Valuing Financial Services Companies

Financial services companies are not quite amenable to a discounted cash flow analysis, because there is no wall separating operating and financial assets.

In such cases, it is difficult to figure out an ROIC, because “IC” in this context is a nebulous concept. This problem pops up in one form or another, when one attempts to do a firm level valuation (debt + equity). For example the sales/capital ratio which is handy in modeling reinvestment for growth is not particularly meaningful.

One way out of this quandary is to focus on equity (from Damodaran), and use a (potential) dividend discount model based on the Gordon growth model.

Let us define the relevant terms.

BV = book value of equity
ROE = return on equity
COE = cost of equity
nNI = normalized net income for next year = ROE * BV
g = stable earnings growth into perpetuity

The amount of free cash is determined by the g and ROE. This free cash can be distributed as a potential dividend. The payout ratio of this “free cash dividend” is

p = dividend payout ratio = (1 - g/ROE)

As a reality check, it is useful to compare the historical payout ratio to this value of “p”. One might have to account for all forms of cash return including dividends and buybacks while doing this.

Thus, the value of the equity is:

Equity IV = nNI * p/(COE - g)

Of course, if it makes sense, then the future can be split into explicit stages in which variables vary with time before settling into their terminal values.

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