Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
3.6.9 Discount rates
We mentioned above that banks are inherently leveraged. Even a bank whose
capital entirely comprised equity would have a balance sheet for which the larger
part of the liabilities represented creditors representing customer deposits. The
corollary is that assets will never be fully backed by equity capital, as can happen
for industrial companies. We have seen that one approach is to estimate the
amount of economic capital (risk capital is a more easily interpreted definition)
that the bank needs, and to assume that it distributes any surplus over and above
that amount. But distributing a surplus has the effect of increasing the cost of
equity.
Our recommended approach to this is to assume that the Tier I capital in a bank
can be valued as having two components. The first is the economic capital of the
bank. The second is the surplus capital of the bank. The cost of capital to the latter
is the risk free rate, since it is not being allocated as risk capital, and the cost of
capital to the former can be derived by adjusting the measured Beta, in exactly the
same way that one would deleverage the Beta of an industrial company with net
cash in its balance sheet. Instead of the leveraged Beta being divided by (1+D/E)
to derive an unleveraged Beta it is divided by (1-Cash/Equity), to derive an
unleveraged Beta. In our case we are just treating surplus capital as if it were cash.
3.6.10 Valuation
Our valuation on page seven is an absolutely standard DCF/residual income to
equity model, and should require no explanation, since it is structurally identical
to the model used for Metro in Chapter five, other than that it values equity
directly, rather than debt.
As usual, most of the DCF value lies in the terminus, which represents about 80
per cent of the value derived. Much more interesting is the allocation of value in
the residual income model. Even assuming that incremental investments after
2008 earn exactly their cost of capital, and add or subtract nothing from the value
of the business, it turns out that the current book value represents more than the
appraised value of the equity. Forecast residual income is negative throughout the
projected period and into the long term future with respect to capital that is
already installed by end 2008.
3.6.11 Sum-of-parts and economic capital employed
Where adequate information is provided it may be possible to value the bank
business by business. In that instance we would again recommend modelling
returns (cash flow or profit) to projections of economic capital, and then adding on
the value of the surplus capital as a separate item. In this instance, the discount rates
used would be determined separately on a business by business basis, and would
again apply only to risk capital, with surplus capital treated as risk free cash.
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