Dividend Discount Model - Commercial Bank Valuation (FIG)

Introduction

This tutorial provides a comprehensive guide on using the Dividend Discount Model (DDM) for valuing commercial banks. Unlike traditional Discounted Cash Flow (DCF) analysis, the DDM is more suited for banks due to their unique financial structures and regulatory constraints. We will outline the steps necessary to set up a DDM, allowing you to project dividends based on key financial metrics.

Step 1: Make Assumptions

Start by establishing the foundational assumptions needed for your model. Focus on the following key metrics:

• Total Assets
• Asset Growth
• Targeted Tier 1 Capital Ratios
• Risk-Weighted Assets
• Return on Assets (ROA) or Return on Equity (ROE)
• Cost of Equity

These assumptions will guide your projections and ensure your model is grounded in realistic expectations.

Step 2: Project Assets and Risk-Weighted Assets

With your assumptions in place, proceed to project the bank's Total Assets and Risk-Weighted Assets. Consider factors such as:

• Historical growth rates
• Economic conditions
• Regulatory requirements

Ensure your projections align with the assumptions made in the previous step.

Step 3: Project Net Income

Next, calculate the bank's Net Income using either ROA or ROE. Use the following formula:

• If using ROA: [ \text{Net Income} = \text{Total Assets} \times \text{ROA} ]
• If using ROE: [ \text{Net Income} = \text{Shareholders' Equity} \times \text{ROE} ]

This step is critical as it directly influences dividend projections.

Step 4: Project Shareholders' Equity

Project the Shareholders' Equity, also known as Tier 1 Capital, based on the targeted capital ratio. Consider the following:

• Growth in Net Income
• Retained earnings
• Any planned capital raises or distributions

This will help you understand how much equity the bank will have available.

Step 5: Back Into Dividends

Unlike traditional DDMs, you'll need to back into dividends. Set the dividends such that the minimum capital ratios are maintained. Use:

• Starting Shareholders' Equity
• Projected Net Income

This ensures compliance with regulatory capital requirements and reflects realistic distributions to shareholders.

Step 6: Flesh Out the Model

Enhance your model by adding:

• Key statistics
• Growth rates for assets, income, and dividends
• Other relevant metrics

This comprehensive approach will provide a clearer picture of the bank's financial health.

Step 7: Discount and Sum Up Dividends

Calculate the present value of projected dividends. Use the formula: [ \text{PV} = \frac{D}{(1 + r)^n} ] Where:

• (D) = Dividend in year (n)
• (r) = Cost of equity
• (n) = Year

Sum these present values to get the total value of dividends.

Step 8: Calculate Terminal Value

Estimate the Terminal Value at the end of your projection period. You can use the Gordon Growth Model: [ \text{Terminal Value} = \frac{D \times (1 + g)}{r - g} ] Where:

• (g) = Growth rate of dividends

Discount this value back to present value and add it to the total value of dividends.

Step 9: Calculate Implied Share Price

Determine the Implied Share Price using the formula: [ \text{Implied Share Price} = \frac{\text{Total PV of Dividends + PV of Terminal Value}}{\text{Number of Shares Outstanding}} ] Compare this with the actual Share Price to assess if the bank is undervalued or overvalued.

Conclusion

By following these steps, you can effectively use the Dividend Discount Model to evaluate commercial banks. Start with realistic assumptions, project necessary financial metrics, and ensure compliance with regulatory requirements. For further refinement, consider applying more advanced features like mid-year discounts, multiple growth stages, and other valuation methodologies. With practice, you can enhance your analysis and gain deeper insights into a bank's valuation.