Peculiarities associated with valuing financial services firms

Financial services firms have certain peculiarities, and there fore FCFE calculation has to be more measured and careful.

1. Regulation
Banks and financial services firms are heavily regulated. In general, these regulations take three forms. First, banks are required to maintain capital ratios to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are a minimum level of Net Owned Funds or Net Worth. Third, entry of new firms into the business is often restricted by the regulatory authorities.

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, particularly relating to capital adequacy levels.

2. Reinvestment
If we define reinvestment as necessary for future growth, there are other problems associated with measuring reinvestment with financial service firms. Primarily, – net capital expenditures and working capital, could be considered as reinvestments required for growth. However, measuring either of these items at a financial service firm can be debated.

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. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation. Similarly, if we define working capital as the different between current assets and current liabilities, a large proportion of a bank’s 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. For example a bank may accrue a large interest cost on its deposits while the actual payouts on account of withdrawals are much less. The bank’s cashflow would in this case, gets artificially inflated.