Valuing Banks and Financial Institutions#

Try to value a bank using standard metrics, and you'll quickly run into problems. Revenue? Banks don't have traditional "sales." EBITDA? Interest is their business, not an expense to add back. Cash flow? The entire balance sheet is basically cash.

Banks require a fundamentally different approach to valuation.

Why Banks Are Different: A bank's "inventory" is money. Its "product" is financial intermediation—borrowing at low rates, lending at higher rates. Traditional operating metrics don't translate.

The Bank Business Model#

How Banks Make Money#

Revenue Source	Description	Typical % of Revenue
Net Interest Income	Loan interest - deposit interest	60-75%
Fee Income	Service charges, advisory, trading	15-30%
Trading Revenue	Securities gains/losses	5-15%
Other	Insurance, asset management	Varies

The Core Metric: Net Interest Margin (NIM)#

Net Interest Margin = (Interest Income - Interest Expense) / Average Earning Assets

NIM	Quality
>3.5%	Excellent
3.0-3.5%	Good
2.5-3.0%	Average
<2.5%	Below average

NIM is driven by:

Interest rate environment (higher rates usually help)
Loan mix (commercial vs. mortgage vs. consumer)
Deposit franchise (low-cost deposits = wider spread)
Competition

Price-to-Book: The Primary Bank Metric#

Why P/B Works for Banks#

For banks, book value (shareholders' equity) is economically meaningful:

Assets (loans, securities) are mostly marked to market
Liabilities (deposits, debt) are at face value
Book value approximates liquidation value

Price-to-Book (P/B) = Stock Price / Book Value Per Share
         or
P/B = Market Cap / Total Shareholders' Equity

P/B Ranges for Banks#

P/B	Interpretation
>1.5x	Premium—market believes ROE will exceed cost of equity
1.0-1.5x	Normal range for quality banks
0.8-1.0x	Discount—concerns about asset quality or profitability
<0.8x	Deep discount—market expects losses or restructuring

Historical Context#

Period	Large Bank Average P/B	Market Conditions
Pre-2008	1.5-2.5x	Credit boom, high ROE
2008-2009	0.3-0.7x	Financial crisis, fear
2010-2019	0.9-1.2x	Post-crisis recovery
2020-2023	0.8-1.3x	Rate volatility, regional stress

The ROE-P/B Connection#

The key insight: P/B should reflect ROE relative to cost of equity.

Justified P/B Formula#

Justified P/B = (ROE - g) / (COE - g)

Where:

ROE = Return on Equity
g = sustainable growth rate
COE = Cost of Equity

Simplified intuition: If ROE = COE, the bank is worth exactly book value (P/B = 1.0x). If ROE > COE, it's worth more than book.

Example Calculation#

Metric	Bank A	Bank B
ROE	12%	8%
Cost of Equity	10%	10%
Growth (g)	3%	3%
Justified P/B	(12%-3%)/(10%-3%) = 1.29x	(8%-3%)/(10%-3%) = 0.71x

Bank A deserves a premium because it generates returns above its cost of capital. Bank B trades at a discount because it destroys value.

The 10% Rule of Thumb

At 10% cost of equity, every 1% of excess ROE is worth roughly 0.14x book value. A bank earning 14% ROE (4% excess) is worth about 1.5x book; one earning 8% ROE (2% below) is worth about 0.7x book.

Key Drivers of Bank Valuation#

1. Return on Equity (ROE)#

The most important metric. Decomposed as:

ROE = Net Income / Shareholders' Equity
    = Net Margin × Asset Turnover × Leverage

For banks specifically:

ROE ≈ Net Interest Margin × Leverage (Assets/Equity)

Banks typically operate at 10-12x leverage, so a 1% NIM can generate 10-12% ROE.

2. Asset Quality#

Non-Performing Loans (NPL) Ratio:

NPL Ratio = Non-Performing Loans / Total Loans

NPL Ratio	Quality
<1%	Excellent
1-2%	Good
2-4%	Concerning
>4%	Problem bank

Loan Loss Reserves:

Reserve Coverage = Loan Loss Reserves / Non-Performing Loans

Coverage >100% means reserves exceed current bad loans—conservative. Coverage <100% raises questions.

3. Capital Ratios#

Banks must maintain minimum capital. Key ratios:

Ratio	Minimum	Well-Capitalized
CET1 (Common Equity Tier 1)	4.5%	>10%
Tier 1 Capital	6.0%	>12%
Total Capital	8.0%	>14%

Banks below minimums face restrictions on dividends and growth. Excess capital allows buybacks and expansion.

4. Deposit Franchise#

Low-cost deposits are a bank's moat:

Deposit Type	Typical Cost	Stickiness
Non-interest checking	0%	Very high
Savings/money market	2-4%	Medium
CDs	4-5%	Low (rate-sensitive)
Brokered deposits	5%+	Very low

A bank funded 70% by non-interest and low-rate deposits has structural NIM advantage.

Valuation Methods for Banks#

Method 1: P/B Comparable Analysis#

Bank	P/B	ROE	P/B vs. ROE
Bank A	1.4x	14%	0.10
Bank B	1.1x	10%	0.11
Bank C	0.9x	8%	0.11
Target	?	12%

Target with 12% ROE should trade roughly 1.2-1.3x based on the P/B-to-ROE relationship of peers.

Method 2: Dividend Discount Model (DDM)#

Banks pay substantial dividends, making DDM appropriate:

Value = Expected Dividend / (Cost of Equity - Growth Rate)
      = D₁ / (r - g)

Example:

Current dividend: $2.00
Expected growth: 3%
Cost of equity: 10%
Value = $2.00 × 1.03 / (0.10 - 0.03) = $29.43

Method 3: Residual Income Model#

Values the bank based on excess returns over book value:

Value = Book Value + Present Value of Future Residual Income

Where Residual Income = (ROE - COE) × Book Value

Bank-Specific Red Flags#

1. Rapidly Growing Loan Book#

Fast loan growth often precedes credit problems. The fastest-growing banks in 2006 became the biggest failures in 2008.

2. Concentrated Exposures#

Heavy concentration in:

Commercial real estate (CRE)
Single industry (energy, agriculture)
Geographic region

3. Below-Peer NPLs in Good Times#

Counterintuitively, very low NPLs might mean underwriting is too loose—problems haven't surfaced yet.

4. Non-Interest Income Volatility#

Heavy trading revenue or one-time gains can mask weak core banking.

5. Deposit Outflows#

2023's SVB failure showed how fast deposits can flee. Watch:

Uninsured deposit % (above FDIC limit)
Deposit concentration (few large depositors)
Digital accessibility (easier to move money)

Banks Are Leveraged

A bank with 10x leverage loses 10% of equity for every 1% loss on assets. Small problems compound quickly. This is why bank stocks are volatile and why investors demand discounts for uncertainty.

Key Takeaways

Banks require different valuation approaches—traditional EBITDA and FCF don't work
Price-to-Book (P/B) is the primary metric because bank book value is economically meaningful
P/B should reflect ROE vs. Cost of Equity: higher ROE = higher justified P/B
Justified P/B = (ROE - g) / (COE - g); banks earning 10% COE are worth 1.0x book
Key drivers: ROE, asset quality (NPL ratio), capital ratios, deposit franchise
Use P/B comparables adjusted for ROE differences
Dividend Discount Model works well given banks' high payout ratios
Watch red flags: rapid loan growth, concentration, deposit flight risk
Remember: 10x leverage means small asset losses create large equity losses