Valuing Financial Services Firms

Valuing banks, insurance companies, and investment banks has always been a daunting exercise, but the rolling market crises of the last few years have made a difficult job even more so. There are two key measurement problems that you face in valuing financial services firms. The first is that the cash flows cannot be easily estimated, since many of the ingredients needed are not clearly defined. The second is that most financial services firms operate under regulatory frameworks that govern how they are capitalized, where they invest, and how fast they can grow. Consequently, changes in the regulatory environment can create large shifts in value. In this paper, we confront both factors. We argue that financial services firms should be valued using equity valuation models, rather than enterprise valuation models, and with actual or potential dividends used as cash flows. The two key numbers that drive value are the cost of equity, which is a function of the risk that emanates from the firm's investments, and the return on equity, which is determined by the company's investment choices and regulatory restrictions