Dividend Discount Model - Commercial Bank Valuation (FIG)

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Mergers & Inquisitions / Breaking Into Wall Street

Күн бұрын

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Why the Dividend Discount Model (DDM) is used to value commercial banks instead of the traditional Discounted Cash Flow (DCF) analysis.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
There are 3 main reasons why the DCF and the concept of Free Cash Flow (FCF) do not apply to commercial banks:
1. You can't separate operating vs. investing vs. financing activities - the lines are very blurry for a bank, since items like debt are more operationally-related and fund the bank's lending activities.
2. CapEx doesn't represent re-investment in the business, as it does for a normal company - for a bank,"re-investment" means hiring people, doing more lending, etc.
3. Working Capital represents something much different for a bank - the standard definition of Current Assets Excl. Cash Minus Current Liabilities Excl. Debt makes no sense, because for banks that includes tons of investments, securities, other borrowings, etc. so you could see massive swings...
What You Do Instead - Use Dividends as a Proxy for Free Cash Flow
Why? Because banks are CONSTRAINED by capital requirements - according to the Basel accords (I, II, III), they must maintain a certain "buffer" at all times to cover unexpected losses on their loans...
So just like CapEx requirements, Net Income growth, and Working Capital constrain FCF for normal companies, the Tier 1 Capital / Tangible Common Equity / Total Capital requirements constrain dividends for banks.
So we'll project a bank's regulatory capital, its asset growth, and its net income, and use those to project its dividends - then, discount, and sum up the dividends and discount and add the NPV of its terminal value.
How to Set Up a Dividend Discount Model (DDM)
1. Make assumptions for Total Assets, Asset Growth, targeted Tier 1 (or other) Ratios, Risk-Weighted Assets, Return on Assets (ROA) or Return on Equity (ROE), and Cost of Equity.
2. Next, project Assets and Risk-Weighted Assets.
3. Then, project Net Income based on ROA or ROE.
4. Then, project Shareholders' Equity (AKA Tier 1 Capital) based on targeted capital ratio...
5. And BACK INTO dividends! Different from a normal company's DDM!
Set dividends such that the minimum capital ratio is maintained, based on starting Shareholders' Equity and Net Income that year.
6. Flesh out the rest of the model - stats, growth rates, other metrics.
7. Discount and sum up dividends.
8. Calculate, discount, and add Terminal Value so that NPV = NPV of Terminal Value + NPV of All Dividends.
9. Calculate the Implied Share Price and compare to actual Share Price.
Is the bank undervalued? Overvalued? What are the clues so far?
What Next?
Try it with a real company, using its historical financial information.
Add more complex / realistic assumptions, based on industry research, channel checks, the bank's own strengths/weaknesses, etc.
Add more advanced features - other ways to calculate Terminal Value, more accurate regulatory capital, mid-year discount and/or stub periods, stock issuances / repurchases, multiple growth stages, and so on.

Пікірлер: 57

@TheMoliku 6 жыл бұрын

Thank you so much for teaching about Banking Valuation. That is easy to understand.

@financialmodeling 6 жыл бұрын

Thanks for watching!

@altynayshuakhbayeva5022 2 жыл бұрын

it was a great help. Thank you very much💚💚💚

@financialmodeling 2 жыл бұрын

Thanks for watching!

@Bertztuful 5 жыл бұрын

Hii , the video was really nice, would you please comment on the following questions regarding commercial bank valuation 1) Should Deposits drive or determine the Advances or vice versa ? Which one should be projected first ? 2) How should the Terminal value be determined ? For perpetuity method , how should a Sustainable growth rate be calculated since the typical SGR formula won't work 3) It is said that since a most of a bank's assets are monetary and marked to market, their value is close to book value. By that logic, a bank's justified P/BV should be 1, what if it is not close to 1? Can it still be justified or is it an indication of over /under valuation

@financialmodeling 5 жыл бұрын

1) You can use either one because Deposits and Loans are always linked. Most models assume Loan Growth and then make Deposits a % of Loans. But as long as they are linked in some way, either one is fine. 2) You can calculate the Terminal P / TBV or P / BV multiple based on the final year Net Income Growth, ROE or ROTCE, and Cost of Equity. The formula is: (ROE or ROTCE - Net Income Growth) / (Cost of Equity - Net Income Growth). And then multiply that by the final year BV or TBV. 3) A bank's P / BV might not be close to 1 if it's ROE or ROTCE is higher than those of peer companies, even though its risk (discount rate) is about the same. For example, the bank could be growing more quickly than similar companies because it is using a different business model or superior sales/marketing strategy.

@justincredible00715 7 жыл бұрын

Thank you for the video. Very informative. Do commercial banks warrant using a higher discount rate to account for a higher risk premium of holding so many intangible assets on their b/s?

@financialmodeling 7 жыл бұрын

No. If anything, the Cost of Equity is often lower for commercial banks because they issue dividends more predictably than other companies, and their share prices grow at a more predictable rate... depending on the market/region/company size, of course. But a lot of regional commercial banks in the U.S. have a Cost of Equity of between 8% and 10%, which is lower than many other sectors.

@nataliacarvajal5794 2 жыл бұрын

Thank you very much! I've never valuated a bank before but I was given a commercial bank valuation case for an investment banking interview. This tutorial is very clear and helpful! I just have one curiosity... Would it be also okay to use the perpetuity value to determine the terminal value?

@financialmodeling 2 жыл бұрын

If you mean "the perpetuity growth rate to determine the terminal value," then yes.

@neenyiayirebi-acquah8366 5 жыл бұрын

Hi, thanks for such a great tutorial. Can you do something similar for insurance companies?

@financialmodeling 5 жыл бұрын

Thanks. We do have a few sample lessons for insurance companies on our site... search for "insurance financial modeling" to find them.

@safeershahid9150 4 ай бұрын

Thank you so much for making these videos easy to understand please its a request provide excel or practice sheet as well for practice.

@financialmodeling 4 ай бұрын

If you click "More" or "Show More" below the video, you can scroll down and find links to the files and resources where applicable (we don't have them for every video in this channel).

@Outsider-jp7dg Жыл бұрын

Thank you very much for this video! Any resources for the valuation of insurance companies? Thank you!

@financialmodeling Жыл бұрын

We have a very brief tutorial on insurance companies in our Bank Modeling course, but it is literally just a crash course with a few simplified models. We hope to create more of a full-fledged insurance course in the future. I don't think there are many detailed insurance courses out there because it's very niche, but if you want a book on the topic, check out: www.amazon.com/Valuation-Financial-Companies-Techniques-Institutions/dp/1118617339/ It's not perfect, but it has the best short overview I've seen of both banks and insurance companies.

@financialmodeling 8 жыл бұрын

+Jonathan McHugh This one is not available, but we may make available an alternative model in the future.

@ravidesai4484 8 жыл бұрын

Any news on the alternative model?

@financialmodeling 8 жыл бұрын

Please see the sample lessons for our Bank Modeling course.

@Marina-cr7sd 4 жыл бұрын

Did you make an alternative model? Is it available now? Tnx!

@davytran8631 3 жыл бұрын

thank you

@financialmodeling 3 жыл бұрын

Thanks for watching!

@simon4452 8 жыл бұрын

Hey, Which source/DDM-theory is the foundation/ground pillars of your template? Or is it a kind of "common sense" approach? - Simon

@financialmodeling 8 жыл бұрын

+Simon Davidsen It is the approach used by most banks and other finance firms. We dislike relying too much on theory because it often leads to recommendations that aren't practical in real life.

@vivianeze4889 3 ай бұрын

Thank you for this tutorial. What happens where the dividends calculated is rather positive for instance in the starting period. What does that imply?

@financialmodeling 3 ай бұрын

??? Not really sure what you mean. The Dividends should never be a positive on the statements. Use MIN/MAX functions to enforce negative or 0 for Dividends because they cannot be positive on the CFS.

@medetyertayev2470 8 ай бұрын

Thank you for such an exhaustive video! I am curious what shall we do if we don't know the amount of dividends paid, because it is a private bank and there is no such information. For example, in 2022, a company X purchased 100% shares of the bank from a company Y. But in 2021, the bank paid as dividends 99.97% of its income after corporate taxes to the company Y. Also, in 2022, a new law was introduced stating that no more than 50% of income should be paid as dividends. Shall I take the dividends just as the half of the income?

@financialmodeling 8 ай бұрын

All you can really do is back into the Dividends based on all those requirements, such as Dividends as a % of Net Income and the targeted CET 1 and other regulatory capital levels. If the bank is private, you still need its financial statements to do any modeling work. If there are no financials or even summary information on the loans, deposits, equity, etc., you can't value the bank, and it is all just guesswork.

@bingyolamiryan3223 6 жыл бұрын

Couldn’t you give a link, for reading materials? Thank you

@financialmodeling 6 жыл бұрын

Please see the coverage of FIG on M&I for additional sources (you can do a search on the site).

@sitemp1 7 жыл бұрын

The excel file would be of great help! The tutorial is fantastic thanks a lot!

@financialmodeling 7 жыл бұрын

This one is not available, but please see some of the samples in our Bank Modeling course for examples.

@simon4452 8 жыл бұрын

Is this what you would categorise as a two staged dividend discount model ?

@financialmodeling 8 жыл бұрын

+Simon Davidsen Technically, yes, because the Terminal Period counts as another stage, but this is really more like a one-stage model because there is only one stage for the actual net income and dividend projections.

@vaibhavkalwadkar5492 4 жыл бұрын

Is this technique applicable for Indian Equity Market as well ?

@financialmodeling 4 жыл бұрын

Yes

@JimTheProducer 2 жыл бұрын

Where do you get that blue highlight box tool?

@financialmodeling 2 жыл бұрын

It's part of the Camtasia Studio recording tool we use.

@Vezarici 7 жыл бұрын

Good video! Please, how can you estimate the RWA ? why you choosed 60%? THank you!

@financialmodeling 7 жыл бұрын

You have to look at the company's filings to determine this or use numbers from peer companies.

@Vezarici 7 жыл бұрын

where in the filling i can find the numbers ?

@financialmodeling 7 жыл бұрын

Well, let's see... maybe do a search for "Risk-Weighted Assets" to start with... or look for the ratios, such as "Common Equity Tier 1" and find the number there.

@Vezarici 7 жыл бұрын

Yes, i see thank you so much for responding. But the problem is how to estimate RWA in the future ? Does it depends on inflation ? What are the factors we can use to forecast RWA in the future ?

@Vezarici 7 жыл бұрын

Thank you,

@Vezarici 6 жыл бұрын

Hi, Could you please tell me the difference between core tier 1 and tier 1 capital ? Do you consider these formaulas true : Core Tier Capital = Share capital + Disclosed reserves (legal reserves, surplus and/or retained profits) - Goodwill - Investments in unconsolidated banking and financial subsidiary companies and investments in the capital of other banks & financial institutions Tier 1 Capital = Core Tier 1 + Qualifying Hybrid Securities and Non-controlling Interests Thank you

@financialmodeling 6 жыл бұрын

Core Tier 1 is not used anymore since Basel III changed the terminology and rules. Please see our Bank Modeling course or the samples on the page. The categories are now Tangible Common Equity (TCE), Common Equity Tier 1 (CET 1), Tier 1, Tier 2, and Total Capital. CET 1 is basically Common Shareholders' Equity minus Goodwill & Intangibles + Qualifying Portion of Noncontrolling Interests, and sometimes other adjustments. Tier 1 Capital = CET 1 + Preferred Stock + Another Qualifying Portion of NCI (calculated differently).

@Black182heart 4 жыл бұрын

The 2 Banks I am analysing has RWA greater than its total assets. I am so confused. 172 billion in Total assets and 208 billion of total risk exposure How is that possible? When I checked some items, some investment of the banks have risk weight of 150%. How do I move forward from the first step in this case? Any help will be appreciated. Am I getting something wrong? I tried searching for answers on the Internet but could not find any. So in desperation made a comment on a 7 years old video.

@financialmodeling 4 жыл бұрын

It's possible if the risk-weight percentage is higher than 100%. You can still calculate all the ratios and other metrics the same way. All that means is that the bank will need to maintain a lot more in regulatory capital in the projections.

@Black182heart 4 жыл бұрын

@@financialmodeling thank you. Wasn't expecting a reply. Glad you cleared some confusions.

@rieno4443 Жыл бұрын

Can you send us the excel through the link? I really appreciate your works and need for assignment

@financialmodeling Жыл бұрын

This one no longer exists, but you can find a more complex version for a real company here: breakingintowallstreet.com/kb/bank-modeling/dividend-discount-model-example-banks/

@erickmokayacfa4985 8 жыл бұрын

Is it possible to access the Excel file?

@financialmodeling 8 жыл бұрын

This one is not available, but there are similar Excel files elsewhere in this channel. There are also examples in the sample video links for our Bank Modeling course.