High Level Questions Flashcards
Walk me through a bank’s income statement
- Net Interest Income: A bank’s income statement starts with interest income less interest expense - the difference between the interest the bank earns on loans and the interest a bank must pay on deposits.
- Non-Interest Income: The next line items are income not related to interest, e.g. fees, commissions, service charges, and trading gains.
- Provision for Credit Losses: An expense that accounts for expected losses due to bad loans.
- Non-Interest Expenses: The next line item captures non-interest expenses, such as salary and employee benefits, amortization, and insurance expenses.
- Net Income: The final line item is income tax expense, which once subtracted, leaves us with net income.
Walk me through a bank’s balance sheet
- Assets: A bank’s largest asset will be its loan portfolio, which is comprised of residential and commercial real estate, as well as loans for both businesses and individuals. Other common assets include investments and cash.
- Liabilities: Deposits are typically the largest liability on a bank’s balance sheet, and interest-bearing deposits will contribute to its interest expense. Short and long-term borrowings typically account for the rest of a bank’s liabilities.
- Equity: The equity section of a bank’s balance sheet is fairly similar to that of a typical company’s, as it comprises of common stock, treasury stock, and retained earnings.
What is the impact of an inverted yield curve on a bank’s profit?
Banks make a profit via long-term lending, which is funded via short-term borrowing, so banks make a greater profit when there is a larger spread between short and long-term rates.
When yield curves flatten or invert, the opposite is happening; i.e., the spread between short and long-term yields is shrinking, so the bank’s profits will contract.
What multiples are appropriate for valuing a bank?
- Price to book (P/B)
- Price to earnings (P/E)
- Price to tangible book value (P/TBV)
Can you explain how a commercial bank makes money?
First, the bank gets money (deposits) from customers and then loans it out at higher interest rates, to businesses (and other organizations) that need to borrow money.
Banks make money on the interest rate spread: the difference between the interest it pays to depositors and the interest it charges on loans
Additionally, many large commercial banks have non-interest sources of revenue such as credit card fees, asset management fees, investment banking, and sales & trading
How does an insurance firm make money?
Insurance companies make money in 2 ways:
1) Thru the premiums they receive from customers who buy insurance protection
2) Income from investment portfolios that they maintain to service their claims
How are commercial banks different from normal companies?
5 key differences:
1) Balance sheet-centric: unlike normal companies that sell products to customers, banks are Balance Sheet-driven and everything else flows from the deposits they take in from customers and the loans they make with them
2) Difficulty differentiating Operating activity from Financing activity? For normal companies it’s easy to categorize activities as operating, investing, or financing, but for banks it’s much tougher because debt is used as a raw material to create their “products” - loans
3) Can’t use Enterprise Value for valuation: Enterprise Value and Enterprise Value-related multiples have no meaning for banks, because you can’t define what debt means and you can’t separate operations from financing. So you use Equity Value and Equity Value-based multiples instead
4) Cash flow can’t be defined: metrics like cash flow from operations and free cash flow have no meaning for banks because CapEx is minimal and swings in Working Capital can be massive - so you need to use Dividends or Residual Income as a proxy for cash flow in valuations
5) Regulation: Finally, banks operate under a set of regulatory requirements that limit the loans they can issue and their leverage; they must also maintain certain capital levels at all times
What about asset management and investment banking firms? Are they different as well?
The points above only apply to commercial banks – e.g. institutions that accept deposits from customers and then issue loans to other customers, effectively making money based on the interest rate spread.
Asset management firms and pure investment banks do not do this, so they are closer to normal companies and you can still look at metrics like EBITDA and revenue growth.
How are insurance companies different from normal companies?
The 5 key differences above between banks and normal companies also apply here: they’re Balance Sheet-centric, Operational and Financing activities are difficult to separate, they’re Equity Value-based, “Free Cash Flow” doesn’t mean much, and regulatory capital is extremely important.
In addition, there are a few more differences to note:
• Premiums rather than Loans / Deposits drive everything for insurance.
• Non-Interest Revenue is more significant and tends to be higher as a percentage than it is for banks, because insurance firms earn so much from Premiums.
• They use Statutory Accounting, a different system from IFRS / GAAP that is closer to cash accounting in some ways.
• Valuation is similar to commercial bank valuation, but Embedded Value is an extremely important methodology for Life Insurance (see the Valuation section).
How are the 3 financial statements different for a commercial bank?
Balance Sheet: Loans on the Assets side and Deposits on the Liabilities side are the key drivers; you also see new items like Allowance for Loan Losses (a contra-asset) and more categories for Investments and Securities; common working capital items like Inventory may not be present.
• Income Statement: Revenue is divided into Net Interest Income and Non-Interest Income; COGS does not exist; Provision for Credit Losses is a major new expense; operating expenses are labeled Non-Interest Expenses.
• Cash Flow Statement: It’s similar but the classifications are murkier; all Balance Sheet items must still be reflected here and Net Income still flows in as the first item at the top, but you also see new items like Provision for Credit Losses, a non-cash expense that must be added back.
How are the 3 statements different for an insurance firm?
• Balance Sheet: Assets are split into Investment Assets and Non-Investment Assets (Cash, Premiums Receivable, Reinsurance Recoverables, Deferred Acquisition Costs, and then normal items). Liabilities is similar but there are a number of Reserves for Claim Expenses and Unearned Premiums (similar to Deferred Revenue).
• Income Statement: Revenue is divided into Premiums, Net Investment and Interest Income, Gains / (Losses), and Other; COGS does not exist; Claims are the major expense, as well as G&A, Commissions, and Interest.
• Cash Flow Statement: It’s similar, but you also need to reflect changes in the new Balance Sheet items such as Deferred Acquisition Costs.
How would you value a commercial bank?
You still use public comps and precedent transactions, but:
• You screen based on Total Assets or Deposits rather than the usual Revenue and EBITDA criteria; your criteria should also be much narrower because few banks are directly comparable.
• You look at metrics like ROE, ROA, Book Value, and Tangible Book Value instead of Revenue and EBITDA.
• You use multiples such as P / E, P / BV, and P / TBV instead.
Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:
• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s Dividends in future years and then add it to the present value of the bank’s terminal value, which is based on a P / BV or P / TBV multiple.
• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and add the present value of the Excess Returns to that Book Value to value it. The “Excess Return” each year is (ROE * Book Value) – (Cost of Equity * Book Value). Basically, it’s how much the returns exceed your expectations by.
You use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source.
What are common metrics and valuation multiples when analyzing banks?
• Book Value (BV): Shareholders’ Equity
• Tangible Book Value (TBV): Shareholders’ Equity – Preferred Stock – Goodwill – (Certain) Intangible Assets
• EPS: Net Income to Common / Shares Outstanding
• Return on Equity (ROE): Net Income / Shareholders’ Equity
• Return on Assets (ROA): Net Income / Total Assets
• P / E: Market Price Per Share / Earnings Per Share
• P / BV: Market Price Per Share / Book Value Per Share
• P / TBV: Market Price Per Share / Tangible Book Value Per Share
There are more variations – for example, you could look at the Common Book Value, the Return on Common Equity, the Return on Tangible Common Equity, and so on.
The “Return On” metrics tell you how much in after-tax income a bank generates with the capital it has raised or the Assets it has on-hand; the P / BV and P / TBV multiples tell you how the market is valuing a bank relative to its Balance Sheet.
How would you value an insurance firm?
Mostly the same way as you would value a commercial bank: with P / E, P / BV, and P / TBV multiples for public comps and precedent transactions, and with a Dividend Discount Model (DDM) instead of the normal DCF analysis.
There are also a few new methodologies: you can create a Net Asset Value (NAV) model where you adjust the Assets and Liabilities to their true market values and subtract to estimate the value – that’s not as relevant for commercial banks because their Balance Sheets are marked to market.
And for Life Insurance, there’s Embedded Value, which adds a firm’s adjusted Book Value (see above) to the present value of its future profits from its insurance policies and measures its value based on that.
What are common metrics and multiples you look at for insurance firms?
Many of the metrics and multiples are similar to bank metrics: BV, TBV, EPS, ROE, ROA, P / E, P / BV, and P / TBV.
A few additional metrics that matter: the Loss Ratio (LAE Ratio) (the Claims or Loss Expense divided by Net Earned Premiums), the Expense Ratio (Commission + Underwriting Expenses divided by Net Written premiums) and then the Combined Ratio, which sum both of these ratios and gives an overall picture of profitability.
You can also calculate Net Asset Value (Adjusted Assets – Adjusted Liabilities – Capital Deficiency) for insurance firms and make a multiple out of that (P / NAV).
Finally, Embedded Value is very important on the Life Insurance side – it adds the firm’s Adjusted Book Value to the present value of their future profits from insurance policies. You can also make metrics and multiples out of it (Embedded Value Profit, Return on Embedded Value, P / EV…).
