Principles of Bank Valuation  741
Over the five years analyzed, ABC’s loan portfolio has grown by around 
3.0 to 3.5 percent annually. Since 2015, ABC’s interest rates on loans have been 
declining from 7.0 percent to 6.5 percent in 2019, but this was offset by an even 
stronger decrease in rates on deposits from 5.0 percent to 4.3 percent over the 
same period. Combined with the growth in its loan portfolio, this lifted ABC’s 
net interest income from $22 million in 2015 to $29 million in 2019. The bank 
also managed to improve its cost-to-income ratio significantly from a peak 
level of 53 percent in 2016 to 45 percent in 2019.
Higher regulatory requirements for equity risk capital forced ABC to dou-
ble its Tier 1 ratio (equity to total assets) from 4 percent to 8 percent over the 
period. The combination of loan portfolio growth and stricter regulatory re-
quirements has forced ABC to increase its equity capital by some $50 million 
since 2015. As a result, ABC’s return on equity declined significantly in 2019 
to 12 percent, from nearly 20 percent in 2016.
Exhibit 38.6 shows the financial forecasts for ABC Bank, assuming its 
loan portfolio growth rate increases to 4.5 percent in the short term and 
settles at 3.5 percent in perpetuity. Interest rates on loans and deposits are 
expected to decrease to 6.1 and 3.9 percent, respectively. Operating expenses 
will decline to 43 percent of net interest income. As a result, ABC’s return on 
equity increases somewhat to 12.8 percent in 2021 and stays at that level in 
perpetuity. Note that a mere one-percentage-point increase in interest rates 
on loans would translate into a change in return on equity of around 12 per-
centage points, a function of ABC’s high leverage (equity capital at 8 percent 
of total assets).
Discounting Equity Cash Flows
To estimate the cost of equity, ke, for ABC Bank, we use a beta of 1.1 (based on 
the average beta for its banking peers), a long-term risk-free interest rate of 
4.5 percent, and a market risk premium of 5 percent:6
k
r
e
f
=
+
×
=
+
×
=
β
MRP
4 5
1 1 5 0
10 0
. %
.
. %
. %
where rf is the risk-free rate, β is the equity beta, and MRP is the market risk 
premium. (There is no need to adjust any estimates of equity betas of banking 
peers for leverage when deriving ABC’s equity beta, assuming that banking 
peers have similar capital coverage ratios.)
In the equity DCF approach, we use an adapted version of the value driver 
formula presented in Chapter 3, replacing return on invested capital (ROIC) 
and return on new invested capital (RONIC) with return on equity (ROE) and 
6 See Chapter 15 for more details on estimating the cost of capital.

742  Banks
return on new equity investments (RONE), and replacing net operating profit 
after taxes (NOPAT) with net income:
CV
NI
RONE
t
t
e
g
k
g
=
−




−
+1 1
where CVt is the continuing value as of year t, NIt+1 is the net income in year 
t + 1, g equals growth, and ke is the cost of equity.
EXHIBIT 38.6  ABC Bank: Financial Forecasts
$ million
2020
2021
2022
2023
2024
2025
Balance sheet1
Loans
 1,226.2 
 1,281.4 
 1,332.6 
 1,379.3 
 1,427.6 
 1,477.5 
Total assets
 1,226.2 
 1,281.4 
 1,332.6 
 1,379.3 
 1,427.6 
 1,477.5 
Deposits
 1,128.1 
 1,178.9 
 1,226.0 
 1,268.9 
 1,313.4 
 1,359.3 
Equity
 98.1 
 102.5 
 106.6 
 110.3 
 114.2 
 118.2 
Total liabilities
 1,226.2 
 1,281.4 
 1,332.6 
 1,379.3 
 1,427.6 
 1,477.5 
Income statement
Interest income
 71.6 
 74.8 
 78.2 
 81.3 
 84.1 
 87.1 
Interest expense
 (41.6)
 (43.4)
 (45.4)
 (47.2)
 (48.9)
 (50.6)
Net interest income
 30.0 
 31.4 
 32.8 
 34.1 
 35.3 
 36.5 
Operating expense
 (13.5)
 (13.5)
 (14.1)
 (14.7)
 (15.2)
 (15.7)
Operating profit before tax
 16.5 
 17.9 
 18.7 
 19.4 
 20.1 
 20.8 
Income taxes
 (5.0)
 (5.4)
 (5.6)
 (5.8)
 (6.0)
 (6.2)
Net income
 11.6 
 12.5 
 13.1 
 13.6 
 14.1 
 14.6 
Cash flow statement
Net income
 11.6 
 12.5 
 13.1 
 13.6 
 14.1 
 14.6 
(Increase) decrease in equity
 (4.2)
 (4.4)
 (4.1)
 (3.7)
 (3.9)
 (4.0)
Other comprehensive (income) loss
–
–
–
–
–
–
Cash flow to equity
 7.3 
 8.1 
 9.0 
 9.9 
 10.2 
 10.6 
Key ratios, %
Loan growth
 4.5 
 4.5 
 4.0 
 3.5 
 3.5 
 3.5 
Loan interest rate
 6.1 
 6.1 
 6.1 
 6.1 
 6.1 
 6.1 
Deposit growth
 4.5 
 4.5 
 4.0 
 3.5 
 3.5 
 3.5 
Deposit interest rate
 3.9 
 3.9 
 3.9 
 3.9 
 3.9 
 3.9 
Cost/income
 45.0 
 43.0 
 43.0 
 43.0 
 43.0 
 43.0 
Tax rate
 30.0 
 30.0 
 30.0 
 30.0 
 30.0 
 30.0 
Equity/total assets
 8.0 
 8.0 
 8.0 
 8.0 
 8.0 
 8.0 
Return on equity2
 12.3 
 12.8 
 12.8 
 12.8 
 12.8 
 12.8 
1 Book value per end of year.
2 Return on beginning-of-year equity.