Principles of Bank Valuation  743
Assuming that ABC Bank continues to generate a 12.8 percent ROE on its 
new business investments in perpetuity while growing at 3.5 percent per year,7 
its continuing value as of 2025 is as follows:
CV
million
million
=
−




−
=
$
.
. %
. %
. %
. %
$
.
15 1
1
3 5
12 8
10 0
3 5
168 4
The calculation of the discounted value of ABC’s cash flow to equity is 
presented in Exhibit 38.7. The present value of ABC’s equity amounts to $134.2 
million, which implies a market-to-book ratio for its equity of 1.4 and a price-
to-earnings (P/E) ratio of 11.6. As for industrial companies, whenever possible 
you should triangulate your results with an analysis based on multiples (see 
Chapter 18). Note that the market-to-book ratio indicates that ABC is creating 
value over its book value of equity, which is consistent with a long-term return 
on equity of 12.8 percent (which is above the cost of equity of 10.0 percent).
Pitfalls of Equity DCF Valuation
The equity DCF approach as illustrated here is straightforward and theoreti-
cally correct. However, the approach involves some potential pitfalls. These 
concern the sources of value creation, the impact of leverage and business risk 
on the cost of equity, and the tax penalty on holding equity risk capital.
7 If the return on new equity investments (RONE) equals the return on equity (ROE), the formula can be 
simplified as follows:
CV
NI
ROE
ROE
t
t
e
t
e
g
k
g
E
g
k
g
=
−




−
=
−
−






+1 1
where E is the book value of equity.
EXHIBIT 38.7  ABC Bank: Valuation
$ million
Cash flow to 
equity (CFE)
Discount 
factor
Present value 
of CFE
2020
7.3
0.909
6.7
2021
8.1
0.826
6.7
2022
9.0
0.751
6.7
2023
9.9
0.683
6.7
2024
10.2
0.621
6.3
2025
10.6
0.564
6.0
Continuing value
168.4
0.564
95.0
Value of equity
134.2
Market-to-book ratio
1.4
P/E ratio1
11.6
1 Forward price-to-earnings ratio on 2020 net income.

744  Banks
Sources of Value Creation  The equity DCF approach does not tell us how 
and where ABC Bank creates value in its operations. Is ABC creating or de-
stroying value when receiving 6.5 percent interest on its loans or when paying 
4.3 percent on deposits? To what extent does ABC’s net income reflect intrinsic 
value creation?
You can overcome this pitfall by undertaking economic-spread analysis, 
described in the next section. As that section will show, ABC is creating value 
in its lending business but much less so in deposits, which were not creating 
any value before 2019 in this particular example. A significant part of ABC’s 
net interest income in 2019 is, in fact, driven by the mismatch in maturities of 
its short-term borrowing and long-term lending. The mismatch in itself does 
not necessarily create any value for shareholders, because they could set up a 
similar position in the bond market. The key question is whether ABC Bank 
can attract deposits and provide loans at better-than-market interest rates—
and this is addressed by economic-spread analysis.
Impact of Leverage and Business Risk on Cost of Equity  As for industrial 
companies, the cost of equity for a bank such as ABC should reflect its busi-
ness risk and leverage. Its equity beta is a weighted average of the betas of all 
its loan and deposit businesses. So when you project significant changes in a 
bank’s asset or liability composition or equity capital ratios, you cannot leave 
the cost of equity unchanged.
For instance, if ABC were to decrease its equity capital ratio, its expected 
return on equity would go up. But in the absence of taxes, this by itself should 
not increase the intrinsic equity value, because ABC’s cost of equity would 
also rise, as its cash flows would now be riskier. It will increase ABC’s value 
only to the extent that the bank is creating value on the deposit business that 
it is growing as a result of the leverage increase (see next section, on economic-
spread analysis).8
The same line of reasoning holds for changes in the asset or liability mix. 
Assume ABC raises an additional $50 million in equity and invests this in 
government bonds at the risk-free rate of 4.5 percent, reducing future returns 
on equity. If you left ABC’s cost of equity unchanged at 10.0 percent, the es-
timated equity value per share would decline. But in the absence of taxation, 
the risk-free investment cannot be value-destroying, because its expected re-
turn exactly equals the cost of capital for risk-free assets. There is no impact on 
value creation if we assume that the bank has no competitive (dis)advantage 
in investing in government bonds. The assumption seems reasonable, as it 
implies that the bank does not obtain the government bonds at a premium or 
8 Note that leverage has a different impact on the value of banks than on the value of industrial com-
panies. An industrial company’s value is not affected by leverage in the absence of corporate income 
taxes, because it is assumed that there is no value creation in the issuance of corporate debt raised at 
market rates (see Chapter 10).