Why is valuing financial institutions different? How are financial institution valued?
Complexity: Must rely on rough estimates from management’s accounting decisions Their choice of leverage is the core of how they generate earnings Generally highly leveraged Therefore, extremely sensitive to small changes in key drivers
Non-Financial Institutions Discounted Cash Flow (DCF) Financial Institutions Equity Cash Flow In a simplified world ECF equals Discounting Dividends ECF = NI – Increase in Equity + Other Comprehensive Income
Conclusion DCF is not a good valuation method for Financial Institutions Financial Institution make money on fee and spreads Debt valuated differently It is hard to know how much risk a bank current has Equity Cash Flows can be very different every year Need to trust management