You will be able to choose a valuation method for banks and REITs and explain why free cash flow does not fit them.
Marcus tried to run his Larkspur DCF on his local bank and stopped within ten minutes. Free cash flow made no sense. The bank's operating cash flow swung by billions from year to year as deposits came in and loans went out, and "capital spending" was a rounding error. Then he tried it on his S-REIT and hit the opposite problem: the REIT pays out almost everything, so there was nothing to forecast but the payout itself. Both businesses need valuation methods built for how they actually work.
All figures here are made up.
An industrial company borrows to fund its operations, and its debt sits apart from the business. A bank's borrowing is its business. It takes deposits, which are debts to customers, and lends them out at a higher rate. Deposits, wholesale funding and loans all move with operations, so the line between operating cash flow and financing disappears, and free cash flow to the firm stops meaning anything.
So analysts value bank equity directly, from what shareholders receive or earn, discounted at the cost of equity rather than a WACC.
The simplest version is a dividend discount model: value per share equals next year's dividend divided by the cost of equity minus long-term dividend growth. It suits banks better than most companies, because banks pay steady dividends and regulators require them to hold capital in proportion to their loans, which ties growth to retained profit.
Take Marcus's bank, with made-up figures: book value of S$20 a share, a return on equity of 12%, a cost of equity of 9% and long-term growth of 3%. To grow its loans and capital by 3% a year at a 12% return on equity, it must retain a quarter of its profit, since 3% divided by 12% is 25%. Earnings are 12% of S$20, which is S$2.40 a share, so the dividend is 75% of that: S$1.80. Value is S$1.80 divided by 9% minus 3%, which is S$30.
The sensitivity is sharp. At a cost of equity of 8%, the same bank is worth S$36. At 10%, it's worth about S$25.70. A one-point change moves value by roughly a fifth either way, because the dividend is assumed to grow for ever.
An excess return model reaches the same place by a route that shows where value comes from. Value equals book value plus the present value of profits above what shareholders require. The bank earns 12% on S$20 of book value when shareholders want 9%, so its excess return is three points on S$20, or S$0.60 a share, growing at 3%. That stream is worth S$0.60 divided by 6%: S$10. Add book value of S$20, and you get S$30 again.
That route explains why bankers and analysts quote price to book value so often, and why it misleads on its own.
A bank whose return on equity just equals its cost of equity earns nothing above what shareholders require, so it's worth about its book value: a price to book of 1. One earning more is worth more than book. The justified price to book is return on equity minus growth, divided by cost of equity minus growth. For Marcus's bank: 12% minus 3%, which is 9 points, over 9% minus 3%, which is 6 points, gives 1.5 times book, the same S$30.
At a made-up price of S$32, his bank trades at 1.6 times book. That's cheap if its return on equity can stay at 12% or more, and expensive if return on equity drifts down to 9%, at which point fair price to book falls to 1 and value to S$20. So the question for a bank is never "is 1.6 times book high?" but "can this bank keep earning 12% on its equity through a credit cycle?" Module 9 lists the measures that answer it, in lesson 9.6, Industry frameworks: banks, insurers, commodity producers and software.
S-REITs distribute most of their taxable income to unitholders, which lets them avoid tax at the REIT level, as Dividend stocks and S-REITs explains in lesson 4.2, The payout rule and tax transparency. With so little retained, growth comes mainly from rent increases, new acquisitions funded by new units or debt, and changes in property values. Free cash flow to the firm still exists in theory, but in practice two methods do most of the work.
The first values distributions. Marcus's S-REIT pays a made-up distribution per unit of S$0.12, a 6% yield at S$2.00. If he expects it to grow at 1% a year and wants a 7% return, the same formula as the bank's gives 0.12 times 1.01, about S$0.121, divided by 6%: about S$2.02. At a required return of 7.5% it's about S$1.86. At 6.5%, about S$2.20.
The second compares price with net asset value. Lesson 5.4 of Dividend stocks and S-REITs, NAV per unit and what price to NAV tells you, explains how NAV is built from property valuations. With a made-up NAV of S$2.30, Marcus's units trade at about 0.87 times NAV. Use the two methods together. A REIT on a low price to NAV whose distributions don't support even the current price usually has a reason for the discount.
The measures that tell you whether a REIT's distribution is safe, gearing, interest cover, the debt maturity profile, occupancy, rent reversions and the weighted average lease expiry, are taught in Dividend stocks and S-REITs, module 5, Read a REIT's numbers like a lender would. This lesson adds only the valuation step. Read the REIT's numbers with that course's scorecard before you trust any distribution you discount.
For the activity, value one STI bank with the simple dividend discount model above, using its latest dividend, book value and return on equity, then rerun it at a cost of equity one point higher and one point lower.
Value one STI bank with a simple dividend discount model and note how sensitive the result is to the discount rate.
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