Bank Valuation

Read more on how to value banks through different approaches and explore top ratios that make a bank’s profitability easier to understand.

Banks in America play a key role in the U.S. economy and rest of the world. America has a total of 5033 banks and the market cap of only the top 20 banks in the United States is approximately $2.04 trillion which is more than the GDP of many Asian countries. With the sheer size of the combined market cap, we know that no country can function without them.

At their core, banks profit by earning an interest spread on deposits and loans, and by charging transaction fees for their financial services. The interconnectedness of various services they offer makes it necessary for customers to use multiple banking products alongside credit or investment options.

Bank Valuation Metrics

Valuation of banks poses unique challenges due to their intertwined operating and financing activities because one of their core products is providing loans. Hence, multiples like EV/EBIT or EV/EBITDA are not applicable to banks.

Instead, equity value multiples such as P/E (Price-to-Earnings) and P/B (Price-to-Book) ratios are more suitable for evaluating banks.

P/E Ratio

The P/E ratio helps to assess if a bank’s stock is priced fairly relative to its earnings. A higher P/E ratio means investors expect strong future growth and revenue potential.

In the banking sector earnings growth is influenced by economic conditions and lending activities. A high P/E ratio compared to the market or peers with slow earnings growth shows that the stock could be overvalued.

Using the P/E ratio in the context of industry benchmarks and growth trends, investors can gauge whether a bank’s stock represents a good investment opportunity or poses a risk of being overpriced.

P/B Ratio

P/B ratio provides insight into how efficiently a bank uses its assets to generate returns. Since banks are affected by macroeconomic conditions such as inflation rates, interest rates, and liquidity, the differentiating factor becomes how well each bank manages its assets and controls NPAs.

A higher P/BV ratio shows a bank’s ability to generate higher returns on its assets. Investors also use this ratio to find whether a stock is overvalued or undervalued by doing market assessments with the company’s equity. Banks with greater growth potential should exhibit higher P/B ratios, assuming all other factors remain constant.

Bank Valuation Approaches

Let’s understand the how valuation of Banks can be done using the following methods:

Asset-Based Valuation

Asset-based valuation finds the current value of a financial service by deducting its debts and liabilities from its assets and considering the remaining balance as the value of equity.

The first step is to study the bank’s loan portfolio (bank’s primary assets) and any other tangible assets it may have. Then, subtract the outstanding debts to determine the equity value. To value a loan portfolio, estimate the price the portfolio would fetch when sold to another financial institution.

Equity Value = Loan Portfolio + Other Tangible Assets − Outstanding Debt

DescriptionValue (in million USD)
Loan Portfolio1,500
Other Tangible Assets500
Outstanding Debt-1,200
Equity Value800

The Value as per the asset-based approach is 800 million USD.

Here’s an example of how you can compute the value of a bank’s loan portfolio.

Suppose a bank has a loan portfolio of $1 billion, an average maturity of 8 years, and an annual interest earnings of $70 million. If the fair market interest rate for the loans, accounting for default risk is 6.5%, the value of the loans can be calculated as:

Value of loans = $70 million (Present Value of an 8-year annuity at 6.5%) + $1 billion (discounted at 6.5%)

= $426.21million + $ 604.2312 million
=$1.03 billion

Here, the fair market value exceeds the book value because the bank charges an interest rate higher than the market rate. If the bank charged a lower rate than the market, the fair value would fall below the book value.

To find out the equity value, liabilities such as deposits, debts, and other claims would be subtracted from this asset value.

Income Method

The Income Approach for bank valuation calculates the present value of future earnings or cash flows generated by the bank. It is commonly applied through models like Free Cash Flow to Equity (FCFE), Dividend Discount Model (DDM), and Excess Return Model.

Free Cash Flow to Equity

This model focuses on the cash flows available to equity investors after accounting for regulatory capital needs and other reinvestments. For banks, reinvestment is tied to regulatory requirements rather than physical assets.

FCFE=Net Income−Reinvestment in Regulatory Capital

  • Reinvestment in Regulatory Capital – Determined by the equity capital ratio (percentage of equity needed for loans).
  • Net Income – Assumes profitability from additional investments tied to growth in loans.

Dividend Discount Model

The DDM values a bank by discounting the expected future dividends at the cost of equity. It assumes dividends are a proxy for cash flows.

Let’s understand with an example:

  • Dividends Paid in Year 1: $200 crore
  • Expected Growth Rate in Dividends: 6% annually
  • Cost of Equity: 10%

Step 1 – Forecast Next Year’s Dividend:

Dividend for Year 2=$200×(1+0.06) = $212 crore

Step 2 – Calculate Terminal Value (Assuming Constant Growth):

Terminal Value = $212/0.10−0.06 = $5,300 crore

Step 3 – Calculate Present Value of Terminal Value:

PV of Terminal Value= $5,300/1.10 = $4,818.18 crore

Step 4 – Add Present Value of Year 1 Dividend:

Since Year 1 Dividend = $200 crore and does not require discounting, the total value of the bank’s equity is:

Bank Value=$200+$4,818.18=$5,018.18 crore

Excess Return Model

This model calculates the value of a bank as the sum of the book value of equity and the present value of expected excess returns (returns above the cost of equity).

Excess Return=(ROE−Cost of Equity)×Equity Capital
Value of Equity=Book Value of Equity+Present Value of Expected Excess Returns

Market Approach

The Market Approach assesses a bank’s value by comparing it with similar banks. Some of the common financial multiples used are the P/E and P/B ratios.

Here’s a step-by-step guide to use the market approach for Bank’s Valuation:

Step 1 – Choose banks that have similar growth rates and operate in a similar macroeconomic environment.

Step 2 – You can use the P/E and P/B ratios for the bank’s valuation by regressing the multiples with risk factors like beta or standard deviation. Once you find the regression equation, express it for the chosen banks and find the predicted P/E or P/B. Doing this analysis will help you understand if the ratios are currently overvalued or undervalued.

The P/E ratio shows how much an investor can pay for a dollar of earnings. The P/E ratio depends on factors like earnings growth, payout ratios, and the cost of equity.

The P/B ratio shows how the market values a bank’s net assets compared to its book value.

Step 3 – Adjust the differences per the bank’s size and risk levels compared to the peers to get an accurate valuation.

Understanding Profitability Ratios

Profitability ratios help to understand the performance of a bank and get an idea of the intrinsic value of banks. Let’s understand some of these top ratios in depth:

Return on Equity(ROE)

ROE shows the bank’s ability to use equity efficiently to generate profits.

ROE=Net Income/Shareholder’s Equity

Higher ROE leads to a higher valuation. Banks with consistently high ROE are efficient in using equity and also lead to higher P/B ratios.

Return on Assets (ROA)

ROA evaluates how effectively a bank uses its assets to generate income.

ROA=Net Income/Total Assets

A higher ROA means better use of assets and contributes positively to market valuation. Low ROA can signal inefficiency or issues with asset quality.

Net Interest Margin (NIM)

NIM measures the profitability of a bank’s lending activities, calculated as net interest income over interest-earning assets.

Net Interest Margin=Net Interest Income / Interest-Earning Assets

A higher NIM shows the bank’s efficiency in lending, boosting investor confidence and valuation multiples such as P/E. A declining NIM may indicate rising funding costs or competitive pressures.

Efficiency Ratio

The efficiency ratio assesses a bank’s cost efficiency by comparing non-interest expenses to revenue.

Efficiency Ratio=Non-Interest Expenses/Revenue

A lower efficiency ratio can lead to a higher valuation. Banks with lower efficiency ratios are seen as better managed and more profitable, leading to higher market valuations.
High-efficiency ratios reflect operational inefficiencies and result in reduced investor confidence and lower valuation multiples.

RatioKey InsightsValuation Impact
ROEMeasures equity usage for profitabilityDrives P/B and P/E ratios higher when above cost of equity.
ROAChecks asset usage and qualityImproves P/E valuation when ROA is high.
NIMHighlights profitability from core lending activities.Improves future earnings and valuation when strong.
Efficiency RatioReflects cost management and operational effectiveness.Lower ratios lead to higher market confidence and value.

Get Your Valuation Done by Eqvista Today

Valuing a Bank is a complex process that demands a thorough understanding of financial statements, market dynamics and business structures.

It is important to find out the fair market value of any business whether it’s a bank or a financial institution. Without valuation, it’s pointless to invest money or raise a round of funding.

At Eqvista, our valuation specialists are equipped to handle all levels of complexity. Our valuation services cater to diverse clients, including family offices, venture capital firms, private equity firms, and micro-capital organizations.

Contact us to know more.

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