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Banks and other financial services firms can be particularly challenging to value. Their

financial statements are unlike those found in other industries, and once familiar

concepts like working capital and operating income become confusing and difficult to

define let alone calculate. The consequence is that to value a bank requires a wholly

different approach which carries its own set of potential pitfalls that the investor must beaware of.

A banks cash flows tend to be highly volatile and related to macroeconomic factors. This

makes forecasting cash flows extremely challenging and prone to mistake. Thankfully,

there is an easier way. For most businesses, the balance sheet is largely affected by

management assumptions and historical events. For example, the decision between LIFO

and FIFO inventory valuations can have a large impact on a business with a large

inventory balance in an inflationary environment (See my post on Tesoros massive LIFO

reservehere). The consequence of this is that, for non-banks, shareholders equity is a

somewhat arbitrary measurement that is difficult to compare across firms of different

ages, sizes and business strategies. For banks, this is not the case.

Banks use Mark-to-Market accounting, which carries most assets and liabilities at fair

market value, rather than historical cost. In this manner, unrealized gains and losses are

actually recognized (either via the income statement directly or through other

comprehensive income on the balance sheet). This translates into Shareholders Equity

on the balance sheet that is more reflective of the net difference between the actual market

valueof assets and liabilities.

Since the book value of equity is more reliable than in other businesses and the

statement of cash flows is highly volatile and less accurate as a metric of assessing

management competence (given the greater impact of macro rather than microeconomicfactors), most analysts rely on shareholders equity as a starting point for valuing banks.

This method is known as the Excess Return Model and it arrives at the value of equity as

the sum of the current equity capital and the present value of expected excess returns to

equity.

http://www.frankvoisin.com/2011/07/26/tesoro-corporation-large-and-volatile-off-balance-sheet-assets-tso/http://www.frankvoisin.com/2011/07/26/tesoro-corporation-large-and-volatile-off-balance-sheet-assets-tso/http://www.frankvoisin.com/2011/07/26/tesoro-corporation-large-and-volatile-off-balance-sheet-assets-tso/http://www.frankvoisin.com/2011/07/26/tesoro-corporation-large-and-volatile-off-balance-sheet-assets-tso/

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