There
are many dimensions on which financial service firms differ from other firms in
the market. In this section, we will focus on four key differences and look at
why these differences can create estimation issues in valuation. The first is
that many categories (albeit not all) of financial service firms operate
under strict regulatory constraints on how they run their businesses and
how much capital they need to set aside to keep operating. The second is that
accounting rules for recording earnings and asset value at financial service
firms are at variance with accounting rules for the rest of the market.
The third is that debt for a financial service firm is more akin to raw
material than to a source of capital; the notion of cost of capital and
enterprise value may be meaningless as a consequence. The final factor is that
the defining reinvestment (net capital expenditures and working capital)
for a bank or insurance company may be not just difficult, but impossible, and
cash flows cannot be computed.
Financial
service firms are heavily regulated all over the world, though the extent of
the regulation varies from country to country. In general, these regulations
take three forms. First, banks and insurance companies are required to maintain
regulatory capital ratios, computed based upon the book value of equity and
their operations, to ensure that they do not expand beyond their means and put
their claimholders or depositors at risk. Second, financial service firms are
often constrained in terms of where they can invest their funds. For instance,
until a decade ago, the Glass-Steagall Act in the United States restricted commercial
banks from investment banking activities as well as from taking active equity
positions in non-financial service firms. Third, the entry of new firms into
the business is often controlled by the regulatory authorities, as are mergers
between existing firms.
Why
does this matter? 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, which
can have an effect on value. Put more simply, to value banks, insurance
companies and investment banks, we have to be aware of the regulatory structure
that governs them.
The
accounting rules used to measure earnings and record book value are different
for financial service firms than the rest of the market, for two reasons. The
first is that the assets of financial service firms tend to be financial
instruments (bonds, securitized obligations) that often have an active market
place. Not surprisingly, marking assets to market value has been an established
practice in financial service firms, well before other firms even started
talking about fair value accounting. The second is that the nature of
operations for a financial service firm is such that long periods of profitability
are interspersed with short periods of large losses; accounting standard have
been developed to counter this tendency and create smoother earnings.
a.
Mark to Market: If the new trend in
accounting is towards recording assets at fair value (rather than original
costs), financial service firms operate as a laboratory for this experiment.
After all, accounting rules for banks, insurance companies and investment banks
have required that assets be recorded at fair value for more than a decade,
based upon the argument that most of a bankÕs assets are traded, have market
prices and therefore do not require too many subjective judgments. In general,
the assets of banks and insurance companies tend to be securities, many of
which are publicly traded. Since the
market price is observable for many of these investments, accounting rules have
tilted towards using market value (actual of estimated) for these assets. To the extent that some or a significant
portion of the assets of a financial service firms are marked to market, and
the assets of most non-financial service firms are not, we fact two problems.
The first is in comparing ratios based upon book value (both market to book
ratios like price to book and accounting ratios like return on equity) across
financial and non-financial service firms. The second is in interpreting these
ratios, once computed. While the return on equity for a non-financial service
firm can be considered a measure of return earned on equity invested originally
in assets, the same cannot be said about return on equity at financial service
firms, where the book equity measures not what was originally invested in
assets but an updated market value.
b.
Loss Provisions and smoothing out earnings:
Consider a bank that makes money the old fashioned way – by taking in
funds from depositors and lending these funds out to individuals and
corporations at higher rates. While the rate charged to lenders will be higher
than that promised to depositors, the risk that the bank faces is that lenders
may default, and the rate at which they default will vary widely over time
– low during good economic times and high during economic downturns.
Rather than write off the bad loans, as they occur, banks usually create
provisions for losses that average out losses over time and charge this amount
against earnings every year. Though
this practice is logical, there is a catch, insofar as the bank is given the
responsibility of making the loan loss assessment. A conservative bank will set
aside more for loan losses, given a loan portfolio, than a more aggressive
bank, and this will lead to the latter reporting higher profits during good
times.
In
the financial balance sheet that we used to describe firms, there are only two
ways to raise funds to finance a business – debt and equity. While this
is true for both all firms, financial service firms differ from non-financial
service firms on three dimensions:
a. Debt is
raw material, not capital:
When we talk about capital for non-financial service firms, we tend to talk
about both debt and equity. A firm raises funds from both equity investor and
bondholders (and banks) and uses these funds to make its investments. When we
value the firm, we value the value of the assets owned by the firm, rather than
just the value of its equity. With a financial service firm, debt has a
different connotation. Rather than view debt as a source of capital, most
financial service firms seem to view it as a raw material. In other words, debt
is to a bank what steel is to a manufacturing company, something to be molded
into other products which can then be sold at a higher price and yield a
profit. Consequently, capital at financial service firms seems to be narrowly
defined as including only equity capital. This definition of capital is
reinforced by the regulatory authorities, who evaluate
the equity capital ratios of banks and insurance firms.
b. Defining Debt: The definition of what comprises debt
also is murkier with a financial service firm than it is with a non-financial service
firm. For instance, should deposits made by customers into their checking
accounts at a bank be treated as debt by that bank? Especially on
interest-bearing checking accounts, there is little distinction between a
deposit and debt issued by the bank. If we do categorize this as debt, the
operating income for a bank should be measured prior to interest paid to
depositors, which would be problematic since interest expenses are usually the
biggest single expense item for a bank.
c. Degree of
financial leverage: Even
if we can define debt as a source of capital and can measure it precisely,
there is a final dimension on which financial service firms differ from other
firms. They tend to use more debt in funding their businesses and thus have
higher financial leverage than most other firms. While there are good reasons
that can be offered for why they have been able to do this historically - more
predictable earnings and the regulatory framework are two that are commonly
cited – there are consequences for valuation. Since equity is a sliver of
the overall value of a financial service firm, small changes in the value of
the firmÕs assets can translate into big swings in equity value.
We
noted earlier that financial service firms are constrained by regulation in
both where they invest their funds and how much they invest. If, as we have so
far in this book, define reinvestment as necessary for future growth, there are
problems associated with measuring reinvestment with financial service firms.
Note that, we consider two items in reinvestment – net capital
expenditures and working capital. Unfortunately, measuring either of these
items at a financial service firm can be problematic.
Consider
net capital expenditures first. Unlike manufacturing firms that invest in
plant, equipment and other fixed assets, financial service firms invest
primarily in intangible assets such as brand name and human capital.
Consequently, their investments for future growth often are categorized as
operating expenses in accounting statements. Not surprisingly, the statement of
cash flows to a bank show little or no capital expenditures and correspondingly
low depreciation. With working capital, we run into a different problem. If we
define working capital as the difference between current assets and current
liabilities, a large proportion of a bankÕs balance sheet would fall into one
or the other of these categories. Changes in this number can be both large and
volatile and may have no relationship to reinvestment for future growth.
As
a result of this difficulty in measuring reinvestment, we run into two
practical problems in valuing these firms. The first is that we cannot estimate
cash flows without estimating reinvestment. In other words, if we cannot
identify how much a company is reinvesting for future growth, we cannot
identify cash flows either. The second is that estimating expected future
growth becomes more difficult, if the reinvestment rate cannot be measured.