How to Value a Bank (1995)

Wile bank owners usually have a sense of what their businesses are worth, Internal Revenue Service and minority shareholders sometimes want specific numbers. A formal valuation is most needed at critical junctures during a bank's life cycle, such as: 1. When there's a change in ownership, especially if a dispute arises. 2. When owner gifts all or a portion of bank's stock to heirs. 3. When a stock option or warrant is exercised. 4. When an Employee Stock Ownership Plan is formed. Providers of professional bank valuations take caution in defining business because term is open to interpretation. Accountants, for example, may take to mean Insurance companies tend to concentrate on insurable value, and investors consider going-concern value. This article will explore accepted procedures for determining market value--the proceeds a bank owner would get upon sale. An accepted definition of fair market value is the amount at which an exchange would occur between a willing buyer and seller, provided both parties are fully aware of all facts and seller is not under a compulsion to sell. Valuation factors At a minimum, IRS suggests that following factors, as described in Revenue Ruling 59-60, be considered when valuing a business: 1. The nature of and its history. 2. The economic outlook in general and condition and outlook of specific industry. 3. The book value of stock and financial condition of business. 4. The earnings and dividend-paying capacity of company. 5. Whether or not enterprise has goodwill or other intangible value. 6. Sales of company stock and size of block of stock to be valued. 7. The market price of stocks of corporations engaged in a similar line of where stock is actively traded in a free and open market, either on an exchange or over-the-counter. There are three overall methods used in appraising value of a bank: income approach, market approach, and asset approach. Based on these, an appraiser will likely use several valuation calculations to estimate a range for fair market value of a company. The relative weight assigned to each computation depends on several issues including stability of historical earnings; projected future earnings; number of tangible assets appearing on balance sheet; quality of available information; and purpose of valuation. There is much subjectivity in valuation process because of lack of perfect information; insufficient data on comparable companies; and imprecision in making adjustments in order to calculate fair market value. Income approach The income approach values a bank based on its historical and projected earnings and cash flows. There are two basic calculations--capitalization of historical cash flow and discounted projected net cash flow. Under capitalization of historical cash flow approach, normalized historical cash flows are viewed as an indication of a bank's future capacity to provide returns to both debt and equity holders. The key to this method is determination of a normalized historical cash flow estimate and calculation of a capitalization rate that is appropriate for particular cash flow base. The normalization process adjusts bank's historical cash flows to reflect industry norms. It eliminates any effects of unusual events or circumstances as well as industry highs and lows that are inconsistent with average or expected level of cash flows. A normalized cash flow is then determined using a suitable rate of return that reflects risk associated with receipt of that cash flow and market's required rate of return for an investment in bank. The capitalization rate is weighted average cost of capital, which is a function of required rates of return on debt and equity, as dictated by capital markets. …