Valuation of Banks: Business models of Banks

Valuation of Banks: Business models of Banks

Joris Kersten, Place: Uden/ Netherlands, April 6th 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.

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

But 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.

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.

The business of banking

While some banks only offer one type of service, most banks offer a wide array of financial products and services.

When we look at the business models of banks and different types of revenues, it looks as follows:

1.     Commercial bank: Net interest income;

2.     Commercial bank, investment bank, assets management: Fee and commission income;

3.     Investment banking: Trading income;

4.     Bank assurance: Premium underwriting.

Historically the core source of revenues for (commercial) banks is the issuance of loans to individuals and/ or businesses.

And collecting money in the form of deposits.

Then “net interest income” is typically the difference between the interest earned on loans and the interest paid to depositors.

So in this sense commercial banking is a “spread business”.

(Massari, Gianfrate, Zanetti, 2015)

Fee & commission income

The second major source of revenue in the banking industry is “fee & commission income”.

Services such as “underwriting” and “placements of securities”, “trust services” and “securities brokerage” are commonly performed for a fee or commission.

Both “commercial banks” and “investment banks” undertake these activities, but the difference lies here lies in which type of client they target.

For “investment banks” the clients here are generally large corporations to be served with tailored advisory services like:

Initial public offering (IPOs), seasoned equity offerings or Mergers & Acquisitions (M&As).

For “commercial banks” the clients here are individuals and small & medium sized enterprises for which less customized services are provided.

Typically fee-based services offered by commercial banks are:

·       Asset management: Management fee for assets under management.

·       Private banking: Advise to wealthy individuals.

·       Corporate advisory: Risk management services, advise on financing structure & issuing new securities (debt + equity), and M&A transactions.

·       Brokerage & dealership: Commission on trades in the secondary market.

A third source of revenue (trading income) are “trading” activities of banks “in the name” of the bank (proprietary trading). 

And a fourth source of revenue are non-banking activities like for example real estate development, insurance activities, minority investment in non-banking companies etc.

(Massari, Gianfrate, Zanetti, 2015)

Commercial banks

Commercial banks are the banks people have in mind when we speak about banks.

They receive money from customers as deposits (liabilities), and they provide money in the form of loans (assets).

This is the main part of the business, but commercial banks also provide some other services like:

1) Trust services (managing the client’s assets), and 2) investment- or financial advice.

The balance sheet of a commercial bank is both asset- and liability driven.

Because these banks have to compete, and succeed, in both “attracting money” (deposits) and lending out money (issuance of loans).

And the ability to attract deposits at a cost lower cost than the return on the assets is the core of a bank’s profitability.

(Massari, Gianfrate, Zanetti, 2015)

Commercial banks: Introduction bank’s Profit & loss statement

So banks make interest income which simply is: Loans, mortgages and other investments times the “interest rate for assets”.

And banks make interest expenses which simply is: Deposits and other interest bearing liabilities times the “interest rate for liabilities”.

The result here is: Net interest income.

Then there are the operating expenses that need to be deducted.

And a popular ratio here is: Operating expenses / Net interest income = “cost/ income ratio”.

This since it tells something about the operational efficiency of a bank.

After that, loan loss provisions and taxes are deducted to get to net income.

And net income/ equity = return on equity.

And as we know, when the return on equity is higher than the cost of equity, then we are creating value.

This is a very simplistic overview of how a bank works over the P&L!

In the next blog I will talk about this in way more depth when discussing “financial statement analysis” of banks.

(Massari, Gianfrate, Zanetti, 2015)

Commercial banks: Introduction bank’s balance sheet

At last, let’s take a first look at the balance sheet of banks:

The consolidated balance sheet items for all US commercial banks (at December 2012) show on the asset side “loans and leases net of loan provisions” as a majority of the assets of about 51,5%.

With “net” loans we mean: Taking the estimates for loan losses into account.

The other two main asset categories (all US commercial banks consolidated at December 2012) are securities of 21% (which do not include securities held in trading accounts) and cash 10%.

And on the liability side deposits represent about 83% and equity only 11,5%.

This is just a first introduction on the balance sheet of banks, and in the next blog I will dive into these issues in way more depth.  

(Massari, Gianfrate, Zanetti, 2015)

Investment banks

Investment banks help corporations and governments to raise debt and equity securities in the market.

The investment banking activities range from the origination to the “underwriting”, and placement, of securities.

With the term “underwriting” is meant the practise of purchasing securities from the issuer and then selling them in the market.

Investment banks are also involved in the stages following the placement. This through brokerage, deal services and/ or market making in the “secondary market”.

And they are also involved in advising in M&As and corporate restructuring based on a fee.

At last, they are active in “proprietary trading”, basically trading “in their own name” of:

Stocks, bonds, currencies, commodities, derivatives etc.

In the next blog in this sequence; Financial statement analysis of banks, I will look at the P&L and balance sheet of commercial- and investment banks in great detail! Stay tuned! ??

(Massari, Gianfrate, Zanetti, 2015)

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 (over 40) 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 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/

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/

Training calendar

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

But 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