Valuing Financial Service Firms

A financial service firm's valuation may include banks' valuation, valuation of insurance companies, Investment Banks valuation, or valuing investment firms. These firms differ in the perspective of how they make their money.

Banks: Bank makes money on the spread between the interest it pays to those from whom it raises funds and the interest it charges those who borrow from it, and from other services it offers its depositors and its lenders.

Insurance Companies: Insurance companies make their income in two ways. The first is through the premiums they receive from those who buy insurance protection from them. The other is income from the investment portfolios that they maintain to service the claims.

Investment Banks: Investment banks provide advice and supporting products for other firms to raise capital from financial markets or consummate deals such as acquisitions or divestitures.

Investment Firms: Investment firms provide investment advice or manage portfolios for clients.

Unlike other firms, in the financial firm valuation process, one must consider the debt and the regulation.

What is unique about a financial service firm's valuation?

Similar to non-financial service firms, financial service firms attempt to be as profitable as they can. They compete with other firms, trying to grow rapidly over time. If they are publicly traded, they are judged by the value creation they make for their stockholders. Unlike other firms, in the financial firm valuation process, one must consider the debt and the regulation.

The Debt

When we talk about capital for non-financial service firms, we tend to talk about debt and equity. A firm raises funds from equity investors and bondholders (and banks) and uses these funds to make its investments. When one values the firm, he calculates the firm's value of assets, rather than just the value of its equity.

When valuing a financial service firm, the debt seems to take on a different connotation. Rather than view debt as a capital source, most financial service firms seem to view it as a raw material.

Especially on interest-bearing checking accounts, there is little distinction between a deposit and debt issued by the bank. If we categorize this as debt, the operating income for a bank should be measured before interest paid to depositors, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

The Regulatory Overlay

Financial service firms are heavily regulated worldwide, though the extent of the regulation varies from country to country. In general, these regulations take three forms.

First, banks and insurance companies must maintain capital ratios to ensure that they do not expand beyond their means and put their claim holders or depositors at risk.

Second, financial service firms are often constrained in terms of where they can invest their funds.

Third, entry of new firms into the business is often restricted by the regulatory authorities, as are mergers between existing firms.

From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints. There might also be implications for how we measure risk at financial service firms. If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, affecting value.