Bank Valuation Presentation to Hskli slands Haraldur Yngvi

Bank Valuation Presentation to Háskóli Íslands Haraldur Yngvi Pétursson, Equity Research - Iceland 15 April 2008

Valuation Method: The very basic one stage DDM

Value Measures – banks equity n Book Value ― Reported value of equity, based on the prevailing accounting standards n Economic Value ― Difference between market value of assets and liabilities at a given time n Market Value ― Current share price multiplied by the number of outstanding shares n Intrinsic Value ― Discounted value of future earnings ― Analyst's most used tool ― DDM the most common valuation model ― Analysts may argue for a discount or a premium Bank Valuation 15 April 2008 4

Premiums and discounts n Discounts ― Size (or lack thereof) ― Liquidity and free float ― Asset quality ― Balance sheet structure ― Capital raising risk ― Ownership, corporate governance and transparancy ― Holding company and conglomerate discount ― Management quality ― Demand Bank Valuation 15 April 2008 5

Premiums and discounts n Premiums ― Wheight of money – Mutual fund inflows – Asset-class allocation – Liquidity and free float ― Excess capital ― Index issues ― Takeove or other speculation Bank Valuation 15 April 2008 6

The dividend discount model (DDM) n Some DDM Strengths ― Communicability and basis ― Absolute valuations ― Comparability ― Simple sensitivity measures n Key assumptions ― Cost of Equity ― Return on Equity ― Long term growth Bank Valuation 15 April 2008 7

The dividend discount model (DDM) n DDM has various forms ― Basic one stage model ― Multistage models n The most basic DDM ― Fair value P/B multiple = ― ROE = return on equity ― COE = cost of equity ― g = long-run growth Þ Book value per share * P/B multiple = Fair value per share Þ Fair value per share * number of shares = Total fair value Bank Valuation 15 April 2008 8

The dividend discount model (DDM) n Cost of Equity ― Risk free rate – Varies by markets – Normally 10 yr government bonds are used for base ― Market risk premium – Generally 4 -5% ― The troublemaker – Beta – Historic vs. future – Time period and frequency – Liquidity – Earnings volatility ― Judgement Bank Valuation 15 April 2008 9

The dividend discount model (DDM) n Return on Equity (Net profit / average equity) ― Earnings – Trading profits and loss, included? – Goodwill writedown? – Other one-offs? – Place in the economic cycle – Bad debt charges – Numerous other company specific issues – Aim to estimate the "through the cycle" ROE Bank Valuation 15 April 2008 10

The dividend discount model (DDM) n Growth – long term ― A banks earnings growth can not be higher in perpetuity than long term GDP growth – Better to err on the side of caution – Higher growth in developing than developed countries – One of the reasons for a multiple stage models Bank Valuation 15 April 2008 11

The dividend discount model (DDM) n Example – 3 banks Bank Valuation 15 April 2008 12

Valuation Method: Multi stage DDM

The dividend discount model (DDM) n Underlying assumption in the one stage model ― Value of equity grows at the same rate as earnings ― Dividend payout ratio therefore must be ― A bank can not payout more than this ratio in the long run as capital restrictions will eventually come into place ― The payout ratio can be higher, but that would lead to less gearing, lower ROE and actual value of discounted dividends will be lower ― Is there an excess capital? – A war chest – A fear factor Bank Valuation 15 April 2008 14

The dividend discount model (DDM) n Two stage models are common ― Give short term flexibility in e. g. ― Earnings estimates ― Growth n Lets look at one simple example ― COE is 10% ― Growth is 4% ― ROE (long term) is 14, 8% ― Payout ratio (POR) => Bank Valuation 15 April 2008 15

The dividend discount model (DDM) n Our basic assumptions ― Equity = last year + earnings – dividends ― Equity in perpetuity = Equity last forecast * (1+g) ― Earnings in perpetuity = Earnings last forecast * (1+g) ― Dividend last year (and perpetuity) according to our POR Bank Valuation 15 April 2008 16

The dividend discount model (DDM) n The valuation process is in two parts (hence two stage model) ― First we calculate the present value of dividends in the forecast period ― Discount rate = COE ― Then we calculate the PV of perpetuity ― Fair value multiple as before ― Add PV of dividends over forecast Bank Valuation 15 April 2008 17