In keeping with the way we
have estimated the cost of equity for firms so far in this book, the cost of
equity for a financial service firm has to reflect the portion of the risk in
the equity that cannot be diversified away by the marginal investor in the
stock. This risk is estimated using a beta (in the capital asset pricing model)
or betas (in a multi-factor or arbitrage pricing model). There are three estimation notes that we
need to keep in mind, when making estimates of the cost of equity for a
financial service firm:

1.
__Use bottom-up betas__: In our earlier
discussions of betas, we argued against the use of regression betas because of
the noise in the estimates (standard errors) and the possibility that the firm
has changed over the period of the regression. We will continue to hold to that
proposition, when valuing financial service firms. In fact, the large numbers
of publicly traded firm in this domain should make estimating bottom up betas
much easier.

2.
__Do not adjust for financial leverage__:
When estimating betas for non-financial service firms, we emphasized the
importance of unlevering betas (whether they be
historical or sector averages) and then relevering
them, using a firmÕs current debt to equity ratio. With financial service
firms, we would skip this step for two reasons. First, financial service firms
tend to be much more homogeneous in terms of capital structure – they
tend to have similar financial leverage primarily due to regulations. Second,
and this is a point made earlier, debt is difficult to measure for financial
service firms. In practical terms, this will mean that we will use the average
levered beta for comparable firms as the bottom-up beta for the firm being
analyzed.

3.
__Adjust for regulatory and business risk__:
If we use sector betas and do not adjust for financial leverage, we are in
effect using the same beta for every company in the sector. As we noted
earlier, there can be significant regulatory differences across markets, and even
within a market, across different classes of financial service firms. To
reflect this, we would define the sector narrowly; thus, we would look the
average beta across large money center banks, when valuing a large money center
bank, and across small regional banks, when valuing one of these. We would also
argue that financial service firms that expand into riskier businesses –
securitization, trading and investment banking – should have different
(and higher betas) for these segments, and that the beta for the company should
be a weighted average.

4.
__Consider the relationship between risk and
growth__: Through the book, we have emphasized the importance of modifying a
companyÕs risk profile to reflect changes that we are assuming to its growth
rate. As growth companies mature, betas should move towards one. We see no need
to abandon that principle, when valuing banks. We would expect high growth
banks to have higher betas (and costs of equity) than mature banks. In valuing such banks, we would
therefore start with higher costs of equity but as we reduce growth, we would
also reduce betas and costs of equity.

To
ensure that assumptions about dividends, earnings and growth are internally
consistent, we have to bring in a measure of how well the retained equity is
reinvested; the return on equity is the variable that ties together payout
ratios and expected growth. Using a fundamental growth measure for earnings:

Expected
growth in earnings = Return on equity * (1 – Dividend Payout ratio)

For instance, a bank that payout out 60% of its earnings as
dividends and earns a return on equity of 12% will have an expected growth rate
in earnings of 4.8%. When we
introduced the fundamental equation in chapter 2, we also noted that firms can deliver growth rates that deviate from this expectation,
if the return on equity is changing.

Expected Growth_{EPS}
_{}

Thus,
if the bank is able to improve the return on equity on existing assets from 10%
to 12%, the efficiency growth rate in that year will be 20%. However,
efficiency growth is temporary and all firms ultimately will revert back to the
fundamental growth relationship.

The
linkage between return on equity, growth and dividends is therefore critical in
determining value in a financial service firm. At the risk of hyperbole, the
key number in valuing a bank is not dividends, earnings or growth rate, but
what we believe it will earn as __return on equity in the long term__. That
number, in conjunction with payout ratios, will help in determining growth.
Alternatively, the return on equity, together with expected growth rates, can
be used to estimate dividends. This linkage is particularly useful, when we get
to stable growth, where growth rates can be very different from the initial
growth rates. To preserve consistency in the valuation, the payout ratio that we
use in stable growth, to estimate the terminal value, should be:

Payout ratio in stable growth _{}

The risk of the firm should also adjust to
reflect the stable growth assumption. In particular, if betas are used to
estimate the cost of equity, they should converge towards one in stable growth.

The cashflow to equity is the
cashflow left over for equity investors after debt payments have been made and
reinvestment needs met. With financial service firms, the reinvestment
generally does not take the form of plant, equipment or other fixed assets.
Instead, the investment is in regulatory capital; this is the capital as
defined by the regulatory authorities, which, in turn, determines the limits on
future growth.

FCFE_{Financial}_{ Service Firm} = Net Income – Reinvestment in
Regulatory Capital

To estimating the
reinvestment in regulatory capital, we have to define two parameters. The first
is the __book equity capital ratio__ that will determine the investment;
this will be heavily influenced by regulatory requirements but will also
reflect the choices made by a bank.
Conservative banks may choose to maintain a higher capital ratio than
required by regulatory authorities whereas aggressive banks may push towards
the regulatory constraints. For instance, a bank that has a 5% equity capital
ratio can make $100 in loans for every $5 in equity capital. When this bank
reports net income of $15 million and pays out only $5 million, it is
increasing its equity capital by $10 million. This, in turn, will allow it to
make $200 million in additional loans and presumably increase its growth rate
in future periods. The second is the __profitability of the activity__,
defined in terms of net income. Staying with the bank example, we have to
specify how much net income the bank will generate with the additional loans; a
0.5% profitability ratio will translate into additional net income of $1
million on the additional loans.