2013. 62

Appendix O. Boxplot, net income discount without OCI and Valuation for 2014. ................ 63

Appendix P. Line chart, two stage DDM, dividends grow with expected growth rate and 4%
in perpetuity, valuation applied for 2014 ......................................................................... 64

Appendix Q. Boxplot, two stage DDM, dividends grow with expected growth rate and 4% in
perpetuity, valuation applied for 2013. ............................................................................ 65

Appendix R. Boxplot, two stage DDM, dividends grow with expected growth rate and 4% in
perpetuity, valuation applied for 2014. ............................................................................ 66

Appendix S. Table, Banks used for the study .......................................................................... 67

   

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Valuation Methods for Banks

LIST OF ABBREVIATIONS
593 BCA POPOLARE DI SONDRIO
48CA CAIXABANK
4BE BCA POPOLARE EMILIA ROMAGNA
ACB ALPHA BANK
AOCI Accumulated Other Comprehensive Income
APM Arbitrage Pricing Model
B8ZB BCO POPOLARE
BAKA BANKINTER
BAT BCO ESPIRITO SANTO
BCP BCO COMERCIAL PORTUGUES
BCY BARCLAYS
BDSB BCO SABADELL
BIR BANK OF IRELAND
BKP1 PIRAEUS BANK
BNP BNP PARIBAS
BOY BCO BILBAO VIZCAYA ARGENTARIA
BPD UBI BCA
BPG BCA POPOLARE DI MILANO
BSD2 BCO SANTANDER
CAPM Capital Asset Pricing Model
CAR Capital Adequacy Ratio
CBK COMMERZBANK
CET 1 Common Equity Tier 1
CFE Cash Flow to Equity
CFO Chief Financial Officer
COE Cost of Equity
CRD 4 Capital Requirements Directive 4
CRIH UNICREDIT
CV Continuing Value
DBK DEUTSCHE BANK
DCF Discounted Cash Flow
DDM Dividend Discount model
DPS Dividends per Share
DSN DANSKE BANK
E(CF) Expected Cash Flow
EBITDA Earnings before Interest, Tax, Depreciation and Amortization
EBO ERSTE GROUP BANK
EPS Earnings per Share
ERP Equity Risk Premium
FRYA SWEDBANK
FV01 BANKIA
g Growth rate
HBC1 HSBC

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Valuation Methods for Banks

IES INTESA SANPAOLO


IPO Initial Public Offering
ISIC International Standard Industrial Classification
JYS1 JYSKE BANK
KDB KBC GRP
KONN KOMERCNI BANKA
LLD LLOYDS BANKING GRP
MBV Market-to-Book Value
ME9 MEDIOBANCA
MPI1 BCA MONTE DEI PASCHI DI SIENA
NBA DNB
NBP NATIXIS
NDB NORDEA BANK
OCI Other comprehensive Income
P/BV Price/ Book Value
P/E Price/ Earnings
POPD BCO POPULAR ESPANOL
PV Present Value
r Discount factor
RAW RAIFFEISEN BANK INTERNATIONAL
RBS ROYAL BANK OF SCOTLAND GRP
Rf Risk-free rate
Rm Required return of the market
ROE Return on Equity
ROI Return on Investment
RWA Risk-weighted Assets
SEBA SKANDINAVISKA ENSKILDA BK A
SGE GRP SOCIETE GENERALE
STD STANDARD CHARTERED
SVHA SVENSKA HANDELSBANKEN A
TM2 SYDBANK
TV Terminal Value
WACC Weighted Average Cost of Capital
XCA CREDIT AGRICOLE
 
 

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Valuation Methods for Banks

1.  INTRODUCTION
1.1.  The Importance of Valuation
Valuation of companies is important for many professions. Private and Institutional
investors try to estimate the value of a company, seeking for a high yield and limited risks.
Auditors and consultants need to estimate companies worth for mergers and acquisitions as
well as for other special events. The chief financial officer (CFO) needs to know the
principles of valuation in order to understand what drives the value of the company. There is a
large number of valuation methods on the market, but all methods can be categorized into
three valuation approaches i.e. relative valuation, intrinsic valuation and option pricing
approach. Which valuation approach should be applied depends on the purpose, data
availability and specifics of the asset. In this study I want to examine which intrinsic
valuation method has the most explanatory power and subsequently should be used in future
bank valuations.
1.2.  Intrinsic Value
When looking at the value of a company or any other asset, two values are important
and have to be distinguished. On the one hand side, there is the market value of an asset,
which is the price one has to pay to become the owner of the asset and on the other side, there
is the underlying value or intrinsic value of an asset. The market value for a publicly traded
company can easily be observed and is calculated as the product of the share price and the
number of shares outstanding.
𝑀𝑎𝑟𝑘𝑒𝑡  𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝐴𝑠𝑠𝑒𝑡 = 𝑆ℎ𝑎𝑟𝑒  𝑃𝑟𝑖𝑐𝑒×  𝑆ℎ𝑎𝑟𝑒𝑠  𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
The market value of an asset cannot be right or wrong, it is simply the amount of
money one has to pay to become the sole owner of the asset. While the definition and
calculation of the market value of an asset is straightforward and logically sound, the intrinsic
value is not.
The intrinsic value represents the theoretical worth of an asset. Meaning, “Price is
what you pay, value is what you get” (Buffet, 2008). This term however, is a more
philosophical one than the market value and a definition is more complicated. A generally
accepted definition is that the intrinsic value of an asset represents the accumulated benefits
received from that asset. In a financial manner this benefit is predominately a monetary
benefit. This does not include an interest in controlling the asset or receiving any other benefit
from it, which would result in differing values for different buyers. In this sense, not every
asset has an intrinsic value but every asset has a market price as long as it has a market. The
famous painting The Scream from Edvard Munch for example, has a market value but no

1
Valuation Methods for Banks

intrinsic value that one could calculate and furthermore it has a different value for different
people. Some would say that the value of the painting is represented by the sum of the
expenses necessary to draw the painting i.e. canvas, paintbrush and paint while others would
say that the value of the paint is represented by the cost to produce the painting which
includes the sum of the expenses plus the compensation for the actual work of the artist i.e.
creativity and drawing. Still others would argue that the worth of the painting is just the
amount of money one would get when selling the old paint of the painting and the used
canvas separately. For most people though, the value of the painting is what other offered
before for it. Although, value is in the eye of the beholder they share one common value and
that is the price in monetary terms.
However, in order to calculate the intrinsic value of a company one has to neglect all
previously mentioned definitions of value and state that the value of an asset is represented
solely by the expected future economic profit of this asset. Taking this definition already
reveals the incumbent problem of intrinsic valuation. Expected future economic profit varies,
depending on who analyzed the security and whether his or her expectations are rather high or
rather low, which has a significant impact on the valuation of that asset. Graham and Dodd
characterized the role of intrinsic valuation as follows.
“The essential point is that security analysis does not seek to determine exactly what
is the intrinsic value of a given security. It needs only to establish either that the value
is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the
value is considerably higher or considerably lower than the market price” (Graham &
Dodd, 2008, p.66).
This characterization is supported by Warren Buffet who wrote that, he cannot tell a
precise number for the intrinsic value of his company, nor can he for any other business
(Warren Buffet, 2014). Nevertheless, there is a strong point in intrinsic value:
“Intrinsic value is an all-important concept that offers the only logical
approach to evaluating the relative attractiveness of investments and businesses.
Intrinsic value can be defined simply: It is the discounted value of the cash that can be
taken out of a business during its remaining life“ (Warren Buffet, 2014, p.107).
1.3.  What Drives Value?
There are multiple approaches to assess the intrinsic value of a company, but in
general they share one specific characteristic. The requirement that an asset has to fulfill in
order to have any value is to generate positive cash flows in some point in time. “Companies
create value for their owners by investing cash now to generate more cash in the

2
Valuation Methods for Banks

future”(Koller, Goedhart, & Wessels, 2010, p.15). For most companies it is sufficient to have
a positive cash flow or in total a positive return on investment (ROI) which has managerial
implications when considering the following statement “(…) any action that doesn´t increase
cash flows doesn´t create value” (Koller et al., 2010). The latter statement however, falls short
especially for banks where cash flows cannot be measured reliably. A manager of a bank has
to consider the effect on the income rather than the cash flow when considering an action.
Therefore, when talking about banks, only what increases income or decreases risks adds
value to the company. Banks are historically well known as stable dividend payers making it
difficult for managers to challenge this expectation. The term stable in this regard means that
they payout a stable absolute dividend not in terms of a stable dividend payout ratio. Deutsche
Bank for example states on their investor relations web page, that they paid out € 0.75 as
dividends per share (DPS) for the years 2009 to 2013 each. This does not mean that Deutsche
Bank´s income were stable or that their payout ratio was stable, in fact it does not even mean
that they generated a positive income during the time. Actually, the dividend payout ratio,
calculated by dividing the DPS by the earnings per share (EPS), was 271% for the year 2012
meaning that they paid out 2.71 times what they generated as net income. A bank can only act
like this on the short run, but on the long run the company needs to have a retention ratio that
is positive in order to grow. In consequence, taking absolute dividends for a valuation of a
bank is not sufficient, especially when one considers what banks can do with additional
retained earnings.
For banks that are regulated on the basis of capital ratios like the debt-to-equity ratio,
earnings that are not paid out to the shareholders, increase the equity and in turn the capital
for a bank. A bank that has an equity capital ratio of 10% is able to make € 100 in debt for
every € 10 in equity capital and vice versa (Damodaran, 2009). The bank having now € 110
on the asset side can lend this amount to their customer for an interest rate of for example
10%. Assuming a weighted average cost of capital (WACC) of 5%, would result in an income
generation before tax of € 5.50 by utilizing just € 10 in equity when ignoring expenses and
risk for lending the money. Banks as opposed to other companies tend to have a leverage ratio
that is as high as possible or as allowed, therefore the retention ratio is an important figure in
valuing banks and assessing the growth rate. However, taking historical retention ratios when
valuing a bank can result in an undervaluation. Banks have to retain earnings to increase their
capital ratios and to meet supervisory standards, but when the requirements are finally met,
there is no reason why the historical retention ratio should be valid anymore. Therefore, just

3
Valuation Methods for Banks

looking on the past payout ratios would imply, given the bank had high retention ratios in the
past, that the bank would need to increase their equity at that rate forever.
1.4.  Specifics of Bank Valuation
Assessing the value of a bank is a quite challenging task. Banks differ from other
companies in multiple ways, which necessarily leads to different valuation approaches. A
simple dividend discount model could for example lead to an undervaluation of the target
bank, when banks are restricted in their dividend payout policy to keep their capital
requirements and to fulfill the regulations. The banking industry is highly regulated especially
since the financial crisis beginning in the year 2007. The Third Basel Accord and upcoming
regulations will further increase restrictions and force banks to react on these requirements
(Basel Committee on Banking Supervision, n.d.) Additionally, banks are traditionally highly
leveraged; Deutsche Bank for example has a debt to equity ratio of 3.4% in 2013 (Deutsche
Bank AG, Financial Report 2013, 2014), which has to be reflected by the valuation method
applied. Today, many banks generate their revenues not alone from lending money and
receiving interest, but from many sources like asset management fees and other services,
actually requiring separate valuations for each revenue generating branch. One can in general,
distinguish three main forms of income for a bank, interest income, fee income and trading
and other income (Koller et al., 2010, pp. 742–743). The sources of income and the reason
why one has to differentiate between them will be discussed in the following.
Net interest income is generated, as discussed before, by issuing capital and lending it
to the customer. The loans given to the customer can have different forms with different
levels of repayment risks, while the interest, the customer has to pay to the bank, reflects this
risk. The loans can have the form of credit card loans, mortgage loans corporate or private
loans et cetera. The difference between the interest expenses that the bank has to pay and the
interest income paid by the customer is the net interest income. Next to the classical way for
banks to generate income, they developed other ways to create additional income.
Fee and commissions income is created by offering services and charging a fee for it.
The fee income as reported on the financial statements of a bank consists primarily of
investment fund management fees, fiduciary and custodian fees, portfolio and management
advisory fees, credit-related fees, underwriting fees, corporate finance fees and brokerage fees
and commissions income (Deutsche Bank Financial Report 2013, 2014).
Proprietary trading income is created when the bank trades on its own account instead
of on behalf of a client (Farlex Financial Dictionary, 2012).

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Valuation Methods for Banks

Other income consists of nonbanking activities like real estate brokerage and others.
In general other income contributes just a relative small amount to the total income of a bank.
Indeed, relative to the interest income, trading, commissions and other income became more
and more important for banks during the years 1988 to 2007 as Appendix A shows (Koller et
al., 2010, p. 744).
However, the increase of noninterest income like trading income is not merely due to
their higher profitability but due to the amount of different securities that can be traded
nowadays. Creative bankers developed a variety of derivatives that can be traded and which
serve different needs. The most prominent instruments are equity stocks, bonds, foreign
exchange, credit default swaps and asset-backed debt obligations (Koller et al., 2010). For
some banks trading and other income accounts for a high proportion of total income, as for
example the Deutsche Bank reported a total trading income of € 8,868 Million in 2006 which
was 31% of total net revenue. On the other hand, trading accounts for large losses when the
economic situation is difficult as Deutsche Bank reported a trading income of minus € 33,829
Million in 2008 (Deutsche Bank AG Financial Report 2009, 2010), which easily wiped out
the profits of the previous years. An exemplary breakdown by income for Deutsche Bank can
be seen in Appendix D.
The distinction of the various income sources is a critical part in valuation not least as
they can increase or decrease the risk of the company, hence increasing or decreasing its
worth. The previously mentioned classification according to income sources is just one
possibility and textbooks are not quite clear about it. However, for the purpose of this study
we stay with the previously mentioned classification although others are possible and the lines
are blurred.
1.5.  Bank Regulation
Another important point in what distinguishes a bank from any other business is the
way a bank is regulated. The Basel Committee on Banking Supervision is the main regulatory
standard setter for banks. The committee defines general guidelines and standards on the
supervisory of banks. The central bank governors of the G10 formed it in 1974 after the
breakdown of the Bretton Woods system one year before. The main objectives at that time
were to set minimum capital requirements to enhance the financial stability of the market. A
consultative paper known as Basel 1 or The Accord proposed “a minimum capital ratio of
capital to risk-weighted assets of 8% to be implemented by the end of 1992” (“A brief history
of the Basel Committee,” 2013).

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Valuation Methods for Banks

The following Basel 2 and Basel 3 Accords further increased the capital requirements
and regulated the ways banks generate income still with the goal to strengthen financial
stability. (“Basel Committee on Banking Supervision Charter,” 2013). The reason for these
minimum capital requirements are that especially banks try to leverage their business to the
fullest extend possible as it increases the return on equity ratio, making it on the other hand
difficult to survive in situations when the bank is facing large operating losses that cannot be
absorbed by equity. However, in order to meet the standard, banks need to acquire equity,
therefore the payout ratio can be limited which would have impacts in the valuation especially
for dividend discount models.
Nevertheless, it is important to distinguish between asset and risk-weighted asset, and
between tier one capital and tier two capital. The effects of not doing so are laid out in the
chapter “beta factor” of this thesis. The two forms of equity are: “tier one capital which can
absorb losses without a bank being required to cease trading, e.g. ordinary share capital, and
tier two capital which can absorb losses in the event of a winding-up and so provides a lesser
degree of protection to depositors, e.g. subordinated debt” (Reserve Bank of New Zealand,
2007, p. 2). One could further subdivide tier two capital into upper and lower tier two capital.
The upper tier two, as opposed to lower tier two capital, has no fixed maturity. However for
the purpose of this study, we do not subdivide tier two capital and we ignore the existents of
tier three capital, as it is not required for a valuation and furthermore, there will be no tier
three capital with Basel three anymore (Accenture, 2012). On the other hand, risk-weighted
assets (RWA) are assets that are weighted to a certain risk level. Most assets of a bank are
loans and the credit default risk depends upon the creditworthiness of the debtor.
Consequently, the RWA of a bank are the assets adjusted to the inherent risk of the asset.
Next to the inherent risk, it also adjusts for market risks, for example a mortgage backed
security where the loan is secured by a mortgage, then movements in the housing market will
have an effect on the likelihood of repayment. Off-balance sheet contracts carry credit risk as
well and are, for the purpose of a RWA calculation, recalculated to a credit equivalent
amount. The weighting of the assets depend on the riskiness, therefor cash will not be
weighted at all and government bonds to a lower amount than fixed assets. The RWAs and
the tier one and tier two capital are then used to calculate the capital adequacy ratio (CAR)
(Reserve Bank of New Zealand, 2007).
𝑇𝑖𝑒𝑟  1  𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑇𝑖𝑒𝑟  2  𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐶𝑎𝑝𝑖𝑡𝑎𝑙  𝐴𝑑𝑒𝑞𝑢𝑎𝑐𝑦  𝑅𝑎𝑡𝑖𝑜 =
𝑅𝑖𝑠𝑘  𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑  𝐴𝑠𝑠𝑒𝑡𝑠

6
Valuation Methods for Banks

Although the Basel Accord defines the lower limit of the Capital Adequacy Ratio,
national banks may determine higher ratios for example for systemic relevant banks. The
Swedish central bank for example requires a core Tier 1 ratio of 12% while Basel 3 requires
just 7% (Sahlström & Öhlin, 2011, p.3). The limitations under Basel 3 will not change the
capital ratio of currently 8%, but the composition and definition of Tier 1 and Tier 2 capital.
For Basel 3 the Tier 1 capital ratio will be 6% as opposed to 4.5% under Basel 2 (Accenture,
2012), additionally Tier 1 capital will consist primarily of common shares and retained
earnings (Basel Committee on Banking Supervision, 2011). Compare Appendix B for a more
detailed view on Basel 3. Apart from the capital ratios, bank regulators will additionally focus
on the liquidity of a bank and various other things. However, all measures share the common
goal to make banks more stable on an international level. The implications for a valuation are
therefore that due to a higher demand for capital quality, the return on equity will probably
decrease and as a counterpart, the systemic risk will decrease as well. Whatever force is
stronger will determine whether a bank has a higher or lower value than now.
2.  LITERATURE REVIEW
2.1.  Recent Studies
Studies about valuation in general and bank valuation in particular can be classified
into four approaches. Surveys that ask market participants about what valuation models they
apply and what values they use as their input factors. Secondly, studies that focuses on just
one or more input factors. Thirdly, studies about bank valuation approaches, that summarize
what models to use and what input factors to apply, in the end proposing a guideline or
framework to bank valuation. And fourthly, other studies like event studies that focus on
events and their impact on firm value.
Bancel and Mittoo conducted a survey beyond 356 European valuation experts in
2012 to gain insight on how practitioners make use of valuation methods. They asked what
valuation methods they use and respectively, what values they use in these models (Bancel &
Mittoo, 2014). This survey is the most recent and focuses on European valuation experts and
will be continuously cited throughout this thesis although the survey was not primarily about
bank valuation.
2.2.  General Assumptions About the Market
When doing a valuation for investment purposes, one needs to assume that the market
is not strong efficient according to the efficient market hypothesis, otherwise the share price
of a stock multiplied by the number of shares outstanding would always be the same as the
intrinsic value of a company. Therefore valuation practitioners assume that the market is at

7
Valuation Methods for Banks

the most, semi-strong efficient but will correct mispricing over time. When doing relative
valuation one assumes that the market prices assets correctly on average, but is wrong on
individual assets (Damodaran, 2013).
2.3.  Intrinsic Valuation
Intrinsic valuation tries to assess the value of a company based on the specific
characteristics of a company. The survey of Bancel and Mittoo shows that nearly 80 percent
of the respondents use a discounted cash flow model (2014). The DCF model is a tool for
intrinsic valuation and consist of the discounted cash flows that the asset will generate in the
future, the estimated growth rate and the risk of the company. Therefore, only cash-flow
generating assets can be valued with an intrinsic valuation approach as the following formula
shows:
J
𝐸(𝐶𝐹H )
𝑉D =
(1 + 𝑟)H
HKL

Where
V = is the present value of the asset
E(CF) = are the expected cash-flows
r = is the discount factor
While the formula is very simple to calculate, the problem lies within the input factors
that have to be estimated. First one needs to decide whether the equity should be valued or
whether the entity should be valued. For the equity valuation the post-debt cash flows have to
be estimated and for the entity valuation the pre-debt cash flows need to be estimated
(Damodaran, 2013).
Second, the expected cash flows need to be projected, which can be done in a variety
of ways. The most prominent way is to look in the past and to run a regression on the cash
flows. Although this might be reasonable for stable companies with steady streams of cash
flows, it cannot be used for start-up companies that never generated cash flows or companies
with negative cash flows in the past. For banks, the estimation of cash flows is critical as well,
as they generate cash flows form several sources and these cash flows were in the past years
very volatile, making the valuation already more complex. Alternatively, cash flows can be
projected by not alone relying on the financials of a company but taking into account the
estimates of the management, the growth of the GDP weighted to where the past revenues
have been generated, and in a multiple other ways. The general problem is that forecasting the
future is always difficult, if not impossible, but necessary for an intrinsic valuation. The risk

8
Valuation Methods for Banks

of the asset is, in the previous equation, reflected by the discount factor, which is either the
cost of capital for an entity valuation or the cost of equity for an equity valuation.
2.3.1.  The Two-Stage Dividend Discount Model
Apart from the simple dividend discount model, one can split this model into two or
more stages of dividend growth to estimate the value more realistically. The first growth stage
is usually called the high-growth stage and the second is called the stable-growth stage.
However, the term high-growth stage can be misleading, as the high-growth stage can show a
lower growth rate than the stable-growth stage. This could for example be the case for a
company that is currently facing an industry or market crisis, but the analyst expects that this
crisis will end sooner or later. Hence, one should see the high-growth stage as the expected
dividend growth rate in the foreseeable future and the stable-growth stage as the long-term
constant perpetual dividend growth rate. Sometimes, it is argued that the stable-growth stage
is lower “(…) because of limited growth opportunities (…)” (Dermine, 2008). However, it is
unlikely that a bank that exists and grows for hundred or more years will face limited growth
opportunities in a few years. A more likely explanation for the, on average, lower stable-
growth rate is that it contains an uncertainty risk buffer for not being able to look into the
future that far. The general formula for a two stage DDM is presented below (CFA Institute,
n.d.).
N
𝐷D (1 + 𝑔)H 𝑃𝑉N
𝑃𝑟𝑒𝑠𝑒𝑛𝑡  𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦 = +
(1 + 𝑟)H (1 + 𝑟)N
HKL

Where
g is the short-term growth rate
t is the short-term growth period
𝑃𝑉N  is the present value of the company in year N
N is the long-term growth period
r is the cost of capital
2.4.  Relative Valuation
In relative valuation the investor compares the price of one asset, for example the
price of a publicly traded company, with the price of an asset that share specific
characteristics. The important part is to find an asset or group of assets that are in fact
comparable. The importance of finding the right peer group for an asset can be seen when
looking at the real estate market. Real estate agents use multiples to assess the value of real
estates in order to find a price for it. Normally, this is done by taking the average price per

9
Valuation Methods for Banks

square meter of the surrounding area. The major problem with this approach is that for the
calculation of the average price per square meter, any real estate that fulfills simple
requirements is taken into the calculation. For example, when calculating the price per square
meter for an apartment, all apartments nearby are taken into consideration, in defiance of the
quality of the real estate. This would cause problems in more heterogeneous areas where very
exclusive apartment houses are built next to apartment buildings for people with lower
income. Finding now a homogenous group of assets can be very difficult. When taking a too
large peer group with thousands of assets like for example the German housing market as a
whole, one would end up with a price per square meter that is nice to know but in fact
meaningless when used to assess the value of an individual real estate. When talking about
the real estate market, the necessity for a homogeneous peer group is very intuitive. However,
transferring this to relative valuation for other assets like companies, this can become a major
problem. One could for example take the whole financial service industry as a peer group to
value banks, or one can rely on classifications undertaken by others like the International
Standard Industrial Classification (ISIC) as proposed by the United Nations Organization. At
the end, there are literally hundreds of possible aggregation possibilities one can choose of
and which one to choose is depended on the purpose of the valuation but still very subjective.
When valuing banks for example, one could argue that comparing Deutsche Bank with
Svenska Handelsbanken is not feasible as they generate their share of income in different
ways. While, Deutsche Bank generates a large fraction of income with trading and other
income; Svenska Handelsbanken generates their income primarily with interest income. In
order to overcome the problem of finding a nearly identical company and to identify price
differences, company share prices are commonly compared to a sector average or an industry
average. However though, to find a homogenous group of banks one has to identify what
differentiates one bank from another.
The income generation approach as seen before can be used to differentiate a
predominantly investment bank from a more classical spread-business bank to then in the next
step form a peer group of investment banks and classical banks. Although, this approach
seems to be reasonable, it has its own pitfalls as well. The income approach neglects that there
are management-, risk-, human resources-, growth-, and regulation differences next to many
more, although there are sometimes huge differences. Taking the example of Apple and
Microsoft, both companies are active in the software market and compete in many different
areas like Internet browser, operating systems, and office software. Although they seem to be
in the same market, not many would say that these two companies are comparable and in turn

10
Valuation Methods for Banks

not many would use the multiple approach with these two companies when valuing them as a
whole. On the other hand, comparing two student bars that are located next to each other
would be more feasible. Therefore, one could say that applying a multiple approach becomes
more difficult the more businesses the company is in. In fact, 63% of the respondents state
that defining a peer group when using comparables is one of the major limitations of the
current valuation models (Bancel & Mittoo, 2014). In summary, applying the multiple
approach implies, as discussed before, that the market prices assets on average correctly but
the market is weak in pricing individual companies (Damodaran, 2013). There is a nearly
unlimited number of relative valuation multiples that are commonly used, but the decision on
which to choose is heavily dependent on the industry the target asset is in.
2.4.1.  P/E Ratio
As noted before, the choice of multiples, given a homogenous peer group or
comparable individual company, depends on the industry the company is in. For banks, as
discussed before, entity value multiples like the commonly used Firm Value/ Sales or Firm
Value/ EBITDA cannot be easily adopted to the bank industry. That is, “(…) because neither
value nor operating income can be easily estimated for banks (…)” (Damodaran, 2009).
However, multiples that can be used for banks are equity valuation multiples like the Price/
Earnings (P/E) multiple or the Price to Book value ratio (P/BV) as recommended by
Damodaran (Damodaran, 2009).
The formula for the Price Earnings Ratio is:
𝑃𝑟𝑖𝑐𝑒  𝑝𝑒𝑟  𝑆ℎ𝑎𝑟𝑒
𝑃𝑟𝑖𝑐𝑒  𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠  𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠  𝑝𝑒𝑟  𝑆ℎ𝑎𝑟𝑒
While the market value per share is easily traceable, the number to use as denominator
is based on accounting rules, meaning that income is opinion and price is fact. Despite all
accounting rules and regulations there is still some level of freedom for the financial
accountant as to show a more conservative number or a higher number for net income. One
example for the level of accounting freedom that is bank specific are provisions for bad loans,
where the bank sets aside money for expected future losses. In general one would expect a
more conservative bank to set aside more money and a less conservative bank to set aside less
money which would increase the earnings multiple (Damodaran, 2009). When using multiples
that are based on accounting income, one should bear in mind that, if someone has an
incentive to show a high income and the opportunity and ability to do so, then he or she will
do it. If the bonus-system of the Chief Financial Officer is linked to a multiple, like the price
earnings ratio, as it is sometimes the case, then the ratio will most probably reflect that

11
Valuation Methods for Banks

incentive. Nevertheless, the P/E ratio is commonly used not just to estimate whether a
company might be over- or undervalued, but also to compare the ratio over time and to look
for discrepancies that may unveil a short-term orientation of the company. The development
of a forward looking P/E ratio by including a growth rate seems to deliver a more
sophisticated view of the company, but again growth rates are still just best estimates of
analysts that are subjective although the growth rates may be based on objective data. In the
end though, research shows that accounting earnings multiples dominate cash flow and
dividend multiples, and that “Forecast earnings perform best; they exhibit the lowest
dispersion of pricing errors. This result is intuitively appealing because earnings forecasts
should reflect future profitability better than historical measures do” (Liu, Nissim, & Thomas,
2007). This result is supported by another research that used multiples to forecast prices of
initial public offerings (IPO) and found that forward looking earnings multiples are more
accurate than historical ones (Kim & Ritter, 1999). Furthermore, in order for P/E ratios to
have any explanatory power, the earnings have to be positive; if that is not the case for a short
period then still a forward looking P/E ratio could be calculated.
2.4.2.  P/BV Ratio
The process to value banks or any other publicly traded company with the price to
book value ratio, also known as market-to-book value ratio (MBV), is similar to other relative
valuation approaches. However, the price to book value ratio is especially common for the
valuation of banks, as the marked-to-market process is more commonly used with financial
service companies than with non-financial companies, making the price to book value
multiple more meaningful for banks. Marked-to-market accounting means that the assets are
carried at fair value in contrast to depreciated historical acquisition costs.
The multiple approach in general, as discussed before, normally starts with the
selection of comparable banks, then the market-to-book value for each of these banks is
calculated by dividing the current market value of shares by the book value of equity as
reported in the balance sheet of the company (Dermine, 2008).
𝑃𝑟𝑖𝑐𝑒  𝑝𝑒𝑟  𝑠ℎ𝑎𝑟𝑒  ×  𝑆ℎ𝑎𝑟𝑒𝑠  𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑃𝑟𝑖𝑐𝑒 − 𝑡𝑜 − 𝐵𝑜𝑜𝑘  𝑉𝑎𝑙𝑢𝑒  𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙  𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙  𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A price-to-book value ratio of below one means that the book value of equity is higher
than the market value of equity and vice versa. Furthermore, a book value of below one could
mean that the companies assets worth after paying back all liabilities, hence the liquidation
value, is higher than the market value. This could lead to the conclusion that one should buy
the entire company, sell all the assets, pay back the debts and keep what is left over and that

12
Valuation Methods for Banks

with theoretically no risk. But when something sounds to good to be true, it normally is not
true. The P/BV ratio for the Deutsche Bank for example was below one for five consecutive
years (March 2009-2014) (see Appendix H), nonetheless nobody attempted to buy all shares
and liquidate the company. There are many reasons why this scenario has not been exercised,
one is that despite the marked-to-market accounting, the book value of equity is not equal the
liquidation value, at least in the eyes of the market. A mismatch of liquidation value and book
value of equity can occur when either the assets are overvalued, or contain intangible assets
that cannot easily be sold on the market, or the liabilities are undervalued. Another point is
that it can be quite a challenge to buy enough shares to execute the plan without anybody
noticing it, which would increase the share price as well as the P/BV ratio.
In the second step of the multiple approach, the average of the P/BV ratio of the peer
group needs to be calculated. The last step is to multiply the average P/BV ratio of the peer
group with the book value of equity of the target bank; the result then is the value of equity
for the target bank (Dermine, 2008).
𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝑒𝑞𝑢𝑖𝑡𝑦HWXYZH  [W\] = 𝑃/𝐵𝑉_ZZX  YX`a_  ×  𝐵𝑜𝑜𝑘  𝑣𝑎𝑙𝑢𝑒  𝑜𝑓  𝑒𝑞𝑢𝑖𝑡𝑦HWXYZH  [W\]
Although this valuation approach requires, compared for example to the discounted
cash flow approach, just two inputs per company i.e. current share price and stated book value
of equity, that can be easily observed, there is a catch to it. It is actually too simple to be used
as a valuation approach alone, as the analyst needs to bank on the market, implicitly assuming
that the market is right without having a look on the rest of the financial statements or other
objective information. Therefore, the analyst should use multiples only to crosscheck his or
her findings from the fundamental analysis. The huge advantage of calculating multiples is
though, that multiples are relatively straightforward and easy to be understood, for that reason
they better qualified to be a communication vehicle than a discounted cash flow analysis that
requires some additional explanation.
3.  INPUT FACTORS
3.1.  Estimating Input Factors
Input factors are always needed to value a company. How many input factors one
needs is dependent on the valuation model one uses. Generally speaking one can say that the
more input factors the model requires, the more complex it becomes. Complexity in valuation
should be avoided as the more complex it becomes, the more mistakes one can make and the
explanatory power of that model becomes questionable.

13
Valuation Methods for Banks

3.2.  The Capital Asset Pricing Model


To calculate the cost of capital for an intrinsic valuation, this study will focus on the
Capital Asset Pricing Model (CAPM), ignoring that more complex calculations, like the
Arbitrage Pricing Model (APM) or Multifactor models exist, because CAPM it is the most
easiest and most often used model. In the survey of Bancel and Mittoo, nearly 80% of the
respondents steted that they use the CAPM (2014). The formula to calculate the cost of equity
using the CAPM is defined as follows:
𝐸 𝑅 = 𝑟𝑓 + 𝛽(𝑅𝑚 − 𝑟𝑓)
Where
E(R) = the expected return
Rf  =  the  risk  free  rate  
Rm  =  required  return  of  the  market  
β  =  the  unlevered  beta  
Furthermore, this study will focus on equity valuation rather than entity valuation
models, following the recommendation of Aswath Damodaran. “Estimating cash flows prior
to debt payments or a weighted average cost of capital is problematic when debt and debt
payments cannot be easily identified, which (…) is the case with financial service firms”
(Damodaran, 2009). As this study uses the least complex models possible, the weighting of
the single input factors are higher than in complex models and therefore need to be even more
carefully estimated.
3.2.1.  Beta factor
The beta factor is an important factor and necessary to calculate the cost of capital
with the CAPM model. The beta is the slope of the regression line calculated with the
formula:
𝑐𝑜𝑣(𝑆𝑡𝑜𝑐𝑘, 𝑀𝑎𝑟𝑘𝑒𝑡)
𝛽=
𝑣𝑎𝑟(𝑀𝑎𝑟𝑘𝑒𝑡)
As can already be seen from the formula, the calculation of the beta requires the stock
price and the index values. For stock listed companies these data is easy to obtain from
various sources on the Internet. For non-stock listed companies or not yet stock listed
companies that simply have no share price history, the formula cannot be calculated. In this
case, one can calculate an average beta for a similar group of companies and use this beta as a
best estimate of the target company’s beta. Taking betas that have been calculated from
somebody else than the analyst him or herself carries various risks as will be discussed later.
However, published betas from organizations like Morningstar, Bloomberg or Reuters can be

14
Valuation Methods for Banks

used to crosscheck and validate the beta calculated by the analyst. Although, the beta factor is
generally accepted by academics as a way to estimate risk and commonly used by
practitioners, just half of the respondents in a survey agreed or strongly agreed, that beta is a
good risk measure (Bancel, 2013). One reasons for this is that, to date there is no consensus
about what beta to use, even though a discounted cash flow analysis requires a forward
looking beta, more than 80% use historical data. Furthermore one can decide whether to use
daily, weekly, monthly or yearly returns which all give different betas. The period for the beta
calculation is an additional choice to make, most practitioners use a period between one and
three years (54%), however other periods like one year or less or even more than three years
are used (Bancel & Mittoo, 2014).
The next decision to make is, what index to take for the covariance and the variance.
The choices are numerous and it depends on the subjective meaning of the evaluator as well
as on the target company whether to choose a country index, a worldwide index, a regional
index or an industry index. All these decisions sum up into an endless number of more or less
feasible beta estimations. It would not be a problem if all these betas were pretty much close
to each other but as shown in Appendix C, these betas vary heavily. Taking three indices,
four time periods, and three kinds of returns end in 36 Betas ranging from 1.02 to 2.13 for a
single bank, which is in this example the Deutsche Bank.
When selecting a reasonable index for the beta factor calculation, one has to make
sure that not one single company dominates the index as this would result in a beta of close to
one, which makes the beta factor in this case meaningless. The domination of one single
company in an index is most likely in smaller countries that have just a few large cap
companies and many mid and low cap companies like it was the case with Nokia in Finland in
the 2000s (Damodaran, 2013). When a company like Nokia in this scenario is part of the
Finnish index and the index in turn is calculated according to the market capitalization, then
the beta calculation for Nokia with this index is insignificant as it measures the volatility of
Nokia with an index primarily consisting of Nokia which is one or close to one. The
calculation of a forward-looking beta is more difficult and would, given the foregoing, most
probably not increase the accuracy of the beta to that extend that the effort and the risk of
miscalculation would be compensated and is hence not calculated in this study in accordance
with the findings of the study of Bancel and Mittoo.
Bearing all these difficulties in mind, it is not very surprising, that just 50% of the
respondents of the survey consider the beta a good risk measure. Nonetheless, 80% use a
discounted cash flow model to compute the value of an asset (Bancel & Mittoo, 2014),

15
Valuation Methods for Banks

notwithstanding that half of them do not trust their own valuation to full extend. The answer
to the question why they do not use another risk measure instead of the beta factor is probably
because it is still better than others or just because the discounted cash flow model requires it.
The beta covers the relative risk measured in terms of volatility in relation to the company’s
peers, it is hence a company specific risk. Depending on which index has been taken into
account to calculate the beta, it includes partially an industry risk premium. When taking a
bank index to calculate the beta factor for a bank, this bank-industry specific risk is not
covered. On the contrary, taking a more general index like the S&P 500 or the Stoxx Europe
600 that include non-bank companies as well, would cover the industry specific risk.
Although, the beta factor is commonly used, even though heavily criticized, it is not the only
way of estimating the relative risk of a company. In fact, Damodaran collected a subset of ten
different approaches and it can be assumed that all have their raison d'être. Albeit, this study
will use the beta as relative risk measure of choice, as it is most often used.
As discussed before there are a variety of ways to calculate the beta factor,
nonetheless one can assume that banking in general will become less risky over time and that
the beta factor will approach one in the long run. Bank managers are aware of the fact that a
more volatile business model will reduce the intrinsic value and probably try to reduce the
volatility where possible. The other option to increase the value of the company would be,
given a constant volatility, to increase net income though this is more difficult than decreasing
volatility and keeping a relatively constant income. The other argument why banks will have
a lower beta factor in the future is that regulatory requirements like capital ratios force them
to become more stable in the future. A lower debt-to-equity ratio results in a lower beta factor
consequently reflecting a lower systemic risk (Gardner, McGowan Jr., & Moeller, 2010) (see
Appendix E).
On the contrary, one could also argue against a lower future beta factor. Focusing
solely on equity side of the debt-to-equity ratio would ignore that a bank can easily meet
capital requirements by decreasing assets. It is highly probable that a bank that wants to
decrease its asset side would sell marketable assets first in order to avoid liquidation losses.
As a result, less liquid and more risky assets will be left over on the asset side, increasing the
risk of the company. Secondly, a higher debt-to-equity ratio will likely decrease the return on
equity of the bank. To counteract this development, bank managers will probably invest in
more risky assets that promise a higher return, again increasing the risk of the bank (Neus,
2010, p. 31). To overcome the latter two problems, bank regulation does not use the debt-to-

16
Valuation Methods for Banks

equity ratio but a capital adequacy ratio that measures the amount of capital in relation to a
banks risk weighted asset.
3.2.2.  Risk Free Rate
The risk-free rate is just the required rate of return for a theoretically risk-free asset, as
risk-free is in practice not possible. Triple A rated government bonds are commonly
considered to be risk-free. Government bonds however have different interest rates,
depending on the time horizon. A ten-year zero-coupon bond has typically a higher interest
rate than a three-month zero-coupon bond of the same country and the choice made by the
analyst may have a high impact on the CAPM calculation. Damodaran recommends to use the
same time horizon for the zero coupon bond as for the forecasted cash flows (Damodaran,
2012). For example if five years of forecasted cash flows are used in the DCF one should also
use a government bond with five years maturity. As the name risk-free implies the risk-free
rate of return should have a default risk that is negligible, which is not the case for Greek or
Portuguese government bonds at this time. Therefore in this study, with the scope of banks
headquartered in EU member countries, the interest rate of a German government bond is
used for the calculation of the intrinsic value of a bank that is headquartered in the Euro zone.
This is because German government bonds had the lowest interest rates in the past and can be
seen as close to risk-free. For banks headquartered outside the Euro zone, the ten-year
government bond interest rate of the respective country is used.
3.2.3.  Risk Premiums
The Equity Risk Premium (ERP) is the required return necessary to cover the
additional risk for an asset that is not risk free. The calculation of the ERP can be done by
either looking in the past or trying to estimate the future ERP, both approaches have their
downsides and are just best estimates. The decision about which ERP to take for an asset is
very subjective and differs from one investor to another. One approach to estimate what the
market demands for the risk of holding equity is to consider surveys as an estimate. There are
many surveys that ask investors for their personal equity premium and some surveys are
repeatedly undertaken over several years. One survey conducted by Fernandez showing
different equity risk premiums for 51 countries (Fernandez & Carabias, 2006), or the survey
of Bancel and Mittoo just asking for a general market risk premium, show that for well
developed countries like European countries, the range is between 5.5% for Germany and
7.3% for Greece on average in 2013(Fernandez & Carabias, 2006). Furthermore, both surveys
show that these risk premiums change over time and that they on average increased in the last
years (Bancel & Mittoo, 2014). Additionally, Bancel and Mittoo showed that “valuation

17
Valuation Methods for Banks

experts use both historical and expected market risk premiums (58% versus 42%)” for a
discounted cash flow analysis (2014). The second possible approach, next to the survey
approach, is to look at what the market earned historically in contrast to the risk free rate. The
third approach is “to back out an equity risk premium from market prices today”(Damodaran,
2014a). While there is a lot of discussion beyond academics which approach to use and given
the fact that each approach can result in an unlimited number of more or less reasonable
estimates for the equity risk premium, this study will take the survey results of Bancel and
Mittoo as market risk premiums. The reason for this is, that in this survey the respondents are
primarily located in Europe and that they, concerning the business segments they are working
in, are well diversified. The market risk premiums for any given year can be seen in Table 1
on page 24.
Notwithstanding, that Aswath Damodaran adds a country risk premium to the equity
risk premium to end up with a total risk premium, this study will not add a country risk
premium as the scope of the study is just about European Union countries that makes the
additional country risk premium negligible. Another reason for this decision is, that market
participants on average seem to see European Union member countries as actually one big
country, looking at Figure 1, supports this idea. The figure shows the development of the risk
free rates of several European Union member countries over time. The interesting point in this
graph is that it shows the development of the Greek government bond before the European
Union decided for one central monetary policy and the introduction of the Euro as currency.
One can clearly see that the Greece government bond interest rates declined before the Euro
replaced the Greek currency Drachma in 1998 and finally reached the plateau of the other
government bonds. Greece kept this level until Greece was on the verge of bankruptcy in
2012. But, after the European Union member countries helped Greece with various means, the
confidence of the market participants recovered and the interest rates decreased again. These
developments can be a sign that the market participants believe in the stability of the Euro-
zone in the aggregate rather than looking on the country specific economic stability. Because,
the market participants believe that the Euro member countries will bail out other Euro
member countries when a member runs into trouble. Otherwise, the development of the
government bond interest rates is difficult to explain.

18
Valuation Methods for Banks

Long-­‐term  Government  Bond  Interest  rates


30,00

25,00
Germany
20,00 Greece

in  % 15,00 Spain
France
10,00
Italy
5,00
United  Kingdom
0,00
2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992

Figure 1. Line chart. Government bond interest rates with ten years maturity. Source:
Eurostat
Under these special circumstances the addition of a country risk premium is not
necessary, a regional risk premium for the Euro zone as a whole on the other hand may be
appropriate but the additional risk would be that small that it is negligible. Nonetheless, for
any other valuation Damodaran offers a regularly updated table of country risk premiums on
his website that one can use.
In addition to a country risk premium that includes the political risk in a country, one
could add as many risk premiums as one could think of. This could for example be a risk
premium for firm size or maturity of a company (Damodaran, 2013), a risk premium for
probably inaccurate information or honesty of the company’s management or a risk premium
that covers the default risk of a company. All in all, it can be said that there is no clear
consensus about which risk premiums to add or whether to add any risk premiums in general.
On the contrary nobody would put into question a valuation that includes an additional risk
premium for a specific country as long as it seems reasonable. In fact, a valuation of a
company, that is located in Iraq and is generating all their revenues locally, would be highly
questioned if it lacks leastwise a country risk premium. In summary, there is a consensus
about to take an equity or market risk premium to cover the risk of investing in an equity class
asset. On the other hand, the decision of whether to add any additional risk premiums is up to
the evaluators’ discretion. While the Equity risk premium covers the average risk of an equity
investment and a country risk premium covers the average political and country risk any other
additional risk premiums that are more company specific should not be added as the relative
risk of the company in relation to its peers is already covered by the volatility measure beta.

19
Valuation Methods for Banks

To attach further company specific risk premiums would therefor cover the risk twice and
would lead to an undervaluation of the company.
Unpredictable events like a separation of a region from its country can have dramatic
impacts on the value of a bank. The Lloyds Banking Group and the Royal Bank of Scotland
warned in the mid of 2014 about the impacts of Scotland independence, as it would have
unforeseeable effects. It was for example not clear which currency Scotland would have had
when it became independent. Three possibilities existed at that time, the first was that it
would keep the British Pound; the second was that it would join the Euro zone, and the last
was the introduction of a local currency. The British Pound option would have had the least
severe impacts for Scotland, however it is not very likely that Great Britain would have
accepted that. Joining the Euro zone would have taken some time but the likeliness was high
that the Euro zone would have accepted its new member, which would keep the government
bond interest rate on a low level. However, would Scotland have introduced a new local
currency like a Scottish Pound or the like, it would have resulted in a higher government bond
interest rate for Scotland than before. This in turn would likely reduce the economic power of
Scotland, which has immediate impact on banks that are active in this market. The Royal
Bank of Scotland and Lloyds Banking Group already announced that they would relocate
their legal headquarters to London in case of a Scottish independence (Colchester, 2014). If
Scotland would have become independent, then this could have served as a test case for many
other independency movements and the effects would be more predictable than now. This
additional uncertainty is additional risk that is not reflected by the risk premiums in the
intrinsic valuation models as of now and it is not helpful to add a risk premium for a special
event when the effect cannot be assessed.
3.2.4.  Estimating Growth
Estimating growth is one of the most important input factors and one of the most
difficult to estimate. Looking into the future sounds fantastic and that is what it is. Nobody in
the world is able to know what will happen tomorrow, let alone what will happen over the
next few years. In finance however many academics developed tools to come up at least with
an approach. Statisticians developed regression models, which are quite accurate and
therefore helpful to forecast the development of an epidemic or the half-life of radioactive
fallout, but on the other hand are inaccurate when it comes to forecasting the development of
a company or economy. Another method to derive a reasonable growth rate would be to rely
on the meaning of experts like Nouriel Roubini who has an impressive track record when it
comes to forecast black swan events, which have earned him the nickname “Dr.

20
Valuation Methods for Banks

Doom”(Mihm, 2008). The most prevalent way is though to rely on the estimate of many
experts by trusting the forecasts of consultancies, banks, and other organizations, which
regularly publish their findings. The problem with the latter method is that over the past, they
were not able to forecast the future growth in gross domestic product accurately and even
worse, seemed to be, on average, too overoptimistic (Kelm, 2014). Even though optimism is
generally a good thing, otherwise nobody would invest, being too optimistic results in an
overvaluation of a company. In the last two decades, the intervals between crises with an
impact on financial markets shortened. Beginning with the burst of the dotcom bubble in the
year 2000,followed by the terrorist attacks of 11th September 2001, several wars and terror
attacks, the burst of the American housing market resulting in the 2007-2008 financial crisis
and the crisis in Ukraine in 2014. No valuation method is designed to include these major
events.
For banks forecasting the future is even more critical. In 2008 the French bank Societé
General announced that the junior trader Jérôme Kerviel, made a loss of 4.9 billion euros
within one year (“French Bank Says Rogue Trader Lost $7 Billion - NYTimes.com, 2008).
Although this could be a one-time event that will not happen in the future again, it is not.
Before and after this events similar ones had happened before and afterwards, all over the
world. Additionally, in the last decade banks had to set aside huge amounts of provisions for
legal disputes and fines. All these said, it is still necessary to forecast future cash flows and
for that it is necessary to estimate future growth.
According to Aswath Damodaran the expected growth rate is calculated as the return
on equity multiplied with the retention ratio estimating growth, using EPS (2012). For that,
one needs to calculate the return on equity (ROE) as well as the retention ratio.
𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒W{HaW|  }ZWX
𝑅𝑒𝑡𝑢𝑟𝑛  𝑜𝑛  𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐵𝑜𝑜𝑘  𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦_XZ~•`a€  }ZWX
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛  𝑅𝑎𝑡𝑖𝑜 = 1 −
𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒
The expected growth rate is then calculated, based on the existing fundamentals by
multiplying the return on equity with the retention ratio.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑  𝐺𝑟𝑜𝑤𝑡ℎ  𝑅𝑎𝑡𝑒„…•€H•\Y  †a\‡WˆZ\HW|€ = 𝑅𝑂𝐸 ∗ 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛  𝑅𝑎𝑡𝑖𝑜
These formulas are easy to apply but have the disadvantage that they just take into
account the performance of the previous year, which will result into a too optimistic valuation
if the last year was extraordinary good or into a too pessimistic valuation if the last year was
especially bad. For banks, the net income and the dividends necessary for the calculation of

21
Valuation Methods for Banks

the expected growth rate varies strongly from year to year. Depending on the business area
the bank is in these variances in net income are larger or smaller. The Deutsche Bank for
example generates a higher proportion of their revenues in the investment-banking sector than
the Svenska Handelsbanken. Generally speaking, fee and commission income tend to be less
volatile than interest income and interest income is less volatile than income generated from
proprietary trading. “Trading profits tend to be highly volatile: gains made over several years
may be wiped out by larger losses in a single year, as the credit crisis painfully
illustrated”(Koller et al., 2010). The relative standard deviation for Deutsche Bank income
was 11% for fee and commission income, 39% for net interest income and 105% for other
income (including trading income), between the years 2003 and 2012. Therefore, forecasting
growth with these variables is less accurate for companies that generate a higher proportion of
income with trading like Deutsche Bank than banks that generate income primarily with less
volatile forms of income. In comparison with Svenska Handelsbanken this results in a relative
standard deviation of 22% for total net revenues for Deutsche Bank and 8% for Svenska
Handelsbanken, which generates income primarily with interest income (76% in 2013) and
commission fees (22% in 2013). To ease out this inaccuracy at least a little bit, the underlying
fundamentals have to be normalized.
3.3.  Normalizing Fundamentals
Normalizing is an essential part in valuing a company, which eases out extraordinary
successful years as well as special events that led to low or negative income. Instead of the net
income of the actual year Damodaran uses the four-year average of net income.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒  𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒‹DDŒ•‹DDŽ
𝑁𝑜𝑟𝑚𝑎𝑙𝑖𝑧𝑒𝑑  𝑅𝑒𝑡𝑢𝑟𝑛  𝑜𝑛  𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐵𝑜𝑜𝑘  𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦‹DD•
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠‹DDŽ
𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛  𝑅𝑎𝑡𝑖𝑜 = 1 −
𝐴𝑣𝑒𝑟𝑎𝑔𝑒  𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒‹DDŒ•‹DDŽ
The idea behind is to take care of extraordinary events, which will most likely not
happen again in the near future. A deep understanding of the industry is therefore required as
the evaluator has to estimate how long a special event will last and what impact it will have.
Terrorist attacks have the highest negative impact on airline and insurance companies while
banks are affected least (Chesney, Karaman, & Reshetar, 2010). The burst of the US housing
market in 2007 however had long lasting and severe negative effects on banks all over the
world. As a result the evaluator needs to estimate the severity of economic effects, the length
of the effect and whether these effects are globally or regionally limited. In the case that the
event is regionally, one would need to assess the severity according to whether the bank

22
Valuation Methods for Banks

generates revenues in that specific region and if so, what portion of revenues in relation to
total revenues is generated in that region. Svenska Handelsbanken generates, as denoted
earlier, most of their income by interest and commission fees, which can be seen as a more
regional income source than trading income. Furthermore, Svenska Handelsbanken generates
most of their income in Sweden (56% in 2013) and other Scandinavian countries 21% (in
2013) (see Appendix L). Therefore, one can say that the Svenska Handelsbanken are more
exposed to regional risk while more globally active banks like the Deutsche Bank are rather
exposed to global risk as the regional risk is diversified within the company. The
consequences for normalizing fundamentals is now to assess, based on this knowledge, a
proper timeframe over that the fundamentals will be normalized. For Svenska Handelsbanken
with less volatile income sources and not that heavily affected by the global financial crisis of
2007/2008, a three-year timeframe should deliver a more accurate estimate than a three-year
timeframe for Deutsche Bank when the valuation takes place in 2011. As these assessments
are quite subjective, this study will use a four-year period throughout to normalize
fundamentals, following Damodarans approach (2013).
4.  EXAMINATION OF DIFFERENT VALUATION METHODS
4.1.  Methodology
This study will apply several discounted cash flow analyses for European banks, and
compare the stock prices of the following years with the intrinsic values calculated. The
assumption is that the intrinsic values of companies will be reflected by the market value of
the companies over time. This empirical comparison will then assess the explanatory power
of the discounted cash flow analysis. For this study, 44 publicly traded banks, which are
headquartered in a European Union member country since at least 2007 and thereby regulated
under EU law, have been selected. This excludes Swiss banks as well as Romanian or
Bulgarian banks, as these do not fulfill these requirements. Only publicly available, historical
information are used because this information is used by the average market participants,
which excludes insider information. To ensure that information from the financial statements
of a company are as accurate as possible and do not include any wrong data, restated financial
statements, when available, rather than the originally reported statements are used. All 44
banks in this study are part of the Stoxx Europe 600 index, which includes 600 large, mid and
small capitalization companies across 18 European countries (STOXX.com | STOXX®
Europe 600, 2014). Although the composition changes over time, all banks in this study have
been a component part as of 1st of August 2014. The Stoxx Europe 600 index is then taken to
calculate the beta factor for each company considering that no single company dominates the

23
Valuation Methods for Banks

index, which would end in a wrong beta calculation for that company as discussed before.
The market risk premiums of the respective years are taken from the survey of Bancel and
Mittoo (2012) see Table 1.
Table 1
Yearly Equity risk premium

Note. Source: Survey of Bancel and Mittoo (2012)


4.2.  Database Validity and Reliability
The data used for the calculations come from various sources and have been collected
and crosschecked with utmost care. All data are publicly available and the financial
statements have been audited which cannot be said for all other data, like stock prices. The
stock prices however have been taken from Yahoo.finance.com, which gathered the data from
the service provider SIX Financial Information AG, which in turn derived the data from
respective local stock markets directly, an overview of the banks and their local stock market
can be found in Appendix S. An exception for this are the Czech Komercni Banka and the
Austrian Raiffeisen Bank International where Yahoo.finance.com could not deliver accurate
data, hence the data have been taken from the websites of the respective local stock market.
The daily returns of the indices have been taken from the respective official websites of the
index provider. The restated financial statements for the last ten years were downloaded from
Morningstar.com and crosschecked with the officially audited financial statements. The risk
free rates for government bonds come from the European Central Bank and Eurostat, which is
a Directorate-General of the European Commission. For the risk free rates of Norway the data
comes from the Federal Reserve Bank of St. Louis. Because, companies that do not belong to
the Euro zone report their financial statements in their local currency, these statements have
been recalculated with the exchange rates of the respective month. The historical foreign
exchange rates were taken from Oanda.com.
4.2.1.  Assumptions
For this study we need to assume that the stock price will reflect all publicly available
information now or in the near future. This assumption is an inevitable part of any valuation,
to see why, one has to consider other market efficiency forms, which are strong efficient or
weak efficient. “A market is strong form efficient if prices reflect all information, public or
private” (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2010) which in contrast to semi-strong
efficient includes private information as well. Strong form efficient markets would therefore

24
Valuation Methods for Banks

imply that all information at any given time would be correctly priced into the share price of a
company. That would mean that, if the market is strong efficient, a valuation that does not
reflect the actual share price would be wrong. In other words, that the valuation is wrong and
that the share price at any time is correct. Notwithstanding, that many academics see the
market as strong form efficient, that does not mean that a valuation is a waste of time as we
assume the market to be semi strong form efficient to strong form efficient on average, but at
the same time we assume that the market makes pricing mistakes for an individual company.
In fact there are two basic views about the efficiency of markets. Eugene Fama the developer
of the efficient market hypothesis, and together with Lars Peter Hansen and Robert Shiller,
winner of the Nobel Memorial Prize in Economic Sciences (“The Prize in Economic Sciences
2013,” 2013), states that “(…) in an efficient market at any point in time the actual price of a
security will be a good estimate of its intrinsic value” (Fama, 1965). However, this statement
of Fama assumes that all market participants would always act rational, and that they first
estimate the intrinsic value before assessing a price for the share. But given the fact that
nowadays every private investor can sell and buy shares, as he or she likes, it is questionable
if not unrealistic to assume that every market participant has the same information and ability
to assess this information correctly. When the former state owned corporation Deutsche
Telekom AG issued shares in 1996, after their privatization one year before, they attracted
many private investors as they promoted the shares as the new “Volksaktie” (people´s share)
via commercials and other mass advertising, clearly targeting the small and private investor.
The marketing was very successful and the stock sky rocket since the IPO until the burst of
the dotcom bubble (see Figure 2).

25
Valuation Methods for Banks

Share  Price  of  Deutsche  Telekom  AG  -­‐‑ "T-­‐‑Aktie"


120,00

100,00

80,00

60,00
Price
40,00 in  Euro

20,00

0,00
18.11.96
18.11.97
18.11.98
18.11.99
18.11.00
18.11.01
18.11.02
18.11.03
18.11.04
18.11.05
18.11.06
18.11.07
18.11.08
18.11.09
18.11.10
18.11.11
18.11.12
18.11.13
Figure 2. Share Price of Deutsche Telekom AG. Source: Deutsche Telekom AG retrieved 7th
October 2014
If we assume that many small investors never had shares before and just bought the
“T-Aktie” because of the advertisements rather than intrinsic valuation, Fama´s statement of
1965 would be wrong, at least for the time around the dotcom bubble. As long as human
beings invest in shares and hence influence the share price of companies, it cannot be said that
markets are strong efficient, as human beings tend to behave irrational. Another evidence that
markets are not strong efficient is that, if markets would be strong form efficient, bubbles and
their bursts would not be possible. As the dotcom bubble and others have inevitably shown,
bubbles are possible. However, in the last decades many actively managed investment funds
have performed worse than for example the S&P 500 index. This could mean that excess
returns are not possible over the long run. This point of view seems to be supported from one
of the most successful investors in the world, known for being able to beat the index over the
long run, Warren Buffet. In the annual report 2013 of his company Berkshire Hathaway, he
wrote as an advice to the trustee of his cash reserves (in favor of his wife) in case of his death:
My advice to the trustee could not be more simple: Put 10% of the cash in
short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I
suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be
superior to those attained by most investors – whether pension funds, institutions or
individuals – who employ high-fee managers. (Warren Buffet, 2014, p.20)
This is a very surprising statement when keeping in mind that the person who
recommends to buy an exchange traded fund (ETF) is the same person known for being able

26
Valuation Methods for Banks

to beat the index for 39 out of 49 years (Warren Buffet, 2014). However, gaining excess
returns is not necessarily a core objective of intrinsic valuation, it is rather a different way of
investing. Another important statement is that: “All the efficient market hypothesis really says
is that, “on average, the manager will not be able to achieve an abnormal or excess return”
(Hillier et al., 2010). The important word here is, on average, which in turn gives importance
to intrinsic valuation as it protects an individual investor for making bad decision, when the
markets are not perfectly efficient. Not to forget, that intrinsic valuation is necessary for assets
that do not have an active market and therefor no price tag on it, as it is the case with initial
public offerings (IPO) or privately held firms.
4.3.  Application and Comparison
Several valuation methods are used to calculate the intrinsic values for banks. The
values calculated are then compared to the stock prices by dividing the stock price by the
intrinsic value. For example a stock price of € 19.17 and an intrinsic value of € 18.92 will
result in 1.3%. A positive deviation means according to the applied valuation method an
overpricing of the stock and a negative value means an underpricing of the company. The
deviation of the stock price and the intrinsic value will be shown in a line chart for companies
that deviate not more than 50% in at least two periods, to show a movement over time
towards the intrinsic value or away of it. A boxplot shows the distribution of the values for
the valuation method as a whole. Positive and negative outliers are calculated by multiplying
the interquartile range by 1.5 following general standards, however as they are for some
valuation methods very high, they will not be shown in the graphs but presented as a number
of outliers. Because, some valuation methods deliver no results for some companies,
primarily because they do not pay dividends or because they do not show necessary
information in their financial statement, these companies are subtracted from the calculation
of the boxplot and line chart. The Italian Bank Mediobanca (ME9) has been excluded from
the diagrams because their fiscal year ends in June, which makes a comparison with all other
companies whose fiscal year ends in December not feasible. However, the bank is taken into
account for any other calculation where timing is not important. The nomenclature used in
this study for the banks is derived from commonly used ticker symbols like the ones used by
Morningstar.com. An example for this is The Bank of Ireland with the ticker symbol
XETR:BIR, which is then denoted as BIR in this study. The complete list can be seen in the
section Abbreviations and in Appendix S.

27
Valuation Methods for Banks

4.3.1.  Constant Dividend Payments with Expected Growth Rate Normalized


This version of the Dividend Discount Model (DDM) discounts the dividends of the
present year at the present Cost of Equity (COE) minus a normalized growth rate. The
normalized growth rate is calculated as the product of average Return on Equity (ROE) of the
previous four years and the average Retention Ratio of the previous four years.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑  𝑝𝑒𝑟  𝑆ℎ𝑎𝑟𝑒‹DLŒ
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐  𝑉𝑎𝑙𝑢𝑒  𝑝𝑒𝑟  𝑆ℎ𝑎𝑟𝑒 =
𝐶𝑂𝐸‹DLŒ − 𝑔\`XˆW|••Z‡
That is for Banca Popolare Di Sondrio (593) and the year 2013:
0.04  €‹DLŒ
3.87  € =
6.2  %‹DLŒ − 5.2  %\`XˆW|••Z‡
The Share Price for 593 at the 3rd of January 2013 was € 4.60 and three moths later €
4.00. In the case of 593 the valuation was quite accurate and the stock price reflected the
intrinsic value over time. However this is an exception as the line chart (Figure 3 and Figure
4) and the boxplot show (Figure 5 and Appendix M. Constant dividend payments with
expected growth rate normalized and valuation for 2012.; just eight out of 27 companies
where in the range of 50% accuracy within the year 2013.

Constant  Dividend  Payments  with  Expected  Growth  Rate  Normalized;  


Valuation  2012
60%
50%
Deviation  from  Intrinsic  Value

40% BAKA
30%
20% 593
10% BOY
0%
-­‐10% BSD2
-­‐20%
NDB
-­‐30%
-­‐40% RAW
-­‐50%
01.01.12 01.04.12 01.07.12 01.10.12 01.01.13 SVHA
Date  of  Share  Price

Figure 3. Line chart Constant dividend payments with expected growth rate normalized,
valuation applied for 2012

28
Valuation Methods for Banks

Constant  Dividend  Payments  with  Expected  Growth  Rate  Normalized;  


Valuation  2013
40%
30%
Deviation  from  Intrinsic  Value

20% 593
10% NBA
0%
HBC1
-­‐10%
KONN
-­‐20%
NDB
-­‐30%
RAW
-­‐40%
-­‐50% STD

-­‐60% SVHA
01.01.13 01.04.13 01.07.13 01.10.13 01.01.14
Date  of  Shareprice

Figure 4. Line chart, constant dividend payments with expected growth rate normalized,
valuation applied for 2013
Nevertheless, in comparison to the year 2012 except for BAKA, BOY, and BSD2, all
companies within the 50% range are the same, meaning that this valuation method is quite
stable for some companies. On the other hand, a blind application of this method is not
recommended. The boxplot for the valuations of 2013 (Figure 5) shows an extreme picture of
the explanatory power.

29
Valuation Methods for Banks

Constant  Dividend  Payments  with  Expected  Growth  Rate  Normalized  


2500%
and  Valuation  for  2013

2000%
Deviation  of  Intrinsic  Valuation

1500%

1000%

500%

0%

-­‐500%
03.01.2014 03.10.2013 03.07.2013 03.04.2013 03.01.2013
Date  of  Shareprice

Figure 5. Boxplot, constant dividend payments with expected growth rate normalized and
valuation for 2013
Note. Number of outliers from left to right (upper/lower);(4/0);(4/0);(5/0);(6/0);(6/0). Sample
of 27 out of 43.
However, this is true for a blind application of the method and for the method on
average. After all, this method allows for a relatively stable and accurate valuation of some
companies that fulfill several requirements, i.e. they should payout dividends, stable
dividends are better than varying dividends, and the COE should be higher than the
normalized growth rate which is normally but not always the case. Then, according to the line
charts, the stock prices approach the intrinsic value roughly between the first and third quarter
of the year. Additionally, to simple average out the DPS is not always reasonable and lead in
this study to heavy outliers, because some banks paid out dividends just once in the previous
four years. Furthermore, the assessment of what time period to consider for the average DPS
is purely subjective and the reasons for this assessment should be explicitly spelled out.
4.3.2.  Constant Dividend Payments Stable Growth Period 4%
This variation of the DDM anticipates that the company will grow with a predefined
growth rate, which is in this case 4% for every bank. By replacing the normalized historical
growth rate, one needs to assume that the last years have been particularly bad or good and
that the historical growth rate is not a reasonable growth rate in the future because some
things have changed like the macro economic situation. The line chart (Figure 6) shows, that

30
Valuation Methods for Banks

this oversimplification is not reasonable in practice and the boxplot (Appendix N) supports
this assumption.

Constant  Dividend  Payments  Stable  Growth  Period  4%;  2013


100%
80%
Deviation  from  Intrinsic  Value

60%
HBC1
40%
KONN
20%
RAW
0%
STD
-­‐20%
SVHA
-­‐40%
FRYA
-­‐60%
01.01.13 01.04.13 01.07.13 01.10.13 01.01.14
Date  of  Share  Price

Figure 6. Line chart, constant dividend payments stable growth period 4% valuation applied
for 2013
4.3.3.  DDM, Average Dividends of Previous 4y Grow with Normalized Growth Rate
In this variation of the DDM we anticipate that the Dividends will grow with an
expected growth rate in the future, therefor the dividends are not constant anymore. We start
discounting the normalized expected dividends of next year, i.e. DPS of this year multiplied
with the growth factor.
𝐷𝑃𝑆‹DLž
𝐷𝑃𝑆‹DL‹ ×(1 + 𝑔) 𝐷𝑃𝑆‹DL› 𝐷𝑃𝑆‹DL• 𝐶𝑂𝐸‹DL‹ Ž
𝑃𝑉  𝑝𝑒𝑟  𝑆ℎ𝑎𝑟𝑒 = + + ⋯ + +
1 + 𝐶𝑂𝐸‹DL‹L 1 + 𝐶𝑂𝐸‹DL‹ ‹ 1 + 𝐶𝑂𝐸‹DL‹ • 𝐶𝑂𝐸‹DL‹ − 𝑔
For Raiffeisen Bank International (RAW) in 2012 and 6-year period towards a steady
state, this is:
2.32  €
1.94  €×(1 + 3.7%) 2.05  € 2.27  € (1 + 11.9%)Ž
21.73  € = + + ⋯+ +
(1 + 11.9%)L (1 + 11.9%)‹ (1 + 11.9%)• 11.9% − 3.7%
Although it looks like a two-stage DDM, it assumes that the current expected growth
rate is equal to the stable growth rate. The line chart for the 2013 valuations (Figure 7) shows
6 out of 35 banks that are in the 50% accuracy range. Here the stock price seems to move
toward the intrinsic value throughout the year, but the boxplot for 2014 (Figure 8) shows a
tendency toward the intrinsic value between the second and third quarter on average.
However, in comparison with the valuations for 2014 just three out of these six are within the

31
Valuation Methods for Banks

50% accuracy range, meaning that this valuation version is not very stable over time and just
accurate for a few banks.

Dividend  Discount  Model  Average  Dividends  of  Previous  4y  Grow  with  
Expected  Growth  Rate  Normalized;  Valuation  2013
60%
Deviation  from  Intrinsic  Value

40%
BAKA
20%
BOY
0%
BAT
-­‐20% B8ZB
-­‐40% NDB

-­‐60% RAW
01.01.13 01.04.13 01.07.13 01.10.13 01.01.14
Date  of  Share  Price

Figure 7. Line chart, dividend discount model average dividends of previous 4 years grow
with expected growth rate normalized, valuation applied for 2013
Although, the boxplot may indicate a better explanatory power of this model in
comparison with the constant dividend model, it is still weak on average.

Dividend  Discount  Model  Average  Dividends  of  Previous  4y  Grow  


2000%
With  Expected  Growth  Rate  Normalized;  Valuation  for  2014
1500%
Deviation  of  Intrinsic  Valuation

1000%

500%

0%

-­‐‑500%

-­‐‑1000%

-­‐‑1500%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Figure 8. Boxplot DDM with average dividends of previous 4 years and Valuation for 2014.
Note. Number of outliers from left to right (upper/lower);(4/1);(4/1);(4/1). Sample of 34 out
of 43.

32
Valuation Methods for Banks

4.3.4.  Two-stage DDM; Dividends Grow with Expected Growth Rate and 4% in
Perpetuity
The formula for the two-stage DDM is the same like in the previous method with the
difference that one assumes two different stages of growth. The second growth rate can either
be lower or higher than the first growth rate depending on the historical growth rate. For this
study I anticipate a growth rate of four percent in perpetuity and a “high growth” period of
four years. For Alpha Bank (ACB), the intrinsic value for 2013 is:
0.03  €
0.049  €×(1 + (−12.4%)) 0.042  € 0.029  € (1 + 7.8%)
0.50  € = L
+ ‹
+ ⋯+ ›
+
(1 + 9.2%) (1 + 9.2%) (1 + 9.2%) 9.2% − 4%
The share price for ACB as of 3rd January 2013 was € 1.53 and six month later € 0.43.
Out of 35 banks, ten are within the 50% accuracy range for 2013 (Figure 9), but one year later
just four were in the same accuracy range (Appendix P).

Two  stage  Dividend  Discount  Model,  Dividends  Grow  With  Expected  


Growth  Rate  and  4%  in  Perpetuity;  Valuation  2013
250%
ACB
200%
Deviation  from  Intrinsic  Value

BAKA
150%
593
100% BAT
B8ZB
50%
BDSB
0%
BSD2
-­‐50% HBC1

-­‐100% KONN
01.01.13 01.04.13 01.07.13 01.10.13 01.01.14
RAW
Date  of  Share  Price

Figure 9. Line chart, two-stage dividend discount model, dividends grow with expected
growth rate and 4% in perpetuity, valuation applied for 2013
According to the boxplot for 2013 and 2014 (Appendix Q and Appendix R), there is
on average a tendency towards the intrinsic value for the end of the second quarter. The blind
application of this method insinuates an equal growth rate for every bank, furthermore the
sudden jump or decline of the growth rate from one year over another is not reasonable.
Assuming a third stage in which the initial growth rate increases or decreases towards the
stable growth phase can ease the latter problem out. On the whole, DDM´s share one pitfall as

33
Valuation Methods for Banks

they all assume that the dividend payout ratio and the COE will stay the same, which is
according to the tables in Appendix J and Appendix L, not true at all.
4.3.5.  Discounted Cash Flow with Cash Flow to Equity
The principles of discounted cash flow (DCF) models apply to the cash flow to equity
model (CFE) as well. Instead of discounting dividends, this model discounts the equity cash
flow. CFE is defined as the sum of net income less change in book value of equity plus other
comprehensive income. Net income is the theoretically available dividends to shareholder,
and the change in book value of equity represents equity necessary for a sustainable growth,
as the bank has to keep or increase equity to fulfill regulatory requirements in growth phases.
Other comprehensive income (OCI) are yet unrealized net gains or losses that in this formula
eases out noncash adjustments to equity (Koller et al., 2010, p. 745 ff). These adjustments
give a more comprehensive view on the cash flows to equity holders than dividends.
𝐶𝐹𝐸‹DLŒ = 𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒‹DLŒ − 𝐵𝑉  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦‹DL‹ − 𝐵𝑉  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦‹DLŒ + 𝑂𝐶𝐼‹DLŒ
The present value (PV) is of the CFE is then calculated as the sum of discounted CFE
J
𝐶𝐹𝐸H
𝑃𝑉 =
(1 + 𝐶𝑂𝐸)H
HKL

The continuing value (CV) can be calculated by using the formula:


𝑔
𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒×(1 − J )
𝐶𝑉 = 𝑅𝑂𝐸
𝐶𝑂𝐸 − 𝑔J
The sum of PV and CV is then the value of equity. For Skandinaviska Enskilda
Banken (SEB) (SEBA) we assume a stable growth rate of 4% and an average ROE based on
the last four years of 10.9%. The CFE for 2013 in million Euro is:
1,143‹DLŒ = 1,684‹DLŒ − 12,648‹DL‹ − 13,705‹DLŒ + 552‹DLŒ
Then the PV of CFE in million is:
1,143€×(1 + 1.6%) 1,180  € 1,199  € 1,218  €
3,843  € = + + +
(1 + 9.0%)L (1 + 9.0%)‹ (1 + 9.0%)Œ (1 + 9.0%)›
And the continuing value in million is:
4%
1,648€×(1 − )
22,380€ = 10.9%
9% − 4%
Which results in a value of equity in million of:
26,224€ = 3,843€ + 22,380€
Divided by the shares outstanding of 2,191 million results in an intrinsic value per
share of €11.97. The actual share price for SEBA was €9.50 at the beginning of the year 2014

34
Valuation Methods for Banks

and increased to €10.01 at the end of the first quarter 2014. Even though, this model is more
comprehensive than a DDM the explanatory power is still weak as the line chart indicates
(Figure 10). Just six out of 21 banks are within the 50% accuracy range and the boxplot
(Figure 11) shows no trend towards the intrinsic value.

Cash  Flow  to  Equity  Model  with  Net  Income  2013;


Valuation  2014
60%

40%
Deviation  from  Intrinsic  Value

20% POPD
BSD2
0%
NDB

-­‐20% RAW
SEBA
-­‐40%
FRYA

-­‐60%
01.01.14 01.04.14 01.07.14
Date  of  Share  Price

Figure 10. Line chart, cash flow to equity model with net income of 2013,valuation applied
for 2014
This might be due to low net incomes or high comprehensive income losses in the
year of valuation. When taking the four-year average of net income for the calculation, then
the comparison of the two boxplots (Figure 12) show a better explanatory power.

35
Valuation Methods for Banks

Cash  Flow  to  Equity  Model  and  Net  Income  2013;  Valuation  for  
400%
2014

300%
Deviation  of  Intrinsic  Valuation

200%

100%

0%

-­‐‑100%

-­‐‑200%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Figure 11. Boxplot, cash flow to equity model and net income of 2013, valuation applied for
2014
Note. Number of outliers from left to right (upper/lower);(3/0);(4/0);(4/0). Sample of 21 out
of 43.
Cash  Flow  to  Equity  Model  and  Average  Net  Income  Previous  4y;  
400%
Valuation  for  2014
350%
Deviation  of  Intrinsic  Valuation

300%

250%

200%

150%

100%

50%

0%

-­‐‑50%

-­‐‑100%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Figure 12. Boxplot, cash flow to equity model and average net income of previous 4 years,
valuation applied for 2014.
Note. Number of outliers from left to right (upper/lower);(1/0);(2/0);(2/0). Sample of 12 out
of 43.

36
Valuation Methods for Banks

4.3.6.  Excess Return Model


The Excess Return Model is, next to the DDM and CFE, the third DCF approach. In
this model the equity value of a bank is the sum of the PV of expected excess return and the
capital currently invested in the bank (Damodaran, 2009). Hence, the excess equity return
needs to be calculated.
𝐸𝑥𝑐𝑒𝑠𝑠  𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑂𝐸 − 𝐶𝑂𝐸 ∗ 𝐵𝑜𝑜𝑘  𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦
The beginning book value (BV) of equity for the following year is simply the BV of
equity of the following year plus the expected retained earnings of the year.
𝐵𝑉  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦‹DL› = 𝐵𝑉  𝑜𝑓  𝐸𝑞𝑢𝑖𝑡𝑦‹DLŒ + (𝑁𝑒𝑡  𝐼𝑛𝑐𝑜𝑚𝑒‹DLŒ ×𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛  𝑅𝑎𝑡𝑖𝑜)
The excess equity is then discounted by the cumulated COE. Afterwards, the terminal
value is added to result in current value of equity. The valuation of Nordea Bank (NDB) 2014
is as follows, starting with excess equity for 2013 (in million):
815  € = 11.41% − 8.62% ∗ 29,209  €
Then calculating the BV of equity for 2014 by taking the average net income and
retention ratio for the previous four years assuming the payout ratio to be stable (in million):
31,130  € = 29,209  € + (3,332  €×57.66%)
The equity value for NDB is then calculated as the BV of equity in 2013 plus PV of
excess returns and the terminal value. The table below shows the calculation assuming a four-
year “high growth” period and a stable growth rate of four percent.
Table 2
Excess  return  model,  valuation  applied  for  2014  

37
Valuation Methods for Banks

The price per share for NDB was €9.75 at the beginning of 2014 and increased to
€10.37 three months later. However, this model requires some strong assumptions regarding
the future dividend payout policy of the bank and the future ROE and, as for all models so far,
about the COE and growth rate. While some experts argue that the ROE should decrease in
the long run due to limited investment opportunities and that the beta factor should decrease
due to lower risk for mature companies. The tables Appendix I and Appendix K show no
evidence for this assumption. An especially weak point of this model is the assumption about
the future payout policy of a bank, as the table in Appendix K shows; this ratio is very
volatile over time. The boxplot for the year 2014 (Figure 13) shows that this model when
blindly applied tends to overvalue stocks and the line chart (Figure 14) shows no tendency
towards the intrinsic value.

Excess  Return  Model;  Valuation  for  2014


450%
400%
350%
Deviation  of  Intrinsic  Valuation

300%
250%
200%
150%
100%
50%
0%
-­‐‑50%
-­‐‑100%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Figure 13. Boxplot, excess return model, valuation applied for 2014.
Note. Number of outliers from left to right (upper/lower);(1/0);(2/0);(2/0). Sample of 13 out
of 43.

38
Valuation Methods for Banks

Excess  Return  Model;  Valuation  2014


20%
10%
Deviation  from  Intrinsic  Value

0%
-­‐10% NBA

-­‐20% NDB

-­‐30% RAW

-­‐40% SEBA
-­‐50% SVHA
-­‐60%
01.01.14 01.04.14 01.07.14
Date  of  Share  Price

Figure 14. Line chart, excess return model, valuation applied for 2014

4.3.7.  DCF Considering Reinvestment in Regulatory Capital


To overcome the problem with volatile payout ratios, one needs to consider what
influences the dividend payout policy. The most important driver for this is the regulatory
requirement that a bank has to fulfill in terms of capital ratios. So far all models ignored the
reinvestment needs. For a more realistic valuation one needs to know RWA of a bank as well
as the required CET 1 ratio. Because RWA are not shown in the financial statements of a
bank one needs to wade through the whole annual report to find the necessary information
which can be quite time consuming, considering an annual report length of more than 500
pages for some banks. While some banks like the Deutsche Bank (DBK) show a pro forma
statement with all necessary information other do not show them at all like the Commerzbank
(CBK). When valuing a bank considering the reinvestment needs one should focus on future
requirements, that are decided and not on requirements that are active right now. This means
for a valuation for the year 2014 one should use the CET 1 ratios governed under the Capital
Requirements Directive 4 (CRD 4) and not Basle 2.5. Although, this directive will determine
a phase-in period, which increases leverage ratios stepwise (Accenture, 2012), one should
already focus on ratios fully-loaded. The reason for this is that banks are eager to fulfill these
requirements as soon as possible, because it adds confidence to customers, equity and debt-
holders, keeping the cost of equity stable. Additionally, local legislation can require a shorter
implementation period of the capital requirements but not a longer one. However, as denoted
earlier, EU directives have to be implemented by local laws and the ratios can differ from

39
Valuation Methods for Banks

country to country. For DBK we anticipate therefore a CET 1 short-term target ratio of 10%
and a total regulatory capital ratio of 14%. The expected growth rate is 4%. The reinvestment
needs for a bank to meet the capital adequacy ratio (CAR) is therefor:
𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦  𝐶𝑎𝑝𝑖𝑡𝑎𝑙‹DL› = (𝑅𝑊𝐴‹DLŒ ×𝐶𝐴𝑅) − (𝑅𝑊𝐴‹DL› ×𝐶𝐴𝑅)
The net income for the following years grows with the expected growth rate and is
partially paid out to equity holders. The PV of FCFE for the year 2014 is calculated:
𝑁𝑒𝑡  𝑖𝑛𝑐𝑜𝑚𝑒‹DL› − 𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦  𝐶𝑎𝑝𝑖𝑡𝑎𝑙‹DL›
𝑃𝑉‹DL› =
(1 + 𝐶𝑂𝐸)L
The sum of all discounted FCFE is then the PV of equity. The terminal value of equity
is calculated in the same way like in other models before and added to the PV of equity.
Table 3
DCF model considering reinvestment in regulatory capital

Given the difficulties of collecting the necessary data, this model cannot be evaluated
on an empirical level. However, this model is so far the most comprehensive one and the only
model that takes into account the regulatory framework a bank has to deal with. Therefor, the
exemplary valuation for DBK is presented in this thesis. This model was adopted from
Aswath Damodaran (2014) and then adjusted to Basel 3. Furthermore, we assumed that CET
1 ratio as well as the CAR will not grow in the future because there is no need for DBK in
doing so because they fulfill already the capital requirements for CRD 4 in 2013. These
adjustments and a differing database are the reasons why the valuation of €27.71 as of
January 2014 differs from Damodarans´ valuation of €62.27 as of November 2013.
Although, this model seems to be the theoretically most appropriate for bank
valuation, a practical adoption is difficult and based on a variety of assumptions that make the
model fragile.

40
Valuation Methods for Banks

4.3.8.  Other DCF Varieties


The last method presented in this thesis is the theoretically least appropriate one. The
method is a variety of a DDM, which anticipates that net income is equal to dividends,
meaning a dividend payout ratio of 100% each year and a normalized growth rate that is
constant forever. These assumptions are clearly not realistic, because a bank to maintain its
growth rate needs to increase its equity or its ROE. Furthermore it takes unrealized gains and
losses of a bank into consideration.
The valuation formula that showed on average the most accurate result is the sum of
PV, TV and accumulated other comprehensive income (AOCI), for the year 2014 with
normalized EPS and growth rate (g):
𝐸𝑃𝑆‹D‹D
𝐸𝑃𝑆‹DLŒ ×(1 + 𝑔) 𝐸𝑃𝑆‹DL 𝐸𝑃𝑆‹DLž (1 + 𝐶𝑂𝐸)Ž
𝑉𝑎𝑙𝑢𝑒 = + + ⋯+ + +   𝐴𝑂𝐶𝐼‹DLŒ
(1 + 𝐶𝑂𝐸)L (1 + 𝐶𝑂𝐸)‹ (1 + 𝐶𝑂𝐸)• 𝐶𝑂𝐸 − 𝑔
Although, this model uses unrealistic assumptions, the explanatory power in
comparison to other models of this thesis is higher as the line chart shows. 16 out of 35 banks
are within the 50% accuracy range (Figure 15) and the boxplot (Figure 16) shows a tendency
of the stock price to move towards the calculated value over the year.

Net  Income  Discount  with  AOCI;  Valuation  2014


60%
ACB
40%
BAKA
Deviation  from  Intrinsic  Value

20%
BCY
0% BPG

-­‐20% BOY
B8ZB
-­‐40%
POPD
-­‐60%
CBK
-­‐80% XCA
-­‐100% DBK
01.01.14 01.04.14 01.07.14
EBO
Date  of  Share  Price

Figure 15. Line chart, net income discount with AOCI, valuation applied for 2014

41
Valuation Methods for Banks

Net  Income  Discount  with  AOCI;  Valuation  for  2014


250%

200%
Deviation  of  Intrinsic  Valuation

150%

100%

50%

0%

-­‐‑50%

-­‐‑100%

-­‐‑150%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Figure 16. Boxplot, net income discount with AOCI, valuation applied for 2014.
Note. Number of outliers from left to right (upper/lower);(4/0);(4/0);(3/0). Sample of 35 out
of 43.
There are several explanations possible for the alleged accuracy of this model. First,
there is too much capital available on the stock markets, that drive the share prices, therefore
valuation models that show on average a high value, like this one, tend to be more accurate.
Second, although highly unlikely, market participants actually use this model to estimate the
value of a bank, which results in a self-fulfilling prophecy.
5.  LIMITATIONS
Despite that valuation models add confidence to an investment, there are certain
limitations attached to that. The more complex a valuation model becomes and the more time
one spends with carefully estimating the intrinsic value of a company, the more confident one
becomes about the intrinsic value of a company. However, the intrinsic value is not a
guarantee that the share price will reflect the intrinsic value of the company in the future:
“The market can stay irrational longer than you can stay solvent” (John Maynard Keynes,
n.d.). Furthermore, all models that are presented in this thesis require some assumptions about
the future, which makes intrinsic values very subjective and can just be best estimates.
When looking at the results of this study, one could anticipate that intrinsic valuation
with the models used in this study, does not reflect the reality and that one could skip this step
when valuing a bank. However, intrinsic valuation models are not designed to forecast the

42
Valuation Methods for Banks

stock price in the future, neither are the values correct or incorrect. The purpose of an intrinsic
valuation is to estimate whether a bank is under- or overvalued and can just serve as a
justification base. Furthermore, values obtained from these methods need to be crosschecked
with multiples to validate the valuations. A survey conducted in 2012 beyond valuation
professionals showed that discounted cash-flow and relative valuation models are most
popular and that just 21% rely on just one valuation method when valuing a company (Bancel
& Mittoo, 2014). The blind application of intrinsic valuation models can lead to unrealistic
results. Therefore, one needs to assess every bank individually with respect to
competitiveness, attractiveness towards the customer, regulatory challenges, economic
situation of the industry, and economic situation of the country the bank is operating in. In the
end, one can clearly see that depending on the input factors and model one uses, one can
come up with any value. Depending on the analyst and the one who pays for the analysis the
valuation is either upward or downward biased (Damodaran, 2013). However, the calculation
of the intrinsic value in general forces the analyst to think about the company and to
understand the value drivers as well as the risks of the industry, which is not the case with the
multiples or the option pricing approach.
6.  CONCLUSION
The comparison of the different intrinsic valuation methods has shown, that no one
model is superior over another. For some banks, some valuation methods seem to have a
higher explanatory power than for others. For example, a bank that paid out stable dividends,
generated positive net income in the past and continues to grow at a stable rate like Svenska
Handelsbanken, then the DDM with constant dividend payments is more likely to be reflected
by the stock price than a CFE method. Nevertheless, because many banks in Europe still feel
the impacts of the financial crisis 2008 and do not generate enough net income to pay out
stable dividends, other valuation methods need to be used, if one wants to show a positive
value for a bank. The net income discount approach with AOCI, seems to be the most
appropriate for these banks. But, one should bear in mind that this approach discounts all
theoretically available cash flows. However, for this method to have any value, one would
need to assume that these banks will pay out these cash flows some time in the future, which
is not very realistic. The most comprehensive method in this thesis is described in chapter
4.3.7. Although, it requires data that is not easy to find, it is very accurate and the only model
that takes the reinvestment needs in regulatory capital into account. The excess return and
CFE models showed the weakest results in this thesis, not just because they are not very
accurate but the share price seems to move away from the intrinsic values on average. All in

43
Valuation Methods for Banks

all, DDMs have a high explanatory power for firms that pay out stable dividends, and models
that discount the theoretically available cash flows have the highest explanatory power for
non-dividend paying banks. In the end the analyst decides which method he or she wants to
use. This study can be used as an overview and guideline to select the proper valuation
method.

44
Valuation Methods for Banks

DECLARATION OF AUTHENTICITY

45
Valuation Methods for Banks

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46
Valuation Methods for Banks

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47
Valuation Methods for Banks

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48
Valuation Methods for Banks

APPENDIX

Appendix A. Income Sources for European Banks, 1988-2007 (Koller et al., 2010, p. 744)

49
Valuation Methods for Banks

Appendix B. Phase-in arrangements Basel III capital requirements (Accenture, 2012).

50
Valuation Methods for Banks

Appendix C. Table, Beta factors of Deutsche Bank AG as of 1st January 2014.


Note. Minimum 1.02, maximum 2.13, mean 1.68.

51
Valuation Methods for Banks

Appendix D. Income breakdown by business segments Deutsche Bank AG (Deutsche Bank


AG, 2014)

52
Valuation Methods for Banks

Appendix E. WACC for Microsoft. (Gardner et al., 2010, p. 36)

53
Valuation Methods for Banks

Appendix F. Table, net income as of bank and year in million. Source: Morningstar.com
   

54
Valuation Methods for Banks

 
Appendix G. Table, Price/ Earnings Ratio

55
Valuation Methods for Banks

 
Appendix H. Table, Price to Book Value Ratio

56
Valuation Methods for Banks

 
Appendix I. Table, Cost of Equity

57
Valuation Methods for Banks

 
Appendix J. Table, Return on Equity

58
Valuation Methods for Banks

 
Appendix K. Table, Retention Ratios.

59
Valuation Methods for Banks

Total  Income  by  Branch  Operations,  Svenska  Handelsbanken  


2013

Handelsbanken  
International
3% Capital  
Netherland Markets  
1% &  Other
11%
Norway
11%

Finland Sweden
5% 56%

Denmark UK
5% 8%

Appendix L. Pie chart, Total income by branch operations for Svenska Handelsbanken 2013.
Source: Annual Report Svenska Handelsbank 2013.

60
Valuation Methods for Banks

Constant  Dividend  Payments  with  Expected  Growth  Rate  


1200%
Normalized  and  Valuation  for  2012

1000%
Deviation  of  Intrinsic  Valuation

800%

600%

400%

200%

0%

-­‐‑200%
03.01.2013 03.10.2012 03.07.2012 03.04.2012 03.01.2012
Date  of  Shareprice

Appendix M. Constant dividend payments with expected growth rate normalized and
valuation for 2012.
Note. Number of outliers from left to right (upper/lower);(5/0);(6/0);(6/0);(5/0);(6/0). Sample
of 30 out of 43.

61
Valuation Methods for Banks

Constant  Dividend  Payments  Stable  Growth  Period  4%  and  


1200%
Valuation  for  2013

1000%
Deviation  of  Intrinsic  Valuation

800%

600%

400%

200%

0%

-­‐‑200%
03.01.2014 03.10.2013 03.07.2013 03.04.2013 03.01.2013
Date  of  Shareprice

Appendix N. Constant dividend payments stable growth period 4% and valuation for 2013.
Note. Number of outliers from left to right (upper/lower);(5/0);(5/0);(5/0);(4/0);(4/0). Sample
of 28 out of 43.

62
Valuation Methods for Banks

Net  Income  Discount  Without  Comprehensive  Income;  Valuation  


400%
for  2014
350%

300%
Deviation  of  Intrinsic  Valuation

250%

200%

150%

100%

50%

0%

-­‐‑50%

-­‐‑100%

-­‐‑150%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice

Appendix O. Boxplot net income discount without OCI and Valuation for 2014.
Note. Number of outliers from left to right (upper/lower);(2/0);(2/0);(2/0). Sample of 22 out
of 43.

63
Valuation Methods for Banks

Two  stage  Dividend  Discount  Model,  Dividends  Grow  With  Expected  


Growth  Rate  and  4%  in  Perpetuity;  Valuation  2014
160%
140%
Deviation  from  Intrinsic  Value

120%
100%
80%
593
60%
40% BAT
20%
HBC1
0%
-­‐20% RAW
-­‐40%
-­‐60%
01.01.14 01.04.14 01.07.14
Date  of Shareprice

Appendix P. Line chart, two stage DDM, dividends grow with expected growth rate and 4%
in perpetuity, valuation applied for 2014

64
Valuation Methods for Banks

Two  stage  Dividend  Discount  Model,  Dividends  Grow  with  


1000%
Expected  Growth  Rate  and  4%  in  Perpetuity;  Valuation  for  2013

800%
Deviation  of  Intrinsic  Valuation

600%

400%

200%

0%

-­‐‑200%
03.01.2014 03.10.2013 03.07.2013 03.04.2013 03.01.2013
Date  of  Shareprice

Appendix Q. Boxplot two stage DDM, dividends grow with expected growth rate and 4% in
perpetuity, valuation applied for 2013.
Note.  Number  of  outliers  from  left  to  right  (upper/lower);(3/0);(3/0);(3/0);(3/0);(3/0).  
Sample  of  35  out  of  43  
   

65
Valuation Methods for Banks

Two  stage  Dividend  Discount  Model,  Dividends  Grow  With  


1200%
Expected  Growth  Rate  and  4%  in  Perpetuity;  Valuation  for  2014

1000%
Deviation  of  Intrinsic  Valuation

800%

600%

400%

200%

0%

-­‐‑200%
03.07.2014 03.04.2014 03.01.2014
Date  of  Shareprice
 
Appendix R. Boxplot two stage DDM, dividends grow with expected growth rate and 4% in
perpetuity, valuation applied for 2014.
Note.  Number  of  outliers  from  left  to  right  (upper/lower);(4/0);(3/0);(5/0).  Sample  of  
34  out  of  43.    

66
Valuation Methods for Banks

 
Appendix S. Table, Banks used for the study

67

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