Principles of Bank Valuation  739
At of the end of 2018, the bank has $1.134 billion of loans outstanding with 
customers, generating 6.5 percent interest income. To meet regulatory require-
ments, ABC must maintain an 8 percent ratio of Tier 1 equity capital to loan 
assets, which we define for this example as the ratio of equity divided by total 
assets. This means that 8 percent, or $91 million, of its loans are funded by equity 
capital, and the rest of the loans are funded by $1.043 billion of deposits. The de-
posits carry 4.3 percent interest, generating total interest expenses of $45 million.
Net interest income for ABC amounted to $29 million in 2019, thanks to the higher 
rates received on loans than paid on deposits. All capital gains or losses on loans and 
deposits are included in interest income and expenses. Operating expenses such as 
labor and rental costs are $13 million, which brings ABC’s cost-to-income ratio to 
45 percent of net interest income. After subtracting taxes at 30 percent, net income 
equals $11 million, which translates into a return on equity of 12.2 percent.
As discussed in Chapter 10, the equity value of a company equals the present 
value of its future cash flow to equity (CFE), discounted at the cost of equity, ke:
V
k
e
t
e
t
t
=
+
=
∞
∑
CFE
(
)
1
1
We can derive equity cash flow from two starting points. First, equity cash 
flow equals net income minus the earnings retained in the business:
CFE
NI
OCI
t
t
t
t
E
=
−
+
∆
where CFE is equity cash flow, NI is net income, ΔE is the increase in the book 
value of equity, and OCI is noncash other comprehensive income.
Net income represents the earnings theoretically available to shareholders after 
payment of all expenses, including those to depositors and debt holders. However, 
net income by itself is not cash flow. As a bank grows, it will need to increase its eq-
uity; otherwise, its ratio of debt plus deposits over equity would rise, which might 
cause regulators and customers to worry about the bank’s solvency. Increases in 
equity reduce equity cash flow, because they mean the bank is issuing more shares 
or setting aside earnings that could otherwise be paid out to shareholders. The last 
step in calculating equity cash flow is to add noncash other comprehensive income, 
such as net unrealized gains and losses on certain equity and debt investments, 
hedging activities, adjustments to the minimum pension liability, and foreign- 
currency translation items. This cancels out any noncash adjustment to equity.5
Exhibit 38.4 shows the equity cash flow calculation for ABC Bank. Note 
that in 2015, ABC’s other comprehensive income included a translation gain 
on its overseas loan business, which was discontinued in the same year. ABC’s 
cash flow to equity was negative in 2016 and 2017 because it raised new equity 
to lift its Tier 1 ratio from 4 percent to 8 percent.
5 Of course, you can also calculate equity cash flow from the changes in all the balance sheet accounts. 
For example, equity cash flow for a bank equals net income plus the increase in deposits and reserves, 
less the increase in loans and investments, and so on.

740  Banks
Another way to calculate equity cash flow is to sum all cash paid to or 
received from shareholders, including cash changing hands as dividends, 
through share repurchases, and through new share issuances. Both calcula-
tions arrive at the same result. Note that equity cash flow is not the same as 
dividends paid out to shareholders, because share buybacks and issuance can 
also form a significant part of cash flow to and from equity.
Analyzing and Forecasting Equity Cash Flows
The generic value driver tree for a retail bank, shown in Exhibit 38.5, is con-
ceptually the same as one for an industrial company. Following the tree’s 
branches, we analyze ABC’s historical performance as laid out in Exhibit 38.3.
EXHIBIT 38.4  ABC Bank: Historical Cash Flow to Equity
$ million
2015
2016
2017
2018
2019
Cash flow statement
Net income
 7.5 
 8.1 
 9.2 
 9.6 
 11.1 
(Increase) decrease in equity
 (1.2)
 (22.6)
 (24.0)
 (2.9)
 (3.2)
Other comprehensive income (loss)
 0.2 
– 
–
–
–
Cash flow to equity
 6.5 
 (14.5)
 (14.8)
 6.7 
 7.9 
EXHIBIT 38.5  Generic Value Driver Tree for Retail Banking: Equity DCF Version
Value creation
Cost of equity
Growth
Return on equity
Operating 
expenses1
Additions to loan 
loss provisions1
Equity
Net interest
income
Interest rate 
liabilities1
Interest rate 
assets1
Liabilities
Assets
Cost/income
3 
7
1
1
2
3
4
5
6
7
2
5 
6
Capital ratio
4
Key value drivers
Interest rates on 
products
Volumes: Book 
values of assets and 
liabilities outstanding
Cost-to-income 
ratio: Operating costs 
of business relative to 
net interest income
Capital ratio: Equity 
requirements for 
assets outstanding
COE: Cost of equity 
based on asset-
liability mix
Growth: Growth of 
assets and liabilities
Loan losses: 
Expected future 
losses on loans 
outstanding
1 After taxes.