How can you accurately value financial services companies during economic cycles?

1 Understand the business model

The first step in valuing financial services companies is to understand their business model and how they generate income, incur expenses, and manage risks. For example, some financial services companies, such as payment providers, earn fees from processing transactions, while others, such as banks and insurers, earn interest or premiums from lending or underwriting activities. Depending on their business model, financial services companies may have different sources of revenue growth, operating leverage, capital intensity, and regulatory constraints.

2 Choose the appropriate valuation method

The next step is to choose the appropriate valuation method for the financial services company you are analyzing. There are several valuation methods available, such as discounted cash flow (DCF), dividend discount model (DDM), residual income model (RIM), and multiples. However, not all methods are suitable for all types of financial services companies. For example, DCF may not work well for banks and insurers, as their cash flows are highly dependent on assumptions about future interest rates, loan losses, and claims. Similarly, multiples may not capture the differences in risk and growth profiles among financial services companies. Therefore, you should select the valuation method that best reflects the cash-generating ability and the risk-return trade-off of the financial services company.

3 Adjust for the economic cycle

The third step is to adjust for the economic cycle and its impact on the financial services company's performance and valuation. Economic cycles can affect financial services companies in various ways, such as changing the demand and supply of financial products and services, influencing the cost and availability of capital and funding, altering the expectations and behaviors of customers and investors, and triggering changes in regulation and supervision. Therefore, you should consider how the economic cycle affects the key drivers of the financial services company's valuation, such as revenue growth, profitability, risk, and cost of capital, and make appropriate adjustments to your valuation inputs and outputs.

4 Compare with peers and benchmarks

The fourth step is to compare your valuation results with those of the peers and benchmarks of the financial services company. This can help you validate your assumptions, identify any outliers or anomalies, and assess the relative attractiveness of the financial services company. However, you should be careful to compare apples with apples, and adjust for any differences in business models, accounting policies, growth prospects, risk profiles, and capital structures among the financial services companies. You should also use multiple valuation metrics, such as price-to-earnings, price-to-book, price-to-sales, and return on equity, to capture different aspects of the financial services company's value.

5 Incorporate scenarios and sensitivity analysis

The fifth step is to incorporate scenarios and sensitivity analysis into your valuation process. This can help you account for the uncertainty and volatility inherent in the financial services sector, and test the robustness of your valuation results under different assumptions and outcomes. You can use scenarios and sensitivity analysis to explore how changes in key variables, such as interest rates, exchange rates, inflation, credit quality, market conditions, and regulation, affect the financial services company's cash flows, risk, and value. You can also use scenarios and sensitivity analysis to assess the potential upside and downside of the financial services company, and the probability and magnitude of different events and shocks.

6 Update your valuation regularly

The sixth and final step is to update your valuation regularly, as the financial services sector is dynamic and fast-changing, and new information and developments can affect the financial services company's performance and valuation. You should monitor the financial services company's financial statements, news releases, analyst reports, and market data, and revise your valuation inputs and outputs accordingly. You should also review your valuation methods and assumptions, and check if they are still valid and relevant, or if they need to be modified or replaced. By updating your valuation regularly, you can keep track of the changes in the financial services company's value, and adjust your investment decisions accordingly.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?