Economics of Banking  737
commission and trading income. However, trading income collapsed during 
the credit crisis. Despite recovering somewhat since then, it has not regained 
pre-crisis levels.
As the banks have shifted their sources of income, the cyclicality of their 
profitability and market valuations has increased. This is measured by their 
return on equity and their market-to-book ratios (see Exhibit 38.2). These 
measures for the sector in both the United States and Europe rose sharply 
after 1995 to reach historic peaks in 2006. But they fell sharply during the 
credit crisis, with European banks suffering a second decline during the 2010 
euro bond crisis. In 2018, profitability and valuation levels remained well 
below their peak levels on both sides of the Atlantic, though American banks 
were much more successful than their European counterparts in regaining 
some ground.
EXHIBIT 38.2  Increased Cyclicality in Banking
0
1962
1972
1982
1992
2002
2012
2018
2012
2018
1962
1972
1982
1992
2002
U.S. banks1
U.S. banks1
EU banks2
EU banks2
0.5
1.0
1.5
2.0
2.5
3.0
3.5
–5
0
5
10
15
20
25
Market value of equity/book value of equity
Return on equity, %
1 U.S. banks: For 1962–2007, based on aggregate financials and valuation of 957 U.S. banks, of which 346 were active in 2007. For 2008–2013, based on a sample of 
509 U.S. banks active in 2013. For 2014–2018, based on a sample of largest 156 US banks active in 2014. Book value excludes goodwill. 
2 EU banks: For 1980–2007, based on aggregate financials and valuation of 113 EU banks, of which 109 were active in 2007. For 2008–2013, based on a sample of 
211 EU banks active in 2013. For 2014–2018, based on a sample of largest 80 EU banks active in 2014. Book value excludes goodwill.
Source: Bloomberg, Compustat, Datastream, CapitalIQ.

738  Banks
Principles of Bank Valuation
Throughout most of this book, we apply the enterprise discounted-cash-flow 
(DCF) approach to valuation. Discounting free cash flows is the appropriate 
approach for nonfinancial companies, where operating decisions and financ-
ing decisions are separate. For banks, however, we cannot value operations 
separately from interest income and expense, since these are the main catego-
ries of a bank’s core operations. It is necessary to value the cash flow to equity, 
which includes both the operational and financial cash flows. For valuation of 
banks, we therefore recommend the equity DCF method.4 To understand the 
principles of the equity DCF method, let’s explore a stylized example of a re-
tail bank. ABC Bank attracts customer deposits to provide funds for loans and 
mortgages to other customers. ABC’s historical balance sheet, income state-
ment, and key financial indicators are shown in Exhibit 38.3.
EXHIBIT 38.3  ABC Bank: Historical Financial Statements
$ million
2015
2016
2017
2018
2019
Balance sheet1
Loans
 1,030.0 
 1,063.5 
 1,097.5 
 1,133.7 
 1,173.4 
Total assets
 1,030.0 
 1,063.5 
 1,097.5 
 1,133.7 
 1,173.4 
Deposits
 988.8 
 999.7 
 1,009.7 
 1,043.0 
 1,079.5 
Equity
 41.2 
 63.8 
 87.8 
 90.7 
 93.9 
Total liabilities
 1,030.0 
 1,063.5 
 1,097.5 
 1,133.7 
 1,173.4 
Income statement
Interest income
 70.0 
 72.1 
 74.4 
 71.3 
 73.7 
Interest expense
 (48.0)
 (47.5)
 (47.0)
 (45.4)
 (44.9)
Net interest income
 22.0 
 24.6 
 27.5 
 25.9 
 28.8 
Operating expenses
 (11.2)
 (13.1)
 (14.3)
 (12.2)
 (13.0)
Operating profit before taxes
 10.8 
 11.6 
 13.2 
 13.7 
 15.9 
Income taxes
 (3.2)
 (3.5)
 (4.0)
 (4.1)
 (4.8)
Net income
 7.5 
 8.1 
 9.2 
 9.6 
 11.1 
Key ratios, %
Loan growth
 3.0 
 3.3 
 3.2 
 3.3 
 3.5 
Loan interest rate
 7.0 
 7.0 
 7.0 
 6.5 
 6.5 
Deposit growth
 3.0 
 1.1 
 1.0 
 3.3 
 3.5 
Deposit interest rate
 5.0 
 4.8 
 4.7 
 4.5 
 4.3 
Cost/income
 51.0 
 53.0 
 52.0 
 47.0 
 45.0 
Tax rate
 30.0 
 30.0 
 30.0 
 30.0 
 30.0 
Equity/total assets
 4.0 
 6.0 
 8.0 
 8.0 
 8.0 
Return on equity2
 18.9 
 19.7 
 14.5 
 10.9 
 12.2 
1 Book value per end of year.
2 Return on beginning-of-year equity.
4 See Chapter 10 for a comparison of the enterprise and equity DCF methods.