Bank Valuation Worksheet

Why a DCF does not work here

A bank's cash flows are its balance sheet. Reinvestment is not a management choice but a regulatory requirement, free cash flow has no clean meaning for a business whose product is holding assets, and capital expenditure is close to irrelevant. Run a standard discounted cash flow on a lender and you will produce a number, but you will not have valued anything.

What works instead is the residual income identity, which collapses to a single line: the multiple of tangible book a lender deserves is the spread between what its equity earns and what that equity costs, capitalized by how long the spread persists. Written out:

justified price to tangible book = (ROTCE − g) / (COE − g)

Read it once and the consequences are obvious. If a bank earns exactly its cost of equity, the numerator and denominator are identical and the fair multiple is one times tangible book, whatever it grows at. Growth is worth nothing unless the return exceeds the cost. And a lender earning less than its cost of equity is worth less than its book value, which is why so many banks trade below it and why that is usually the market being right rather than an opportunity.

What is inside

• Inputs, two columns so you can hold a comparison. JPMorgan and SoFi are already there at the closes used in the published reports, read from the model files behind them.
• Valuation, the full chain: tangible book, what the market is paying, the spread, the justified multiple, and a fair value per share.
• The same thing backwards. The return on tangible common equity the observed price requires, forever. This is usually the more useful number, because it is a claim you can check against what the bank has actually earned rather than a forecast you have to defend.
• Sensitivity, a grid of the justified multiple and the fair value across return and cost of equity, because the point estimate is never the answer.
• Sanity checks that fire when the inputs make the formula meaningless.

The failure mode, which the sheet warns you about

The denominator is a difference between two similar numbers, so the formula is violently sensitive near the bottom. A lender earning nine percent against a cost of equity of eight and a half has a fair value that moves by half on a quarter-point change in either input. The sheet flags this when the gap between your cost of equity and your growth rate falls under two percentage points.

When that happens the honest conclusion is that you cannot value this bank on this method, not that it is worth whatever the formula printed. Report the range.

What it deliberately does not do

It is not a credit model. This values a lender on its returns and says nothing about whether the loan book is any good. A bank earning twenty percent on tangible equity for three years and then writing off a fifth of its book was never worth the multiple this sheet prints. Read the charge-offs, the reserve build and the capital ratio first, and use this second.

It also assumes a single steady-state return rather than a fade, which flatters banks currently earning above their long-run average and penalizes those in a bad year. Use a through-the-cycle figure for the return input, not last quarter's.

Found an error, or think a calculation should work differently? Tell me. Corrections get published with a date attached, the same as they do for the research reports.