Financial Firm Valuation Challenges

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In his 2025 book "Investment Valuation" (4th edition), Aswath Damodaran explains the three major ways financial service firms break conventional analysis and valuation practices:

These distinctions change every aspect of valuation, from calculating cash flows to estimating growth rates to determining fair value. Standard models simply don’t capture how financial service firms create and measure value.

This post discusses the different types of financial service firms, explains their unique characteristics that make standard valuation methods fail, and shows how to adapt valuation approaches to handle these challenges.

This section provides a condensed overview of how different financial service firms generate revenue, which helps determine the appropriate valuation approach for each type.

Banks operate on a spread model, earning the difference between interest paid and received. A bank paying 2% on deposits while charging 5% on loans earns a 3% spread on those funds.

Beyond interest spreads, banks generate fee income from account services, payment processing, and advisory work. Large banks often combine traditional lending with investment banking, wealth management, and trading operations.

Pure lending banks face credit risk concentration and their profits depend entirely on interest rate spreads. Banks with substantial fee income have more predictable earnings streams that are less sensitive to interest rate changes.

Geographic concentration also affects risk, as regional banks depend heavily on local economic conditions while global banks can offset weakness in one market with strength in another.

Lastly, small banks in emerging markets often derive most income from traditional lending, while large money center banks might generate half their revenue from non-interest sources.

Insurance companies generate income through two distinct channels:

This dual income stream creates complexity. An insurer might have a combined ratio above 100%, meaning it pays out more in claims and expenses than it collects in premiums, while still remaining profitable due to investment returns.

Alternatively, strong underwriting discipline that produces consistent profits can hide deteriorating investment returns from poor asset allocation decisions.

The type of insurance written affects financial characteristics:

The sustainability and quality of underwriting profits differs from investment returns, and mixing them together obscures the true earnings power of the business.

Investment banks earn fees for advisory services, helping companies raise capital, complete mergers, or restructure operations. Revenue closely follows market cycles: when markets decline, companies postpone deals and fee income drops sharply.

Trading operations add another revenue source but increase risk. Proprietary trading, where banks risk their own capital, can produce large gains or losses depending on market movements. Even market-making for clients requires holding inventory that faces price risk.

Investment management firms operate more predictably, earning percentage fees on assets under management (AUM). A firm managing $10B at a 1% fee generates $100M in relatively stable revenue. While market declines reduce AUM and therefore fees, the business doesn't face direct trading losses.

Boutique investment banks might focus on specific sectors or deal types, while large firms offer comprehensive services. Specialized firms face concentration risk - if their sector struggles, revenues collapse. However, deep expertise in profitable niches can support premium valuations during periods of high deal activity in those sectors.

For non-financial service companies, debt represents borrowed capital used to fund operations and growth.

Financial service firms operate differently, viewing debt as raw material to reshape into profitable products.

When a bank takes deposits from customers, it uses these funds to make loans at higher interest rates. The spread between what it pays depositors and charges borrowers generates profit. This key difference changes how we define capital for financial firms.

Damodaran explains this distinction:

This means capital at financial service firms includes only equity and equity-like instruments.

Regulatory authorities reinforce this definition by counting only equity capital when determining if banks meet minimum capital requirements, excluding any debt financing from these calculations.

There's also the question of what counts as debt for financial firms, which makes analyzing them more difficult.

For instance, should customer checking account deposits count as debt? These deposits often pay interest and function similarly to bonds the bank might issue.

Yet if we classify deposits as debt, we would calculate the bank's income differently. We'd have to count all the interest from loans as operating income, then subtract the interest paid to depositors separately.

This would make banks appear far more profitable than they actually are, since paying interest to depositors is their biggest expense.

Financial service firms operate under heavy regulations that affect nearly every aspect of their business. These regulations typically take three forms:

These regulatory requirements matter because they affect growth projections.

Banks must maintain certain ratios of equity capital, which is money invested by shareholders, relative to their total assets.

If a bank needs to maintain 10% equity capital and currently sits at 11%, aggressive growth forecasts would quickly violate regulatory minimums. This is why assumptions about future expansion must account for the additional equity capital required to support new assets.

Regulatory uncertainty can also affect both risk assessment and growth projections. For instance, rules that protected firms for decades can change, opening previously closed markets to competition or restricting profitable activities.

When forecasting cash flow growth, investors should know how much a company reinvests because growth comes from reinvestment.

Most companies measure reinvestment through two components:

Financial service firms face challenges with both components. First, measuring net capital expenditures (CapEx) becomes difficult because financial firms invest differently.

Rather than factories and equipment that show up as CapEx, they invest primarily in intangible assets such as brand development, human capital, and customer relationships.

A bank opening new branches might categorize most costs as operating expenses rather than CapEx. This means that employee training, marketing campaigns, and technology systems that enable future growth get expensed immediately rather than capitalized (spread over multiple years).

This accounting treatment creates two problems:

The second component, working capital changes, presents its own measurement issues.

Banks hold mostly financial assets (loans to customers) and financial liabilities (deposits from customers) that constantly change as part of normal operations.

Consequently, calculating working capital becomes meaningless when a bank making more loans or taking more deposits shows massive working capital swings that have nothing to do with reinvestment for growth.

Therefore, without clear reinvestment measures, two key problems arise:

This forces investors to develop alternative approaches that work within these constraints (as discussed below).

Given the unique characteristics of financial service firms (debt as raw material, heavy regulation, and unclear reinvestment), standard valuation approaches become unworkable.

This creates challenges for both major valuation methodologies (DCF and Comps).

When using discounted cash flow (DCF) valuation, most companies can be valued two ways:

For financial service firms, valuing the entire business becomes nearly impossible. Since we can't separate debt from operations, we can't calculate cash flows before debt payments.

We also can't determine a proper cost of capital, as measured by the weighted average cost of capital (WACC), when debt isn't truly capital.

This leaves only one practical option: value the equity directly by projecting cash flows available to shareholders and discounting them at the cost of equity (i.e., with the capital asset pricing model (CAPM)).

The same logic applies to comparable company analysis using valuation multiples.

Price-to-earnings (P/E) and price-to-book (P/B) ratios work for financial firms because they focus on equity. Enterprise value multiples like EV/EBITDA fail because we can't properly calculate enterprise value without knowing what counts as debt.

Now that we've established the need to value equity directly, the normal approach would be to calculate FCFE using its formula:

However, we've already established that financial service firms don't have meaningful CapEx or working capital figures. This means we cannot calculate FCFE using the formula shown above. This leaves investors with two options:

Each approach handles the reinvestment challenge differently, but both focus on equity valuation as the only practical path forward for financial service firms.