c
 






p  






p  
profits from spread between interest charged to borrowers
and interest it pays to lenders
 p 
  
îrofit from difference between premium
charged and claims they need to pay. Also profits from returns on
invested income
 p 
 
?ees for advising and transactions
 p 

advisory and management fees for investing
money of others
p 
  



 
p 

 

 p maintenance of capital ratios a affects capital structure; banks
with capital ratios < 2% could trigger ?
 takeover; affects
reinvestment rate of the firm (thus growth)
 p onstraints on fund investment a restricts growth
opportunities for the bank weǯre valuing (i.e. prop trading is
highly profitable) i.e. Glass-steagall
 p ^ntry needs approval from state banking and insurance
commissions a creates barrier to entry into the sector thus
limiting potential competition
 p ^ pected change in regulatory constraints adds to a
layer of uncertainty in valuation
 p 


 p    ` since most assets held are
actively traded financial instruments they must be marked to
market at their fair market value
 p îossible cause of crises? 
 p Assuming BV = Market Value can cause error b/c 
p Market can make mistakes which subsequently
would be embedded in BV
 p Assets are marked to market based not on an
observable market price but on models used by
the appraiser
 p e use returns on equity and capital to measure
investment quality but when we mark to market
the RO^ is equal to the cost of equity and thus
there is nothing to distinguish firms from making
good vs. bad investments
p Mark to market acct causes 2 problems`
p Ratio comparison based on BV across financial
and non financial firms
 p
nterpretation of ratios` i.e. RO^ for non financial
firm is a measure of return earned on equity
 invested originally but in a financial firm the
book equity measures an updated market value 
 p ?inancial service firms operate in such a way that long periods
of profitability are interspersed with short periods of large
losses
 p roan loss provisions` smooth out earnings so that the
effect of losses over time are averaged out based on the
financial firmǯs assessment
p Banks face a risk of borrowers defaulting and
rather than write off bad loans as they occur
banks create provisions for losses that average
out losses over time and charge this amount
against earnings every year a more conservative
banks will set aside more while more aggressive
banks will set aside less 
 p !

 p Banks use debt in their operations a not simply for financing
thus canǯt calculate an unlevered bank (banks view debt as a
raw material rather than source of capital) 
 p efinition of debt is unclear` interest bearing checking
accounts a deposits are similar to debt if we measure ^B
 this
is a problem b/c interest e pense is a bankǯs single most
biggest e pense
 p egree of financial leverage` banks tend to use more debt in
funding their businesses so even if we can separate debt from
operating and financing this causes problems in valuation a
since equity is such a small component of a financial service
firm, small changes in the value of the firmǯs assets can
translate into big swings in equity value 
 p "
  

 p Most firms reinvest thru cape but financial service firms have
little to no cape and their primary investment for growth are
brand name and human capital (which are usually part of
operating e penses); also a large proportion of banks balance
sheets are made up of current assets and liabilities thus
changes in this number can be large and volatile and have no
relation to reinvestment for future growth a we cannot
forecast ?? w/o reinvestment rate
 p w/o reinvestment rate we cannot estimate future e pected
growth
p 

p !
#(as we saw before this method requires you to
pretty much already know the value of your firm) banks do not
payout 100% of earnings as dividends as they need the money in
order to reinvest capital for growth
 p $
$
 we need cost of equity capital, e pected
growth rate in dividends, payout policy (determines reinvestment
rate of firm and thus will affect firm growth) aby using this method
youǯre assuming that dividends paid are sustainable and reasonable
 p ome firms may payout high dividends but then compensate
by issuing new share (this would cause us to over value these
firms)
 p ?ocus on current dividends also causes problems when valuing
firms with growth potential and in cases where the firms do
not pay dividends we will arrive at the result of a zero value for
equity
 p 
%# 

 p ifferent types of financial firms have different betas (note that
some financial institutions such as brokerage houses and life
insurance companies have very high betasȄpeople trade less
during a downturn and insurance companies who invest their
premiums would see investment return decrease)
 p ifference in betas are driven by cross sectorial differences in
regulatory and business risks
 p A financial firm that operates in multiple sectors should have a
beta that is the ’
   

  

 
 p e do not unlever and lever for financial firms for 2 reasons`
 p ue to regulations, capital structures among financial
firms in the same sector are often homogenous
 p ifficulty measuring a financial firmǯs debt and capital
structure
 p $&' ( 
 p îayoff between paying dividend and reinvesting in the firm
 p ^nsure assumptions about earnings, dividend payouts and
growth are consistent a check how retained earnings are
reinvested (as RO^ is the variable that ties together payout
ratios and e pected growth)
?or stable growth firm` g = (1- îayout Ratio) * RO^

[Value of ^quity] î = ^ pected ividends ne t year / r^ Ȃg

[ iv per share * g] / r^ Ȃg

Normalized Net
ncome = BV of ^quity * Normalized RO^

iii.p long term RO^ is key determinant of value of a firm

iv.p hen making stable growth assumption the risk of the firm
should also be adjusted such that if beta were used in
measuring the cost of equity a should converge towards 1 ins
stable growth
v.p 2 inputs that determine the value of the firmǯs equity are RO^
and cost of equity (r^)
 1.p lower RO^ a net income will decrease and payout ratio
will decrease
2.p if we perceive banks to be riskier cost of equity will
increase
 p 


'
 '
 p as growth companies mature, betas should move toward 1 thus
as we reduce growth we would also reduce betas and cost of
equity