The Challenges of Conducting a Business Valuation for a Bank

Small business valuation software

Conducting a business valuation for a bank can be particularly difficult. The financial statements of banks are unique and unlike those of other industries. As such, determining the company valuation of a bank takes an unique approach.

The financial statements provide many key inputs to the business valuation process. The two most important statements needed are the income statement and balance sheet. Banks use mark-to-market accounting whereby assets and liabilities are carried at their fair market value. The result of this is that what would be unrealized gains and losses in another industry are actually realized on a bank’s financial statements.

Another key difference between the balance sheets of banks and operating companies is that banks do not distinguish between short and long-term assets and liabilities. Most of a bank’s assets are cash and cash equivalents, including cash kept on-hand in the company vault, deposits held at other banks, and any Fed Funds sold. Other assets may be investments securities or loans. Liabilities, on the other hand, are primarily deposits but may also include any Fed Funds the bank purchased.

A bank’s balance sheet can be particularly confusing because unlike in other industries where cash is the byproduct of selling products or services, for a bank, cash is both the raw material used to generate revenue and the final product. As such, bank balance sheets don’t have items such as inventory, trade receivables or property, plant and equipment. Instead, banks’ balance sheets have items such as loan losses, investments, and trading portfolio.

One method of conducting a business valuation is from the business’s earning power and risk assessment. To determine a bank’s risk assessment, the best place to start is the balance sheet where you can evaluate the loan-to-deposit and loan-to-asset ratios. A high value on either of these ratios signals a bank with higher liquidity risk. A bank with low loan-to-deposit or asset ratios, on the other hand, poses a lower liquidity and credit risk. Keep in mind when using these ratios as a business valuation tool, however, that with lower risk comes lower potential reward. A bank with low loan-to-deposit or asset ratios also has a lower earning power.

Another place to assess risk on the balance sheet is through the bank’s capital. Capital is essentially the “cushion” that will help banks absorb any losses or expand its assets. Banks must abide by certain regulations in terms of the minimum size of this cushion.

In addition to evaluating a business’s earning power and risk assessment, there are two other primary means of business valuation: through a comparison to similar businesses or based on the business in question’s assets. The former is known as the market Approach to business valuation while the latter is simply the asset approach.

Under the market approach, you will need to determine the best banks for comparison. This can be a deceptively hard task. The U.S. has 5,338 commercial banks. These range from large financial institutions to smaller community banks. The best competitor to use as a company valuation tool will depend on a number of factors such as:

  • The size of the bank
  • The location of the bank
  • The bank’s profitability
  • The bank’s loan composition
  • The bank’s growth

After applying these criteria, you will ideally have a small pool of banks with similar asset levels and return on equity rations who operate in the same region as your bank and have similar financial statements.

If you opt to use the asset approach to bank business valuation, it’s important to understand how bank’s assets differ from operating companies. As mentioned above, a bank’s assets include cash kept on-hand in the company vault, deposits held at other banks, and any Fed Funds sold. Loans are the primary asset for most banks because they earn more interest than most securities the bank owns and thus provide a better source of revenue. Bank assets also include tangible items which can be sold for cash such as buildings owned by the bank.

Regardless of the business valuation tools you apply, it’s important to start with a solid understanding of the banking industry and how banks differ from operating companies. The unique way in which banks measure their business on their financial statements requires unique business valuation services and methods.

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