Challenges In Evaluating Financial Firms
BDO Bahrain
Introduction
Issues of Concern
The Bahraini banking sector is
composed of local, regional and
international firms. Realising that
its oil supply was limited, Bahrain
adopted a strategy of economic
diversification at an early stage.
As a result, Bahrain’s financial
sector in 2012 accounts for 25% of
the country’s GDP and is the largest
non-oil contributor to the national
balance sheet and is of prime
importance
to
the
country’s
economic prosperity.
As of March 2012, the Central Bank
of
Bahrain has licensed 23
conventional retail banks, 7 shariacompliant
retail
banks,
20
wholesale
banks
and
55
conventional wholesale banks.
As of 2012, 27 insurance and
reinsurance
firms
are
locally
incorporated in Bahrain, of which
nine operate according to sharia
principles (takaful) and a further 11
overseas firms are licensed to
operate within Bahrain.
In Detail
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Banks in Bahrain
7
20
55
23
Conventional Wholesale Banks
Conventional Retail Banks
Wholesale Banks
Sharia Compliant Retail Banks
Source - Central Bank of Bahrain 2012
The overall significance of the financial services industry to the economy of Bahrain
has prompted BDO to review and comment on the valuation practices suited to this
important sector.
Introduction
Issues of Concern
The
valuation
of
insurance
companies, retail and investment
banks pose several different issues to
those faced by the valuer when valuing
non-financial sector businesses due to
the nature of their operations. These
can be summarised as follows:

Free cash flows to the firms or
equity holders cannot be calculated
by
adjusting
for
capital
expenditure, working capital or
debt as for a non-financial services
business.

Financial services firms are strictly
regulated. Regulations control how
the business is run and how much
capital the bank needs to set aside
to keep operating.

Debt in financial services firms
cannot be classified as a source of
finance rather it is more akin to
raw materials.
In Detail
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“
All these factors render
the calculation of cost of
capital as a weighted
average of cost of debt
and cost of equity
meaningless, a constituent
part of valuing any business
using the Discounted Cash
Flow methodology, one of
the prime valuation
approaches
”
Introduction
Issues of Concern
Financial services firms are highly
regulated with regards to where and
how much they can invest. Retaining
and reinvesting capital is necessary for
future growth however, what classifies
as a reinvestment for financial services
firms is very different to non-financial
services firms. Non-financial services
firms invest in property and plant and
equipment where as financial services
firms mainly focus on investing in
assets like human capital and their
brand name.
In addition, financial services firms are
required to set aside capital to meet
the regulatory requirements for risk
management. Therefore, using free
cash flows adjusted for capital
expenditure relating to property and
plant and equipment may not be
enough for financial services firms.
Valuers should also account for
regulatory capital requirements which
are necessary for future growth and
sustainability of financial services
firms. In addition, due care should be
exercised for differences in regulatory
requirements when comparing cross
border firms as a benchmark for free
cashflows.
In Detail
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The calculation of free cash flows
is further complicated as searching
for
debt
in
the
financial
statements of financial services
firms is also fraught with
difficulties and inconsistencies.
Treating all short term and long
term
borrowings
(including
customer deposits) as debt will
present unreasonably high debt
ratios. In substance though, banks
do not have debt as it is their
business to borrow and lend money
and earn an interest margin on it.
Hence the definition of debt as we
see it in non-financial services
firms does not hold for financial
services firms.
Introduction
Issues of Concern
Given
the
difficulties
outlined
above, valuing financial services firms
using traditional cash flows to
calculate
enterprise
value
and
adjusting for debt to arrive at an
equity value may not be the right
approach. For valuation purposes we
can use dividends as they are a cash
flow to the equity holders and can
avoid the difficulty of determining the
cash flows for reinvestment. We can
also adjust the cash flows for the
reinvestments which financial services
firms make for example reinvestments
to meet the capital adequacy
requirements.
To ensure that the results are within
acceptable parameters and as a cross
check, analysts can also use relative
valuation methods typically the price
to book ratio for comparable listed
businesses operating in the same
sector. The balance sheet of the
financial services firms (banks in
particular) state the current market
values
of
most
assets
and
liabilities, therefore using price to
book ratios can overcome the typical
problem of using the ratio for nonfinancial services firms where the book
values usually represent historical
costs.
In Detail
About Us
Introduction
Issues of Concern
In Detail
About Us
BDO has provided valuation advice to
a wide range of businesses and for
diverse purposes dealing effectively
with issues arising from major
business transactions, including M&A
and valuations for financial reporting.
Based on our valuations experience
with several banks and reviewing the
valuation parameters used by other
analysts it seems that, despite the
obvious
difficulties
and
inconsistencies, analysts are still
using traditional cash flows for
valuing financial services firms
which, given the difficulties outlined
above, may not result in the most
appropriate valuation.
At BDO we have developed a team of
experts for valuing financial services
sector firms through attendance at
external industry specific training
courses
who
are
appropriately
experienced and qualified.
Our experts have experience in
conducting financial services firm
valuations for various purposes such
as annual impairment testing, dispute
resolution, sell-side assistance, buyside assistance, etc.
Our services can provide you with objective support, cost savings, enhanced leverage
in negotiations and overall superior decision making.
HOW WE CAN HELP YOU
If you would like further information
about this publication or our special
knowledge of this sector please
contact:
PHILIP ATKINSON
Director
philip.atkinson@bdo.bh
Contact us
BDO BAHRAIN
Business Development Department
17TH Floor, Diplomat Commercial
Office Tower
PO BOX 787, Manama
Kingdom of Bahrain
T: +973 1753 0077
F: +973 1791 9091
This publication has been written carefully but expresses general terms. BDO
Bahrain, its partners, employees and agents do not accept any liability or duty
of care for any loss arising from any action taken or not taken by anyone in
reliance on the information in this publication or for any decision based on it.