Bank Valuation: Financial Statements of Banks (part 1)

Bank Valuation: Financial statements of Banks (part 1)

Joris Kersten, Place: Uden/ Netherlands, April 16th 2020

www.joriskersten.nl

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).

This at leading (“bulge bracket”) investment banks, corporates and universities.

Feel free to contact me to provide inhouse training sessions on corporate finance in The Netherlands or anywhere on the globe.

Moreover, feel free to contact me to provide consulting in M&A and or valuation for medium sized companies in The Netherlands. [email protected] / +31 (0)6 8364 0527.

At last, my training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.

The my NEW training calendar in The Netherlands is as follows:

1.     17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

2.     24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

3.     28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;

4.     16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl 

And 130 references on my training sessions can be found on: www.joriskersten.nl

Valuation of Banks: An introduction

For people working in M&A and valuation it is important to understand how to valuate banks. Also when you are not working in “FIG” (Financial Institutions Group).

Since I believe that as a valuator you need to have an all-round understanding of valuation. And this for different types of companies, including banks.

I have decided to write this sequence of blogs on the valuation of banks, because “bank valuation” works somewhat different than valuing a “regular” production- or services company.

The topics that I will discuss in this sequence are, the:

1.     Business models of banks;

2.     Financial statement analysis for banks;

3.     Regulatory capital for banks;

4.     Building the ‘financial model’ for banks;

5.     Bank valuation.

And these topics will come back over the next few weeks in different blogs.

The first blog in this sequence is written already, you can just find it below in case you did not read it yet:

Article 1: Valuation of Banks: Business models of Banks

https://www.dhirubhai.net/pulse/valuation-banks-business-models-joris-kersten-msc-bsc-rab/

I got the idea of writing this sequence of blogs on ‘bank valuation’ after I read a brilliant book on bank valuation.

And this is also the book I used as a source for these blogs.

The book is fantastic: Clear and with enough detail. Highly recommended to read when you are working in M&A or valuation.

·       Book: The Valuation of Financial Companies (March 2015). Authors: Mario Massari, Gianfranco Gianfrate & Laura Zanetti. Wiley Publishers.

Financial statement analysis for banks: An introduction

Before we can get to the actual “valuation of banks", we need to look at “financial modelling for banks”, “regulatory capital for banks” and “financial statement analysis for banks”.

Let start now with the “financial statements of banks”.

In this blog a lot of accounting information will come by and here I need to mention that I am NOT an accountant.

I am a 'business economist' with a master of science in strategic management, and I am involved in M&A as a trainer and consultant.

Therefore I have a good basic accounting knowledge, because this is needed for M&A activities, but in the end I am not an accountant.

So always check specific accounting issues in valuation and M&A with a certified public accountant.

In this blog the intention is not to be “correct” from an accounting perspective. I just want to make the reader familiar with the financial statements of banks, and its components on the balance sheet, P&L and cash flow statement.  

Balance sheet: Fixed tangible assets (operating)

Let’s first start with the balance sheet (BS) when discussing the financial statements of banks.

Banks make most of their profits from financial activities, but they still need some tangible fixed assets.

Think of for example: Security systems, real estate, furniture and computers.

Any revaluation in these assets must increase “other items of comprehensive income” in the income statement (IS) and the “revaluation reserve” (on the equity part of the BS).

And on this reserve further devaluations will have an impact afterwards, and not on the IS.

Another asset, Investment property, is defined as land, building or part of a building, utilised to earn rentals or gain from capital appreciation.

An investment property needs to be recognised at its cost (including transaction costs) initially. And they can be measured after that either at “fair value” or at “depreciated cost”.

(Massari, Gianfrate, Zanetti, 2015)

Balance sheet: Intangible assets

Intangible assets are identifiable non-monetary assets without physical substance. And in order to be able to put them on the BS the asset must:

·       Be separately identifiable;

·       Be controlled by the company;

·       Produce probable future benefits to the firm;

·       Have a cost that can be reliably measured.

So concerning banks, these assets could be for example: Computer software, brands or capitalised “development costs” (the D of R&D).

The initial recognition of intangibles consist of recording the asset at its initial historical cost, regardless of whether it was purchased or built internally.

And after that the intangible assets, with exception of goodwill, can be measured with the cost method (depreciation) or revaluation method (fair value).

Concerning goodwill, the so called “acquisition method” needs to be applied to account for a business combination.

This implies that all the assets and liabilities of the controlled entity must be recognised at fair value. This also includes items not recognised before the acquisition.

(Massari, Gianfrate, Zanetti, 2015)

Balance sheet: Securities

With the term securities is meant:

·       Fixed income securities;

·       Shares;

·       Interests in funds held in the bank portfolio either in the “trading book” (securities actively traded by the bank in daily operations with aim for a short term gain), or "banking book" (which includes the securities that are not actively traded by the bank, often held to maturity);

For financial assets the proper measurement and classification is not easy. In general, there are two valuation criteria for securities:

1.     “Amortised cost” with impairment test (ACIT);

2.     Fair value approach.

With ACIT banks have to record an impairment loss whenever the “recoverable amount” of an asset (recoverable either through use or sale) is lower than its carrying amount on the BS.

And with the second approach fair value can be defined as “the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at arm’s length at the measurement date”.

In practice this valuation can result in three methods with method 1 as most favourable:

1.     Mark-to-market: Mark to price of a similar asset traded in an active market;

2.     Mark-to-model: Based on the application of a valuation technique (model);

3.     Mark-to-management: By judgement, this is a subjective procedure.

(Massari, Gianfrate, Zanetti, 2015)

Securities continued: Classification scheme

The book keeping rules also give a “classification scheme” to measure the value of financial assets and liabilities after their initial recognition.

There are four categories:

First category: Fair Value Trough Profit and Loss (FVTPL)

FVTPL consists out of two sub categories:

1.     Financial assets initially recognised at fair value (with the exemption of non listed shares for which the price can not be reliably estimated). Most financial instruments in a bank’s BS are comprehended in this group.

2.     Held for Trading (HFT) assets, so assets acquired principally for being sold. Financial derivatives may be included in this group with the exception of those derivatives that have a hedging instrument role.

Second category: Loans and receivables (L&R)

These are defined as non-derivative financial assets with fixed or determinable payments that are not quoted in an active market.

Third category: Held to Maturity (HTM)

These are defined as non-derivative financial assets with fixed or determinable payments, and fixed maturity, on which an entity has a positive intention and ability to hold until maturity.

Fourth category: Available for sale (AFS) assets

These are non-derivative assets that do not fit in the first three categories.

(Massari, Gianfrate, Zanetti, 2015)

Securities continued: Representation

The value change of financial assets is represented as follows in the financial statements:

1.     FVTPL and HFT financial activities are measured at fair value. And any change in their value is taken up in the IS;

2.     HTM assets are valued at historical “amortised cost” and any impairment loss is recorded in the IS;

3.     L&R are measured at “amortised cost” with impairment testing;

4.     AFS assets are measured at fair value and any revaluation impacts the revaluation reserve.

(Massari, Gianfrate, Zanetti, 2015)

In the second part of this blog on “financial statements of banks”, I will continue with the concepts discussed today. This in combination with the following topics:

·       Equity stakes, loans and receivables, impairment testing, financial liabilities, hedging etc.

Stay tuned!

Source of this blog

I got the idea of writing this sequence of blogs on ‘bank valuation’ after I read a brilliant book on bank valuation.

And this is also the book I used as a source for these blogs. The book is fantastic: Clear and with enough detail. Highly recommended to read when you are working in M&A or valuation.

·       Book: The Valuation of Financial Companies (March 2015). Authors: Mario Massari, Gianfranco Gianfrate & Laura Zanetti. Wiley Publishers.

Under here you can find my previous blogs (almost 50) on valuation:

Earlier blogs on “net debt” (cash & debt free)

Article 1: Valuation: Introduction to "net debt" (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-introduction-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 2: Valuation: Net debt (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 3: Valuation: Adjusted net debt – Cash like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-cash-like-items-kersten-msc-bsc-rab/

Article 4: Valuation: Adjusted net debt – Debt like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-like-items-joris-kersten-msc-bsc-rab/

Earlier blogs on “valuation of banks”

Article 1: Valuation of Banks: Business models of Banks

https://www.dhirubhai.net/pulse/valuation-banks-business-models-joris-kersten-msc-bsc-rab/

Earlier blogs on “Weighted Average Cost of Capital (WACC) – step by step”

Article 1: Capital Market History Lessons – Corporate Finance (part 1)

https://www.dhirubhai.net/pulse/capital-market-history-lessons-corporate-finance-part-joris/

Earlier blogs on Financial Modelling

Article 1: Financial Modelling in Excel: Circular references, interest calculations and iterations

https://www.dhirubhai.net/pulse/financial-modelling-excel-circular-references-kersten-msc-bsc-rab/

Article 2: Excel basics for Finance: SUM, MAX, MIN, AVERAGE, IF, cell referencing, named ranges

https://www.dhirubhai.net/pulse/excel-basics-finance-sum-max-min-average-cell-named-joris/

Article 3: Excel for Valuation: COUNTIF, VLOOKUP, INDEX and MATCH

https://www.dhirubhai.net/pulse/excel-valuation-countif-vlookup-index-match-kersten-msc-bsc-rab/

Article 4: Excel for Business Valuation: OFFSET, FORECAST and CHOOSE

https://www.dhirubhai.net/pulse/excel-business-valuation-offset-forecast-choose/

Article 5: Excel for Business Valuation: NPV, IRR, PMT and EOMONTH

https://www.dhirubhai.net/pulse/excel-business-valuation-npv-irr-pmt-eomonth-kersten-msc-bsc-rab/

Earlier blogs on “various topics”

Article 1: Financing a M&A transaction: An introduction

https://www.dhirubhai.net/pulse/financing-ma-transaction-introduction-joris-kersten-msc-bsc-rab/

Article 2: Valuation: How to adjust for “Operating Lease” (under Dutch GAAP)

https://www.dhirubhai.net/pulse/valuation-how-adjust-operating-lease-under-dutch-gaap-joris/

Article 3: M&A closing mechanisms: Locked Box & Completion Accounts

https://www.dhirubhai.net/pulse/ma-closing-mechanisms-locked-box-completion-accounts-joris/

Article 4: Scoping a financial model built primarily for business valuation:

https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/

Article 5: Consolidation of M&A targets and Purchase Price Allocation (PPA)

https://www.dhirubhai.net/pulse/consolidation-ma-targets-purchase-price-allocation-joris/

Earlier blogs on “bonds”

Article 1: Bonds - An introduction

https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/

Article 2: Bonds & Bond Markets

https://www.dhirubhai.net/pulse/bonds-bond-markets-corporate-finance-joris-kersten-msc-bsc-rab/

Article 3: Bonds, Rating Agencies and Credit Ratings

https://www.dhirubhai.net/pulse/bonds-rating-agencies-credit-ratings-joris-kersten-msc-bsc-rab/

Earlier blogs on “Valuation & funding of start-ups”

Article 1: Valuation & funding of start-ups - Funding rounds

https://www.dhirubhai.net/pulse/valuation-funding-startups-rounds-joris-kersten-msc-bsc-rab/

Article 2: Startup valuation: Pre-money and post-money valuation

https://www.dhirubhai.net/pulse/startup-valuation-pre-money-post-money-joris-kersten-msc-bsc-rab/

Article 3: Valuation methods for Startups (early stage) – Part 1

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-1-kersten-msc-bsc-rab/

Article 4: Valuation methods for Startups (early stage) – Part 2

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-2-kersten-msc-bsc-rab/

Article 5: Startups in Silicon Valley: The beginning – Part 1

https://www.dhirubhai.net/pulse/startups-silicon-valley-beginning-part-1-joris-kersten-msc-bsc-rab/

Article 6: Startup Funding & Convertible Debt (part 1)

https://www.dhirubhai.net/pulse/startup-funding-convertible-debt-part-1-joris-kersten-msc-bsc-rab/

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Article 10: Valuation of a company abroad

https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/

Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts

https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/

Article 12: Valuation: Small firm premiums

https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).

This at leading (“bulge bracket”) investment banks, corporates and universities.

Feel free to contact me to provide inhouse training sessions on corporate finance in The Netherlands or anywhere on the globe.

Moreover, feel free to contact me to provide consulting in M&A and or valuation for medium sized companies in The Netherlands. [email protected] / +31 (0)6 8364 0527.

At last, my training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.

The my NEW training calendar in The Netherlands is as follows:

5.     17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

6.     24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

7.     28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;

8.     16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl 

And 130 references on my training sessions can be found on: www.joriskersten.nl