FIG Flashcards
How do banks make money?
The bank gets money in two ways:
1) First the bank gets money from customers depositing money into their checking or savings accounts (in order to hold and earn interest). Then, the bank pools this capital and offers it out in larger quantities to businesses and individuals at higher rates. The spread of interest rate is how the bank makes money (1% offer to depositors vs 4% charged to loan-holders).
2) The bank also earns revenue on service charges, credit card feeds, management fees, servicing fees, and trading.
How does an insurance company earn money?
Insurance firms earn money in two ways:
1) Firms collect premiums upfront from customers who pay to be protected in the case of an accident (or on an asset) or death. They pay out claims if accidents happen.
2) With this upfront cash, the companies float the money to make investments to earn interest and investment income
How are commercial banks different to regular companies?
Balance Sheet First companies: the balance sheet drives banks’ performance, and you start statements by projecting the BS first.
Equity Value Only: You cannot separate a bank’s operating and financing activities easily so the concept of Enterprise Value does not apply so you use Equity Value and Equity Value multiples.
Dividend Discount Model: FCF doesn’t mean anything for banks because changes in Working Capital and CapEx don’t represent reinvestment in business. Instead you use dvidends as a proxy for FCF, Cost of Equity instead of WACC, and the DDM instead of DCF.
Regulations and Capital: banks are more highly regulated and they must maintain minimum amounts of capital (Tangible Common Equity with modifications) This constrains growth.
Different Valuation Multiples: Price / (tangible) Book Value, Price / Earnings are all important since banks are balance sheet driven and interest is a huge factor of revenue.
How are insurance companies different from normal companies?
The same 5-key differences above also apply: Balance Sheet First, Equity Value Only, DDM, Regulation and Capital, Different Valuation Multiples.
Premiums rather than loans/deposits drive everything for insurance
Non-interest revenue is more significant for insurance firms than banks because insurance firms generate a lot from premiums
Statutory Accounting: a different system to IFRS and GAAP that is closer to cash accounting
Valuation is similar to commercial bank valuation but Embedded Value is an extremely important methodology for Life Insurance.
How are the 3 financial statements different for a commercial bank?
Balance Sheet: Loans on Assets Side (with Allowances for Loan Losses as a contra asset) and Deposits on the Liabilities side. There are more categories for investments and securities; common working capital items may not be included.
Income Statement: Revenue is divided into net interest income and non-interest income. COGS do not exist. Provision for Credit Losses is a major new expense; operating expenses are labelled non-interest expenses.
Cash Flow Statement: it is similar to normal but the classifications are much murkier. All balance sheet items must be reflected here and Net Income still flows in however Provision for Credit Losses must be included as a non-cash expense.
How are the 3 statements different for an Insurance Firm?
Balance Sheet: Assets are split into Investment Assets and Non-Investment Assets (Cash, Premiums Receivable, Reinsurance Recoverables, Ceded Unearned Premiums, Deferred Acquisition Costs, and normal items). Liabilities are similar but there are a number of reserves for claim expenses and unearned premiums (deferred revenue).
Income Statement: Divided into Premiums, Net Investment and Interest Income, Gains/(Losses), and Other; COGS don’t exist; Claims is the major expense, as well as G&A, Commissions, and Interest.
Cash Flow Statement: it is similar but you need to reflect changes in the new balance sheet such as Deferred Acquisition Costs.
How would you value a commercial bank?
For a market valuation:
You can still use comparables, precedent transactions however:
1) Screen based on Total Assets or Deposits rather than Revenue and EBITDA criteria; criteria should be narrower as few banks are directly comparable.
2) You look at metrics such as ROE, ROA, Book Value, Tangible Book Value, rather than Revenue or EBITDA multiples
3) You use multiples such as P/E, P/BV, P/TBV instead for final valuation range.
For intrinsic valuation you may use two methodologies:
1) DDM: you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, which is based on a P/E, P/BV, P/TBV multiple.
2) A Residual Income Model (or Excess Returns Model), you take the bank’s current Book Value and add the present value of [the Excess Returns to that Book Value] to value it. The Excess Return each year is
(ROE*Book Value - Cost of Equity * Book Value)
Basically it is how much the returns exceed your expectations.
Why do we use these methodologies and multiples?
Interest is a critical component of a bank’s revenue and because debt is a raw material rather than a financing source.
What are common metrics and valuation multiples when analyzing banks?
Book Value = Shareholder’s Equity
Tangible Book Value = Shareholder’s Equity - Preferred Stock - Goodwill - Certain Intangible Assets
EPS = Net Income to Common / Shares Outstanding
ROE = Net Income / Shareholders Equity
ROA = Net Income / Total Assets
P/E = Market price per share / earnings per share
P/BV = Market price per share / book value per share
P/TBV = Market price per share / Tangible book value per share
What do Return On metrics tell us?
They tell us how much in after-tax income a bank generates with the capital it has raised (Equity) or the Assets on-hand (Assets).
What do the P/BV, P/TBV multiples tell us?
These tell us how the market is valuing the bank relative to its balance sheet
How would you value an insurance firm?
Mostly the same way as for a commercial bank:
Use P/E, P/BV, P/TBV multiples for public comparables and precedent transactions, and DDM instead of normal DCF analysis.
You could create a Net Asset Value model (NAV) where you adjust the Assets and Liabilities to their true market values and subtract to estimate the value of the firm.
And for Life Insurance you use the Embedded Value, which adds a firm’s adjusted Book Value to the present value of its future profits from its insurance policies and measures its value based on that.
What are common multiples you look for with insurance firms?
BV, TBV, EPS, ROE, ROA, P/E, P/BV, P/TBV
Loss and Loss Adjustment Expense (LAE) Ratio:
Claims or Loss Expense / Net Earned Premiums
Expense Ratio:
Commission + Underwriting Expense / Net Written Premiums
Combined Ratio: sum of LAE and Expense Ratios
and yields an overall picture of profitability
Net Asset Value = Adjusted Assets - Adjusted Liabilities - Capital Deficiency
P/NAV
Embedded Value Profit, Return on Embedded Value, P/Embedded Value
Why does a NAV (Net Asset Value) model not work for commercial banks?
Commercial bank balance sheets are already marked to market so it is not relevant.
What is embedded value?
Embedded Value adds the firm’s adjusted book value to the present value of their future profits from insurance policies.
