How do you value banks and financial institutions differently from other companies?

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:

• You screen based on assets or deposits in addition to the normal criteria.

• You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.

• You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.

Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:

• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.

• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations.

You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps.