Since there is not a special common framework for valuation banks and it gives possibilities to create establishment, improvement and adaptation of various approaches to measuring the value of banks and financial institutions.

Their financial statements are unlike those found in other industries, and once familiar concepts like working capital and operating income become confusing and difficult to define let alone calculate. The consequence is that to value a bank requires a wholly different approach which carries its own set of potential pitfalls that the investor must be aware of.

Most approaches banks valuation note the strong dependence of financial institutions.

The valuation is carried out by experts and expertise for different purposes and with varying degrees of methodological accuracy of the estimate of input factors.

n of dividends paid, potential dividends, and equity repurchases and issues.

The dividend discount model (DDM) is another theoretical extension of the neoclassical discounted cash flow models, which applies to banks since they are publicly traded companies. The general form of the model is presented by the formula:

 

Value per share of equity =

where
DPSi expected dividend per share in period t
Ki cost of equity.

 

The cost of equity for a bank has to reflect the portion of the risk in the equity that cannot be diversified away by marginal investment in the stock. Several methods are available to calculate the expected return on equity or discount rate for banks:

• - Gordon Growth Model
• - An average profitability
• - The cost of foreign funds
• - Capital Asset Pricing Model
• - Arbitrage Pricing Theory model

 

The income-based approach is a well-recognized and frequently used valuation methodology, which has received wide application in practice, mostly because the bank’s value is determined by its future performance, which is of significant concern for shareholders and other suppliers of capital.

Contingent claim valuation

Up to this point we have discussed the classical approaches to valuation.
In recent years, option pricing models (binominal, Black-Scholes-Merton, etc.), based on more advanced mathematical appliance, have been introduced. We suppose that they might be used for bank valuation as well.

The Black-Scholes-Merton model is a function of six input factors:

 

• 1) the current price of the underlying stock (S)
• 2) the dividend yield of the underlying stock (R)
• 3) the option strike price (X)
• 4) the risk-free rate over the life of the option contract ( ef-Rt )
• 5) the time remaining until option expiration (t)
• 6) the price volatility of the underlying stock (σ)

 

The discussion in this article has given an overview of valuation approaches which are applicable to banks. Generally, since each approach involves different advantages and disadvantages, there are gains to considering several approaches simultaneously.

Recently, as an impact of the financial crisis, banks have suffered from losses, which have significantly decreased their economic value.

As a result, shareholders’ and customers’ confidence in profitable bank performance has diminished.