Why the Dividend Discount Model (DDM) is used to value commercial banks instead of the traditional Discounted Cash Flow (DCF) analysis.
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
There are 3 main reasons why the DCF and the concept of Free Cash Flow (FCF) do not apply to commercial banks:
1. You can't separate operating vs. investing vs. financing activities - the lines are very blurry for a bank, since items like debt are more operationally-related and fund the bank's lending activities.
2. CapEx doesn't represent re-investment in the business, as it does for a normal company - for a bank,"re-investment" means hiring people, doing more lending, etc.
3. Working Capital represents something much different for a bank - the standard definition of Current Assets Excl. Cash Minus Current Liabilities Excl. Debt makes no sense, because for banks that includes tons of investments, securities, other borrowings, etc. so you could see massive swings...
What You Do Instead - Use Dividends as a Proxy for Free Cash Flow
Why? Because banks are CONSTRAINED by capital requirements - according to the Basel accords (I, II, III), they must maintain a certain "buffer" at all times to cover unexpected losses on their loans...
So just like CapEx requirements, Net Income growth, and Working Capital constrain FCF for normal companies, the Tier 1 Capital / Tangible Common Equity / Total Capital requirements constrain dividends for banks.
So we'll project a bank's regulatory capital, its asset growth, and its net income, and use those to project its dividends - then, discount, and sum up the dividends and discount and add the NPV of its terminal value.
How to Set Up a Dividend Discount Model (DDM)
1. Make assumptions for Total Assets, Asset Growth, targeted Tier 1 (or other) Ratios, Risk-Weighted Assets, Return on Assets (ROA) or Return on Equity (ROE), and Cost of Equity.
2. Next, project Assets and Risk-Weighted Assets.
3. Then, project Net Income based on ROA or ROE.
4. Then, project Shareholders' Equity (AKA Tier 1 Capital) based on targeted capital ratio...
5. And BACK INTO dividends! Different from a normal company's DDM!
Set dividends such that the minimum capital ratio is maintained, based on starting Shareholders' Equity and Net Income that year.
6. Flesh out the rest of the model - stats, growth rates, other metrics.
7. Discount and sum up dividends.
8. Calculate, discount, and add Terminal Value so that NPV = NPV of Terminal Value + NPV of All Dividends.
9. Calculate the Implied Share Price and compare to actual Share Price.
Is the bank undervalued? Overvalued? What are the clues so far?
Try it with a real company, using its historical financial information.
Add more complex / realistic assumptions, based on industry research, channel checks, the bank's own strengths/weaknesses, etc.
Add more advanced features - other ways to calculate Terminal Value, more accurate regulatory capital, mid-year discount and/or stub periods, stock issuances / repurchases, multiple growth stages, and so on.