Financial institutions, including banks, are highly regulated, extremely leveraged, and susceptible to interest rate fluctuations. Due to this unique exposure, calculating intrinsic value for bank stocks requires modification of the most popular valuation models. There are about five widely accepted intrinsic valuation models used with determining the core price for stock of most companies. Novice or lazy investors rely heavily on these so-called textbook models to calculate intrinsic value as the baseline for buying stock. Sophisticated investors will modify popular models to create a customized formula for each respective industry. It requires some reasoning and reasonable assumptions to design and implement a model for any industry. This article goes into detail about designing and executing an intrinsic valuation model for banks.
To cover the thought process of creating this banking model, it is first explained how banks are in their own corner of the business world. These certain business attributes are unusual and therefore demand modification to any intrinsic calculation model. Secondly, compliance regulation further complicates calculating value. In some situations, the government penalizes banks by restricting their ability to conduct business which then impacts earnings. Since most valuation models are oriented around earnings, compliance in banking demands changes to the intrinsic formula. A third dynamic with banks is the leverage issue. Most stock price valuation models assume the respective company is at least mildly leveraged. Banks are not not mildly leveraged in comparison to other industries. A bank’s asset side of the balance sheet is customarily more than 85% weighted with loans and other earning assets. Therefore, the respective intrinsic value formulas must take this into consideration. Finally, banks and other financial institutions are susceptible to net interest margins which is tied to the portfolio’s risk factors (types of loans) and the sourcing of capital to finance these earning assets. Thus, the formula for intrinsic value must adapt to this interest spread between what is earned and what is paid out for use of money.
This article goes into great detail about how banks make a profit. The intrinsic value formula is designed around this unique business model. The final section goes through an eight step procedure to determine intrinsic value of bank stock. This article is for members only of this site’s Value Investment Club. It uses Wells Fargo as its sample and sets Wells Fargo’s intrinsic value point as of February 2021. For those of you desiring to read the entire article, you must join as a member; click on the Value Investing tab above and select Membership to read about the program and join the Club.