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Valuing Financial Firms Essay

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Below is an essay on "Valuing Financial Firms" from Anti Essays, your source for research papers, essays, and term paper examples.

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Valuing Financial Service Firms
Aswath Damodaran April 2009 Valuing banks, insurance companies and investment banks has always been difficult, but the market crisis of 2008 has elevated the concern to the top of the list of valuation issues. The problems with valuing financial service firm stem from two key characteristics. The first is that the cash flows to a financial service firm cannot be easily estimated, since items like capital expenditures, working capital and debt are not clearly defined. The second is that most financial service firms operate under a regulatory framework that governs how they are capitalized, where they invest and how fast they can grow. Changes in the regulatory environment can create large shifts in value. In this paper, we confront both factors. We argue that financial service firms are best valued using equity valuation models, rather than enterprise valuation models, and with actual or potential dividends, rather than free cash flow to equity. The two key numbers that drive value are the cost of equity, which will be a function of the risk that emanates from the firm’s investments, and the return on equity, which is determined both by the company’s business choices as well as regulatory restrictions. We also look at how relative valuation can be adapted, when used to value financial service firms.

2 Banks, insurance companies and other financial service firms pose special challenges for an analyst attempting to value them, for three reasons. The first is the nature of their businesses makes it difficult to define both debt and reinvestment, making the estimation of cash flows much more difficult. The second is that they tend to be heavily regulated and changes in regulatory requirements can have significant effect on value. The third is that the accounting rules that govern bank accounting have historically been very different from the accounting rules for other firms, with assets being marked to market more frequently for...

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