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A dissertation on Valuation Method.

Which to write a dissertation on Valuation Method.

The title is ” Firm Valuation: Which is model gives the most accurate share price, Dividend discount Model and Free cash flow to Equity ?”

I want to do a cross sectional application of these models to see how accurate they apply to these regions.
Also want to see if particular model suit particular regions.

Want to limit it to financial institutions only(BANKS) about 40 banks with 10 years data

The banks could be taken from
Nigeria stock exchange, South Africa Stock Exchange, Brazil Stock exchange, Argentina and Dubai stock exchange


1.0 Introduction.. 3

1.1      Background of the Study. 3

1.2 Aim of the study. 6

1.3 Justification of the study. 6

1.4 Limitations of the Study. 7

4.0 Literature Review.. 8

4.1 Valuation and Valuation Methods. 8

4.2 Dividend Discount Model 15

4.2.1 The General Model 16

4.2.2 Gordon Growth Model 16

4.2.3 Two-stage Dividend Discount Model 17

4.2.4 Three-stage Dividend Discount Model 19

4.3 Free Cash Flow to Equity. 19

4.3.1 Constant growth FCFE.. 20

4.2.2 Two-stage FCFE.. 20

4.3.3 Three-stage FCFE.. 21

Cross Sectional Application.. 22

Valuation in Nigeria. 22

Valuation in South Africa. 27

Valuation in Dubai 31

Valuation in China. 33

Valuation in Argentina. 33

Valuation in Brazil 33

3.0Research Methodology. 34

3.1 -Information gathering. 35

3.1.1 Sources of data. 35

3.1.2 Secondary data. 36

3.2 Data collection methods and instruments. 37

4.0 Results and Analysis of Results. 38

Conclusions. 45

References. 47

Appendices. 49

1.0 Introduction

1.1    Background of the Study

The purpose of this paper is to analyze valuation models used in the banking sector. Firm valuation as a concept was examined by the use and comparison of the Dividend discount Model and the Free cash flow to Equity Model in the valuation of share price in more than forty banks around different areas. Stock exchanges from different areas were examined in this study. They include Nigeria stock exchange, South Africa Stock Exchange, Brazil Stock exchange, Argentina and Dubai stock exchange. Cross-sectional applications of the models were also reviewed to see how accurately they apply to West Africa, South Africa, South America and the Middle East. In a cross-sectional study, both the Dividend discount Model and Free cash flow to Equity Model are evaluated to see if they fit particular regions. In the literature review, an analysis of whether any particular model fits a particular region is going to be analyzed. An analysis will be made for only financial institutions which include both Islamic and conventional banking systems with ten years of data analysis. The results got from the study suggested that the dividend discounted, and abnormal earnings models which provide a more accurate free cash flow to equity approach.  No significant valuation differences regarding the alternative values used for growth and discount rates.

The paper therefore seeks to compare two measuring techniques which are the dividend discount model and the free cash flow to equity model and see which one of these is a more accurate methodology for calculating the value of financial institutions in emerging stock markets such as those in South America, south and North Africa. The share price of various financial institutions will be calculated including the calculated and the actual share prices. The method that gives the least mean differences will be concluded to be the better method and model in the valuation of the stock prices of financial institutions in financial markets.

The financial statements of the various selected banks will be used to generate the free cash flow to equity and growth. The cost of equity of these banks will be calculated using specific risk free rates. The cost of equity will then be discounted giving a share price base of the calculation. This will then be compared to with the actual cash flow. Where the Dividend Discount Model is concerned, the dividend per share paid for the period will be used in valuation of these financial institutions. The cost of equity method of valuation will be used to calculate the share price. A comparison of the actual share price at a date of course, it will not be the same.

Since time immemorial firms have always been evaluated periodically in order to determine their performance. Bank valuation has always been a relevant topic that has gained interest from various stakeholder groups including market operators, academics, investors and governmental regulatory authorities (Dermine, 2009).  The motivation for these benefits can be seen because of the fact that banks play important roles in the economic systems of the world today. Banks determine the stability of the economic system. Financial institutions play a critical role in global commerce, therefore, having great power in the economic development of individuals, corporations, and states (Kogut, 2003). Therefore, the stability of the economy is always directly dependent of the stability of the banking system in the economy. Financial institutions operate solely as financial intermediaries that link those who have surplus money supplies and those who have a deficit of these supplies (Lewis, 1995). In 2007, after the global financial crisis, banks have been viewed as a prerequisite in the grounded economic growth of the region. The value creation ability of banks and other financial institutions in relation to their capabilities of risk control and management has become an important task under regulatory, academic and professional perspectives (Berlatsky, 2010).

As a result of this, two main bank valuation methods have been postulated in this study. They are the Dividend discount model and free cash flow to Equity Model. These have been effective means through which a firm can be valued, whether or not the firm is making profit or loss (Ang & Liu, 2003). As a result of these, valuation has become undoubtedly one of the best practices in business because it gives the actual situation of the business that ensures that the owners take the necessary measures in case the business performance is not good. However, different ways of evaluating firms exist and sometimes it’s better to compare them in order to know which is better amongst them depending on the results obtained (Copeland, Koller & Murrin, 2000).

With the globalization of world economies, capital has become more mobile. Valuation is gaining importance in emerging markets for the purposes of privatization, joint ventures, mergers and acquisitions, restructuring, and just for the basic task of running businesses to create value. Valuation is however, much more difficult in these environments because buyers and sellers face greater risks and obstacles than they do in developed markets such as those in Europe and North America. In recent years however, these risks and obstacles been more serious in the emerging markets of the middle east, north Africa, south Africa and south America. The basics of estimating a discounted cash flow value, that is, the future cash flows of a company or bank discounted at a rate that reflects potential risk, are the same everywhere you go in the world. For effective and reliable valuations, focusing on how to incorporate into a valuation the extra level of risk that characterizes many emerging markets is important. Those risks may include high levels of inflation, macroeconomic volatility, capital controls, political changes, war or civil unrest, regulatory change, poorly defined or enforced contracts and investor rights, lax accounting controls, and corruption.

In particular relation to banks and financial institutions, several discussions exist on specific approaches to bank valuation, which differ by assumptions and characteristics they are based on. However, it is possible to distinguish a general outline for discussion. The most important performance dimensions for banks are profitability and risk and not production possibilities and technology. As a result it can be noted in this study that particularly large banks rank lower in terms of PE and PBV value in relation to a comparison between banks in Dubai and Abu Dhabi. It therefore makes bank a business corporation organized for the purpose of maximizing the value of the shareholders’ wealth invested in the firm at an acceptable level of risk. In this case therefore, the more the risk the more the value to shareholders maximized.

Copeland et al. (2000), authors of the standard work on valuation, devoted one chapter to the specifics of valuing financial institutions. Other scholars too fail to give specifics to the valuation of banks and other financial institutions because of the complexities in their valuation processes.   Copeland et al. (2000) suggest that the major issue is a transfer pricing between three bank business units namely the retail banks division, the wholesale bank and a treasure. Therefore, the valuation process should take into consideration the determined business model of banking. “It is difficult, if not impossible, to value the bank’s equity by first valuing its assets which includes its lending function by discounting interest income less administrative expenses at the weighted average cost of capital, then subtracting the present value of its deposit business which includes interest expenses plus consumer bank administrative costs, discounted at the cost of debt. The study by Copeland also paid critical attention to the fact that bank liabilities consist of customer deposits and borrowings on funds markets, which perform the same function  but with a different margin. As a result, the spread between the interest received on loans and the cost of capital is so low that small errors in estimating the cost of capital can result in huge swings in the value of the bank.

1.2 Aim of the study

            Valuation of the firm’s performance plays a critical role in determining what strategies are to be employed in order to ensure that their profitability and effectiveness is improved. Therefore, this research paper is purposed to help the management of considered financial institutions to implement the necessary policies as a way of improving their performance and profitability. This paper also aims at providing an overview of the most common valuation techniques that apply to the banking industry. The analysis of the bank valuation is to be provided through a thorough and practical discussion on an appropriate application of bank valuation methods, their formulae, the structure for valuation and also their advantages and disadvantages. In order to settle the issues of the article, studies of relevant literature and financial analysts’ valuation reports were conducted by the use of several resources such as banks scope. The information collected was analyzed and conclusions have been made on the basis of the analysis.

1.3 Justification of the study

The models considered in this study have been based on particular firm valuation methods which are practically applied to evaluate a specific output. For instance, in this case, arguments based on both the dividend discount and the free cash flow to equity model have shown the significance of using the two models to determine which one can be accurately used to give share price. This study is important in that it documents and highlights the value these valuation models provide in the valuation of banks and financial institutions.  

1.4 Limitations of the Study

The study had many limitations including the fact that the results given in the various secondary sources are based on the findings of financial and banking institutions based on a purposefully selected group of countries. This sampled selection may have characteristics that are rather different and may not be representative from those of other countries across the globe. These countries chosen in the study include Nigeria in West Africa, South Africa, Brazil and Argentina in South America and Dubai in the Middle East. The sampling population of the banks evaluated may also have had some characteristics that were not representative to the whole population of banking institutions and products across all nations. The study also faced the limitation that the data and information obtained from the organizations financial statements were from a ten-year period between 1998 to 2008 indicating that the analysis was made specifically for that time and, therefore, may not denote any other periods before or after these dates.

4.0 Literature Review

4.1 Valuation and Valuation Methods

Firm valuation involves a set of procedures used for estimating economic value of an owner’s interest in a business. According to Anderson (2005) participants of financial markets use firm valuation in the determination of the price they willing to get or part with for the sale of the firm, business or asset to be complete.  Fishman (2007) notes that firm valuation in resolution of disputes by business appraisers. Valuation according to Damodaran (2006) has been considered the heart of finance. He suggests that understanding the factors that are determinants to the value of a financial institution and understanding the principles for the estimation of value are prerequisites to the making and formulation of operational and strategic decisions for the company. The valuation of a firm is, therefore, viewed as both an art and science in the sense that science takes the shape of quantitative models of risk-return while art usually refers to the judgment and experience that the appraiser obtains (Pereiro, 2002).

According to Pereiro (2002), the value of a company is dependent on what is being valued, for what purpose, how it is valued and for whom. The nature of the economy in which value is analyzed is, therefore, very important. How much a financial institution is worth, for example, is determinant on the operational risks that are involved in its economic environment. For example, in emerging markets such as Nigeria and Argentina, many financial institutions show a general volatility in returns as compared to other companies in more stable, mature and developed financial environments. Pereiro (2002) therefore argues that the volatility of a company means more risks and more risks mean more returns and therefore more business value in developed and predictable financial environment or less business value in an underdeveloped and unpredictable financial environment.

Valuation is a process that is used in the forecasting of the present value of the expected benefits to shareholders. Valuation also involves forecasting this benefit into one number that usually corresponds to the intrinsic asset base firm value. Damodaran (2001) insists that there are three fundamentals that determine the value of a business. They include a firm’s capability to generate cash flows from its existing investments, the expected growth of cash flows over a stipulated time period and the risk and uncertainty as to whether these cash flows will be generated in the first place. These three fundamentals remain the same even with the valuation of financial institutions, but the emphasis placed on each may defer depending on various circumstances.

Since this paper conducts an empirical examination of valuation techniques with a focus on the practical issues, the dividend discount model and the free cash flow to equity model are analyzed. These models to modern valuation specialists are equivalent but they have practical implementation issues that usually bring a difference to the findings of these valuation models. For example, the fundamentalists of these models need to forecast several common factors such as the required rate of return. The second most important factor to be determined in both these models is the cash flows growth rate. These two variables are usually forecasted differently depending on the approaches used and valuation techniques adhered to.

This paper conducts an empirical examination of valuation techniques with a focus on practical issues. Dividend, cash flow and earnings approaches are equivalent when the respective payoffs are predicted as a matter of going concern or in other terms to infinity. Practical analysts however require prediction over finite horizons. The problems this presents for going concerns are well known. In the dividend discount approach, forecasted dividends over the immediate future are often not related to value so the forecast period has to be long or an often questionable terminal value calculation made at some shorter horizon. Alternative techniques forecast fundamental attributes within the financial institutions. These valuation techniques on the other hand give consistent and identical estimates to the firm’s value when utilized provided all the forecasts and important factors mentioned earlier are identical.

In discounted cash flow (DCF) analysis the terminal value often has considerable weight in the calculation but its determination is sometimes ad hoc or requires assumptions regarding free cash flows beyond the horizon. Techniques based on forecasted earnings make the claim that accrual adjustments to cash flows bring the future forward relative to cash flow analysis, but this claim has not been substantiated in a valuation context. The valuation techniques are evaluated by comparing actual traded prices with intrinsic values calculated, as prescribed by the techniques, from subsequent payoff realizations. Ideally one would calculate intrinsic values from unbiased ex ante payoffs but, as forecasts are not observable for all payoffs, intrinsic values are.

Damodaran (2006) in his paper, “Valuation approaches and metrics”, mentioned four general methods to valuation. These include “the discounted cash flow valuation, which relates the value of an asset to the present value of expected future cash flows on that asset. Another is liquidation and accounting valuation, which is built around valuing the existing assets of a firm, with accounting estimates of value or book value often used as a starting point. The third, relative valuation, estimates the value of an asset by looking at the pricing of ‘comparable’ assets relative to a common variable like earnings, cash flows, book value or sales and the final approach is contingent claim valuation, which uses option-pricing models to measure the value of assets that share option characteristics” (Damodaran, 2006, p. 3).

Pereiro (2002) grouped approaches to company valuation into two: Intrinsic and Extrinsic valuation approaches. In intrinsic valuation, he explained that business value is determined through a precise net cash flow analysis generated by the business overtime. Extrinsic valuation in contrast is a shortcut used to simplify the exercise: instead of dissecting company cash flows, a business similar to the target under valuation, and whose market value is known, is used as a reference in which value is calculated by analogy. Intrinsic valuation include the discounted cash flow model, real option model, and asset accumulation model while the extrinsic is via the value multiples or relative valuation approach.

Vernimmen (2005) outlined many approaches to company valuation but for the purposes of this study, in line with Pereiro (2002, p. 68), we will explore the popularity of four main business valuation techniques among practitioners in the Nigerian emerging market including Models based in discounted cash flows and Models based in real options. The valuation principle implies that to value any security, we must determine the expected cash flows that an investor will receive from owning it. We begin our analysis of stock valuation by considering the cash flows for an investor with a one-year investment horizon. We will show how the stock’s price and the investor’s return from the investment are related. We then consider the perspective of investors with long investment horizons. Finally, we will reach our goal of establishing the first stock valuation method: the dividend-discount model.

There are two potential sources of cash flows from owning a stock. These sources are the total amount received in dividends and from selling the stock will depend on the investor’s investment horizon. Let’s begin by considering the perspective of a one-year investor. Because these cash flows are risky, we cannot discount them using the risk-free interest rate, but instead must use the cost of capital for the firm’s equity. We have previously defined the cost of capital of any investment to be the expected return that investors could earn on their best alternative investment with similar risk and maturity. Thus we must discount the equity cash flows based on the equity cost of capital, rE, for the stock, which is the expected return of other investments available in the market with equivalent risk to the firm’s shares. Doing so leads to the following equation for the stock price.

If the current stock price were less than this amount, it would be a positive-NPV investment. We would, therefore, expect investors to rush in and buy it, driving up the stock’s price. If the stock price exceeded this amount, selling it would produce a positive NPV and the stock price would quickly fall. The sum of the dividend yield and the capital gain rate is called the total return of the stock the total return is the expected return that the investor will earn for a one year investment in the stock. This result is exactly what we would expect. The firm must pay its shareholders a return commensurate with the return they can earn elsewhere while taking the same risk. If the stock offered a higher return than other securities with the same risk, investors would sell those other investments and buy the stock instead. This activity would then drive up the stock’s current price, lowering its dividend yield and capital gain rate.

The valuation techniques reviewed on this paper build on the notion that the market value of a share is the discounted value of the expected future payoffs generated by the share. Although the two models differ with respect to the payoff attribute considered, it can be shown that under certain conditions the models yield theoretically equivalent measures of intrinsic value. The discounted dividend model equates the value of a firm’s equity with the sum of the discounted expected dividend payments to shareholders over the life of the firm, with the terminal value equal to the liquidating dividend. For all other growth rates examined at 2%, 6%, 8%, and 10%, AE value estimates dominate FCF and DIV value estimates in terms of accuracy and smallest absolute bias.  The discounted free cash flow model substitute’s free cash flows for dividends, based on the assumption that free cash flows provide a better representation of value added over a short horizon. Free cash flows equal the cash available to the firm’s providers of capital after all required investments. The discounted abnormal earnings model is based on valuation techniques introduced by Preinreich (1938) and Edwards and Bell (1961).  Several studies investigate the ability of one or more of these valuation methods to generate reasonable estimates of market values. Kaplan and Ruback (1995) provide evidence on the ability of discounted cash flow estimates to explain transaction values for a sample of 51 firms engaged in high leverage transactions. Their results indicated that the median cash flow value estimate is within 10O% of the market price, and that cash flow estimates significantly outperform estimates based on comparables or multiples approaches. Frankel and Lee (1995; 1996) find that the value estimates explain a significantly larger portion of the variation in security prices than value estimates based on earnings, book values, or a combination of the two.

In addition to these horse races which pit theoretically based value estimates against one or more theoretically based value estimates, there are at least two studies which contrast the elements of, or the value estimates from, the DIV FCF, and AE models. Bernard (1995) compares the ability of forecasted dividends and fore-casted abnormal earnings to explain variation in current security prices. Specifically, he conducts a regression analysis current stock price on the current year, one year ahead, and the average of the three to five year ahead forecasted dividends and contrasts the explanatory power of this model with the explanatory power of the regression of current stock price on current book value and current year, one year ahead and the average of three to five year ahead abnormal earnings forecasts. He finds that dividends explain 29% of the variation in stock prices, compared to 68% for the combination of current book value and abnormal earnings forecasts. Penman and Sougiannis (1998) also compare dividend, cash flow, and abnormal earnings based value estimates using infinite life assumptions.

Using realizations of the payoff attributes as proxies for expected values at the valuation date, they estimate intrinsic values for horizons of T = 1 to T = 10 years, accounting for the value of the firm after time T using a terminal value calculations. Regardless of the length of the horizon, PS find that AE value estimates have significantly smaller (in absolute terms) mean signed prediction errors than do FCF value estimates, with DIV value estimates falling in between. Our study extends previous investigations by comparing individual securities’ DI, FCF, and AE value estimates calculated using ex ante data for a large sample of publicly traded firms. In addition to evaluating value estimates in terms of their accuracy (absolute deviation between the value estimate and market price at the valuation date, scaled by the latter), we contrast their ability to explain cross-sectional variation in current market prices. Both metrics assume that forecasts reflect all avail-able information and that valuation date securities prices are efficient with respect to these forecasts. Under the accuracy metric, value estimates with the smallest absolute forecast errors are the most reliable. The explain ability tests which compare value estimates in terms of their ability to explain cross-sectional variation in current market prices-control for systematic over- or underestimation by the valuation models. 

Therefore, in the valuation of banks and financial institutions, Damodaran (2002) considers the valuation of financial service firms with the special  role of debt in their functioning similar to the opinions of Copeland, Adams and Rudolf, all scholars who have written intensively about the valuation of financial institutions.  What is special about Damodoran’s opinion is that he sees debt for financial service institutions as a raw material and not as a source of capital. Damodaran also stated two practical problems in valuating banks. The first is that the estimation of cash flows could not be performed without estimating reinvestments. The second problem in the valuation of banks is that estimating expected future growth becomes more difficult if the reinvestment rate cannot be measured. Hence, it makes more sense to value equity directly at banks, rather than the entire firm.

Adams and Rudolf (2010) distinguish the characteristics of banking business into four categories. First off, banking is a heavily regulated industry. Second, banks operate on both sides of their balance sheets, actively seeking profits not only in lending but also in raising capital. Third, banks are exposed to credit default risk, but they also actively seek risk as a part of their business model. Last but not least, the profit and the value of a bank are much more dependent on the interest rate risk than other industries in different sectors.

An analysis of the revealed characteristics of banking which include risk, business model, and regulation means it  should be stated that only the models, which reflect these characteristics, should be chosen for valuation. In general terms, there are four approaches to valuation with numerous sub-approaches within each. The first, asset-based or accounting valuation, is built around valuing the existing assets of a firm, with accounting estimates of value or book value often used as a starting point. The second, market or relative valuation, estimates the value of an asset by looking at the pricing of ‘comparable’ assets relative to a common variable like earnings, cash flows, book value or sales. The third, income approach or, specifically, discounted cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. The fourth approach, contingent claim valuation uses option pricing models to measure the value of assets that share option characteristics. Each approach is applicable for bank valuation with several conditions.

The discussion on inputs and special cases such as stable growth could be found in Damodaran (2002). To value a stock, using the dividend discount model, the estimates of the cost of equity, the expected payouts ratios, and the expected growth rate in earnings per share over times are required. The expected dividend per share in a future period can be written as a product of the expected earnings per share in that period and the expected payout ratio. It allows us to focus on the expected growth in earnings which provide more accessible and reasonable data and change the payout ratio over time in order that it may reflect changes in growth and investment opportunities with time. However, the calculation of the discount factor for the model leads to some complications and shortcomings.

4.1.1 General Framework for Valuation

            Given the unique role of debt at financial service firms, the regulatory restrictions that they operate under and the difficulty of identifying reinvestment at these firms, the question of how these firms can be valued is critical.  In this section, we suggest some broad rules that can allow us to deal with these issues. First, it makes far more sense to value equity directly at financial service firms, rather than the entire firm. Second, we either need a measure of cash flow that does not require us to estimate reinvestment needs or we need to redefine reinvestment to make it more meaningful for a financial service firm. The distinction between valuing a firm and valuing the equity in the firm need to be made. We value firms by discounting expected cash flows prior to debt payments at the weighted average cost of capital. We value equity by discounting cash flows to equity investors at the cost of equity. Estimating cash flows prior to debt payments or a weighted average cost of capital is problematic when debt and debt payments cannot be easily identified, which, as we argued earlier, is the case with financial service firms.       

            Equity can be valued directly, however, by discounting cashflows to equity at the cost of equity. Consequently, this can be argued for the latter approach for financial service firms. We would extend this argument to multiples as well. Equity multiples such as price to earnings or price to book ratios are a much better fit for financial service firms than value multiples such as value to EBITDA. Another problem that arises is the estimating of cash flows in the valuation of banks and other financial institutions. To value the equity in a firm, normally, an estimate of the free cash flow to equity is required. The free cash flow to equity is:

Free Cash flow to Equity = Net Income – Net Capital Expenditures – Change in non-cash working capital – (Debt repaid – New debt issued)

Therefore, if the estimate of the net capital expenditures or non-cash working capital cannot be made, then it is clear that the estimate the free cash flow to equity. Since this is the case with financial service firms, two choices exist. The first is to use dividends as cash flows to equity, and assume that firms overtime pay out their free cash flows to equity as dividends. Since dividends are observable, we therefore do not have to confront the question of how much firms reinvest. The second is to adapt the free cash flow to equity measure to allow for the types of reinvestment that financial service firms. For instance, given that banks operate under a capital ratio constraint, it can be argued that these firms have to reinvest equity capital in order to be able to make more loans in the future.

4.2 Dividend Discount Model

The Dividend Discount Model (DDM) is the simplest tool for valuing equity. Whilst some analysts view the DDM as out-dated and inadequate there are still a lot of companies where the DDM still is viewed as a convenient instrument for estimating value (Damodaran, 2002). The dividend discount model estimates the equity value based on the idea that the value of the equity equals all future dividends discounted back to today, using an appropriate cost of capital as discount rate. The cost of capital used in each calculation is reflecting the integrated risk in that particular cash flow (Frykman & Tolleryd, 2003). Author Roberg G. Hagstrom describes, in his book “The Warren Buffett way” (2005), how one of the world’s greatest investors believes that the dividend discount model, created over sixty years ago by John Burr Williams, is the best system for determining the intrinsic value of a company.

4.2.1 The General Model

When an individual buys stock, there are two types of cash flows that he or she can expect to receive –namely the dividend that the stock will pay during the time it is owned and the expected price at which the stock can be sold.  In order to obtain the numerator, expected dividends per share, assumptions regarding future payout ratios and growth rates have to be made. The denominator, the cost of equity or required rate of return, is determined by its riskiness and is measured differently in different models, the market beta in capital asset pricing model (CAPM) and the factor betas in the arbitrage and multifactor models. Since the model just presented cannot be applied on “real” dividend projections, due to the assumption of an infinite timeline, numerous varieties of the dividend discount model have been established which are constructed around different assumptions about future growth (Damodaran, 2002).

4.2.2 Gordon Growth Model

The Gordon Growth Model is used mainly to value firms that are in stable growth with dividends growing at a rate that can be maintained for all eternity. Since the model assumes that the firm’s growth rate in dividends is expected to last forever, the term stable growth is widely discussed and questioned. One of the aspects of the Gordon growth model and its “stable growth” is that other performance measures, such as earnings, also can be projected to have the same annual growth rate as dividends. Hence, if a company’s earnings are growing faster than its dividend payout in the long run, the company’s payout ratio will slowly approach zero, and that is not a feature of a company in a steady state of growth. Furthermore, a firm in a “steady state” cannot have a growth rate that exceeds the growth rate of the economy in which the firm operates (Damodaran, 2002).

It is clear that the growth rate plays a crucial role in the model, and if used wrong, the resulting value will be incorrect or misleading. Given the equation, one can see that if a firm’s growth rate goes towards the cost of equity the value per share will approach infinity, and if the growth rate in fact surpasses the cost of equity the resulting value per share instantly turns negative. This means that if an analyst is about to use the Gordon growth model, the firm on which he calculates, has to grow at a rate equal or lower than the growth rate of the economy in which it operates. Another characteristic of a firm suitable for this model is that their dividends payout is in line with what they can afford; otherwise the model will surely undervalue its stock (Damodaran, 2002).

4.2.3 Two-stage Dividend Discount Model

In many cases, companies are witnessing two stages of growth, to begin with, the company may have a growth rate that is not stable, for example a young company on the run, or a company that expands to a new market), followed by a state where the growth rate stables out and is expected to stay there for the long run (Damodaran, 2002). The terminal growth rate, has to have the same characteristics as the growth rate used in the Gordon growth model and cannot exceed the growth rate in the economy where the firm operates. Furthermore, the estimated growth rate and the payout ratio have to be consistent with each other. This means that if the expectation is that the growth rate will drop considerably after the first period of growth, and then the payout ratio must be higher in the later, stable growth period, than it is in the initial growth phase. The idea behind this is that a firm that are currently in a stable growth phase is able to pay out more of their earnings as dividends compared to a firm that is growing (Damodaran, 2002).

According to Damodaran (2002) some guidelines concerning a firm’s beta-value and its return on equity exists. He states that a firm in high growth can be assumed to have a beta of 2.0, when entering stable growth – a firm’s beta-value should be somewhere between 0,8 and 1,2. The same assumptions hold for the return on equity, which can be high during the high growth phase, and then decrease as the firm, enter its stable growth phase. Although a two-stage dividend discount model is applicable on many firms, the model do has some important limitations that have to be considered. The first problem is to define the length of the initial high growth period. This is an important aspect to consider since the value of an investment will increase, as this initial period is made longer. The second problem is connected with the transition period when the firm goes from high growth to stable growth, where the two-stage dividend discount model assumes this to happen over night when in fact this process may happen gradually in real life. The last limitation with the model concerns the dividend payout policy of the firm being valued. A firm that does not pay out as much dividends as they could afford they might chose to reinvest, tends to be undervalued when valued with the two-stage dividend discount model.

A firm most suitable for the two-stage dividends discount model is a firm that is in high growth for a specific time period, and then is expected to assume a stable growth forever. As mentioned, the payout policy is important, to get as a fair value of a firm as possible, it should maintain a policy of paying out its cash (after paying debts and doing the necessary reinvestments as dividends (Damodaran, 2002).  Damodaran (2002) is further providing a troubleshooting guide that could be useful if the value per share his extremely high or low. For example, if you get a extremely low value, the stable period payout ratio is too low for a stable firm (<0.40), the beta in the stable period is too high for a stable firm, the two-stage model is being used when the three-stage model is more appropriate. If you get an extremely high value, the growth rate in the stable period is too high for a stable firm (Damodaran, 2002).

4.2.4 Three-stage Dividend Discount Model

The three-stage dividend discount model tackles one of the limitations of the two-stage dividend discount model since it includes not only an initial phase of high growth and an infinite lower stable growth, but in between them it includes third a phase where the growth rate declines, a transitional period (Damodaran, 2002). Since this formula for the three stage dividend discount model consists of more inputs than the other two dividend discount models, possible noise connected with the estimation process may affect the ending value wrongly even though the model is more flexible than others. The mentioned flexibility that the model has makes it suitable for firms that have very high growth rates3 in their earnings, which are expected to grow at those rates for an early period, but are later expected to drop progressively towards a stable rate (Damodaran, 2002).

4.2.5 Dividend discount model bank valuation illustration (State bank of India)

            State Bank of India is India’s largest bank, created in the aftermath of a nationalization of all banks in India in 1971. It operated as a monopoly for many years since then and was entirely government owned. In the 1990s, the Indian governments privatized portions of the bank while retaining control of its management and operations.

In the turn of the new millennium, State Bank of India earned 205 million Indian rupees on a book value of equity of 1,042 million rupees at the beginning of 2000, resulting in a return on equity of 19.72%. The bank also paid out dividends of Rs 2.50 per share from earnings per share of Rs. 38.98. This yields a payout ratio of 6.41%. The high retention ratio suggests that the firm is investing substantial amounts in the expectation of high growth in the future. We will analyze its value over three phases, an initial period of sustained high growth, a transition period where growth drops towards stable growth and a stable growth phase. If State Bank can maintain the current return on equity of 19.72% and payout ratio of 6.41%, the expected growth rate in earnings per share will be 18.46%:

Expected Growth rate = ROE * Retention ratio = 19.72% (1-.0641) = 18.46%

The key question is how long the bank can sustain this growth. Given the large potential size of the Indian market, we assume that this growth will continue for 4 years. During this period, we also allow for the fact that there will be substantial risk associated with the Indian economy by allowing for a country risk premium in estimating the cost of equity. Using the approach developed earlier in the book, we estimate a risk premium for India based upon its rating of BB+ and the relative equity market volatility of the Indian market.

Country risk premium for India = Country default spread * Relative equity market volatility = 3.00% * 2.1433

4.3 Free Cash Flow to Equity Model

Compared to the dividend discount models, which assumes dividends to be the only cash flow received by and available to stockholders, the free cash flow to equity models defines the payable amount as the cash left over, after meeting all financial obligations. The cash flow available to be paid out as dividends is best explained by illustrating how the financial obligations are considered in a mathematical formula. Apart from the obvious difference (dividends vs. FCFE) there are a lot of similarities between how to conduct valuations with the two different models. This means that instead of discounting the actual dividends paid, we discount the potential dividends in the free cash flow to equity models. The assumption is, thus, that we assume the FCFE to be paid out to the companies’ stockholders (Damodaran, 2002).

4.3.1 Constant growth FCFE

The constant growth model is similar to the Gordon growth model used for discounting dividends. The applied growth rate has to be rational and cannot be greater than the growth rate of the economy in which the company is active As a rule of thumb, growth rates over 25 percent would qualify as very high when the stable growth rate is between 6 and 8 percent (Damodaran, 2002).  Compared to the Gordon growth model this constant growth FCFE model is more suited for stable firms that are paying out dividends that deviates significantly from its free cash flow to equity. If a firm pays out exactly its free cash low to equity as dividends, the value obtained will be exactly the same as if we have used the Gordon growth model (Damodaran, 2002). If you after using the Constant Growth FCFE model believe that your value is either too high or too low, Damodaran (2002) has a troubleshooting guide for finding out what is wrong with the valuation. In his view, if you get a low value from this model, it may be because, capital expenditures are too high relative to depreciation, working capital as a percent of revenues is too high, the beta is high for a stable firm. He also states that if you get too high a value, it is because, capital expenditures are lower than depreciation, working capital ratio as percent of revenue is negative or the expected growth rate is too high for a stable firm.

4.2.2 Two-stage FCFE

The same type of growth applies on the two-stage FCFE model as the two-stage DDM model, namely that the growth rate will be constantly high during an initial phase and then drop down to a stable growth rate that will go on forever. It is appropriate to use the model when valuing firms with dividends levels that are unmaintainable or below what the firm actually can afford to pay out. The value of a stock is calculated by taking the present value of the FCFE per year (for the high growth period) plus the present value of the terminal price at the end of the period (Damodaran, 2002).

Damodaran (2002) is as for the previous models providing a troubleshooting guide if your deriving share price is either to be considered too low or too high therefore it means that you get a extremely low value because of several key reasons. They include the fact that earnings are depressed due to some reasons including economic and political reasons, capital expenditures are significantly higher than depreciation in stable growth phase, the beta in the stable period is too high for a stable firm, working capital as percent of revenue is too high to sustain and the use of the two-stage model when the three-stage model is more appropriate. He also states that if you get a too high a value, it therefore is an indication that earnings are inflated above normal levels, capital expenditure offset or lag depreciation during high-growth period and the growth rate in the stable growth period is too high for stable firm (Damodaran, 2002).

4.3.3 Three-stage FCFE

As of the three-stage DDM model, this model is most suitable for firms which are going through three stages of growth, an initial high growth period which through a transitional growth period ends up in a infinite stable growth rate (Damodaran, 2002). When using a model that assumes three different stages of growth it is important that assumptions about other financial variables are coherent with those of the growth rates.  When estimating the appropriate growth rate there are several aspects to consider, based on if you use dividend discount models or free cash flow to equity models. When estimating growth for the FCFE model, focus lies on the return on equity (ROE) of the firm and at what rate the firm reinvests its net income.  When applying the dividend discount model, however, the fundamental growth rate calculations does not demand for any modifications of the return on equity, since the assumption of dividend discount models is that there do, or could, exist excess cash left in the firm which is not paid out as dividends.

Cross Sectional Application

Valuation in Nigeria

 The Nigerian banking sector has undergone remarkable changes since 1892, when the African Banking Corporation (ABC) was set up to today’s era of consolidation. The

Nigerian financial system has also gone through eras such as Free-Banking Era (1982-1952), emergence of Banking Regulation or Pre-Central Banking (1952-1958), Era of Consolidation

Growth following establishment of the Central Bank of Nigeria, Era of Banking Legislation

(1959-70), the Era of indigenization (1970- 1976), the Post-Okigbo Era (1977-1986), the Era of Deregulation (1986-2005) and the Era of Bank Consolidation which started in 2006 to date (Nwankwo 1990).     Since inception, the changes in the banking industry have been influenced by the need for sounder banking industry, globalization of operations, technological innovation and the adoption of supervisory and prudential requirements that conform to international standards and the need to make Nigerian banks Basel Accord I and II compliant. The reasons which prompted the reform program in the banking sector were due to the weak capital base of the banks, weak corporate governance, gross insider abuse, sharp practices, overdependence on public sector deposits, insolvency and internally focused competition.

The recent consolidation in the banking industry by the Central Bank of Nigeria (CBN) through the recapitalization to N25 billion is monumental. It created a remarkable transformation not only in ensuring more diversified, strong and reliable banks but also enhancing banks’ liquidity position and their ability to assume risks. Moreover, it recreated the Nigerian Capital Market by stimulating activities in both the primary and secondary market through increase in aggregate market capitalization, new issues of bank stocks and increased inflow of Foreign Direct Investment (FDI) into the market (Ebi 2006; Salako 2006).

Business valuation is a processed set of procedures used for estimation of the economic value of an owner’s interest in a business. It is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of business (Pratt, Reilly, & Schweihs, 2000). In addition to estimating the selling price of a business, same valuation tools may be used by business appraisers to estimate the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes such as merger and acquisition. To effectively value of a business, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value (Pratt, et al, 2000). The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions such as going concern or liquidation i.e. continuation for an indefinite period of time or termination at the point of valuation. Banks in Nigeria valued their business as a going concern and the methods adopted include the adjusted book value, the capitalized adjusted earning model, the discounted future earnings model, the cash flow method and the gross revenue multiplier.

Part of the assets valued was goodwill from value created and other intangible assets acquired by the existing owners. Each of these valuation methods will produced different results when conducted for the same company using same data. This leaves the business appraisers with huge levels of choice in most cases and the method that gives the lower or higher figures is favoured depending on the circumstance. To value the share of Diamond Bank plc for example, the following valuation models were applied. They included the Price to book, Net assets valuation model, maintainable earnings (simple average), current earnings, four years projected earnings and DDM valuation methods. The holding period that was assumed for the DDM was three years.  The forward payout ratio that was used was of 24.3% with average dividend growth of 15%. Taking the average value of the above valuations, the fair value of NGN7.84 per share was reached. Given the above findings the Diamond Bank plc right issue is a good investment

According to a newspaper report in June 2007, it was noted that the NCM is in one of its most robust periods ever. With the re-capitalization campaign of many companies especially in the banking sector, the awareness so created has led to greater participation of the public in shares acquisition. Thus, the Nigerian Stock Exchange is now among the country’s vigorous institutions. Landmark financial reforms in Nigeria are bringing both sophistication and improved regulation. Robust economic growth, buoyant investor confidence and the unleashing of the private-sector, are some of the factors presently creating demand for services such as project finance, debt and equity capital financing to fund expansion ventures, corporate advisory, as well as new capital market products like exchange-traded funds and derivative products linked to real estate investment (Siddiqi, 2006)

As reported by Siddiqi (2006), banking system consolidation over the years 2004-2006 has proven to be a catalyst for dynamic reform of pensions, bond market and insurance sectors thus affecting the wider economy. The newly enlarged banks are instrumental in the financial market revolution, which is opening up domestic stock and debt markets and expanding liquidity. This is driving the boom in the non-oil sectors of the economy and is putting increased pressure on the capital markets to fund infrastructure projects, especially in power, water, transportation and communications (Siddiqi, 2006). Economic growth and political continuity is an investor’s dream. Elizabeth Ebi, the chairperson of Future-View one of the major Nigerian issuing houses remarked that investors see a government that is trying to create a market and environment where business can run smoothly and effectively. Standard Bank of South Africa has also noted that the Nigerian market is too big to be ignored. With another four years of policy continuity, it will be unwise to miss the opportunity in the bond market. In essence, the financial sector is poised for radical change (Siddiqi, 2006).

Empirical studies by Bruner (1998) revealed the popularity of DCF as a primary valuation tool in the US and according to Graham and Harvey (2001) DCF is widely used by many corporations and advisors in the US. In the emerging market of Argentina, Pereiro (2002) also reported the wide use of DCF as a primary tool among corporation and financial advisors/experts. In alignment with the popularity of DCF in US and in Argentina, this investigation reveals that DCF is a widely used valuation tool in Nigeria. All the sampled corporations and banks in this survey use models based in DCF for valuation while 80% of financial advisors also use it. Of these, 71% of corporations, 40% of financial advisors and 50% of banks/insurance firms use DCF as a primary valuation tool as shown by

In line with the recommendations by Ross et al (2002) of the use of NPV as the best approach for evaluating capital budgeting projects, over 50% of corporations and financial advisors in this survey use NPV as shown in Table 4.3. However, only 21% of practitioners in banks surveyed use it. The second-rate approaches which include internal rate of return (IRR) and the payback (simple and discounted) are still in use in the US, (Graham and Harvey, 2001) and also in Argentina (Pereiro, 2002). These second-rate methods have drawbacks. IRR approach can present multiple IRRs for a single project due to changes in the algebraic sign of the period cash flows. The simple payback does not account for the time value of money while the discounted payback which include the time value of money, does not take account of the economic value of cash flows occurring after the payback period (Pereiro, 2002). Despite the drawbacks seen with these techniques, the IRR and the payback methods are still in use in Nigeria just as they are still in use in the US, and Argentina. Table 4.4 shows that 29% of corporations, 20% of financial advisors and 43% of banks use IRR. The payback (simple) is common only among corporations (43%), while payback (discounted) is used by 14% of corporations and banks. The payback approach is not used by financial advisors in Nigeria, according to this survey.

NPV remains the most relevant metric among corporations and financial advisors but not among banks instead IRR is their most frequently used metric. This may be due to the inherent differences between the business models used by banks, corporations and financial advisor firms. Evidence of the merits of using discounted cash flow as a valuation technique must have paid off in the US, in the emerging markets of Argentina (Pereiro, 2002) as well as in Nigeria as shown by result from this survey. Profitability index is used by some Nigerian practitioners. Table 4.4 reveals that corporations and bank use it, even though it does not report the absolute value of the expected yield of the investment. The use of DCF in valuation is quite relevant in cash flow generating assets but in order to generate a more complete picture of the asset under valuation, it is helpful to compliment it with other valuation methods.

Valuation in South Africa

            In South Africa, a number of methods are used to value business and financial institutions. They include the income approach, the market approach and the net assets approach. The income approach determines the market value of the ordinary shares of a company based on the value of the cash flows that the company can be expected to generate in the future. This includes traditional discounted cash flow techniques and also real option valuations, which use option pricing models to measure the value of assets that share option characteristics.

The market approach on the other hand gauges the market value of the ordinary shares of a company based on a comparison of the company to comparable publicly traded companies and transactions in its industry, as well as to prior transactions in the ordinary shares of the company using an appropriate valuation multiple. The net assets approach evaluates the market value of the ordinary shares of a company by adjusting the asset and liability balances on the company’s balance sheet to its market value equivalents. The approach is based on the summation of the individual piecemeal market values of the underlying assets less the market value of the liabilities.

There continues to be conflicting views about which valuation approach is best. In private equity and venture capital circles, there is a strong preference for market multiple based valuations. The International Private Equity and Venture Capital Valuation Board Guidelines state that in assessing whether a methodology is appropriate, the valuer should be biased towards those methodologies that draw heavily on market-based measures of risk and return. Fair Value estimates based entirely on observable market data should be of greater reliability than those based on assumptions.  A similar view is upheld in accounting standards, where greater reliance is placed on market-based measures of value.

In the Southern African market, there are relatively few listed companies that can be used as a reliable source for market multiples, it is perhaps not surprising that the income approach continues to remain the most favored methodology. However, the increased usage of alternative approaches supports the view that discounted cash flows should rarely be used in isolation. The income approach relies on the cost of capital. From a company’s perspective, the weighted average cost of capital (WACC) represents the economic return or yield that an investor would have to give up by investing in the subject investment instead of all available alternative investments that are comparable in terms of risk and other investment characteristics (PwC Corporate Finance, 2012)

The WACC is calculated by weighting the required returns on interest-bearing debt, preference share capital and ordinary equity capital in proportion to their estimated percentages in an expected industry capital structure, target or other structure as appropriate. The general formula for calculating the WACC (assuming only debt and equity capital) is:

WACC = kd x (d%) + ke x (e%)


WACC = Weighted average rate of return on invested capital

kd = After-tax rate of return on debt capital

d% = Debt capital as a percentage of the sum of the debt and ordinary equity capital (total invested capital)

ke = Rate of return on ordinary equity capital

e% = Ordinary equity capital as a percentage of the total invested capital

There are three related steps involved in developing the WACC. They are:

• Estimating the opportunity cost of equity financing;

• Estimating the opportunity cost of non-equity financing; and

• Developing market value weights for the capital structure.

Estimating the cost of equity is the most subjective and difficult measure to quantify in the WACC formula, which is why we have dedicated a substantial part of this survey to this issue. There are two broad approaches to estimating the cost of equity. They are the use of deductive and risk and return models.  Deductive models, such as dividend growth models, rely on market data to determine an imputed cost of equity. The dividend growth model is one such approach, which requires market data that include the current share price, expected dividends and the long-term steady dividend growth rate.  The capital asset pricing model (CAPM) is probably the most widely used of the risk-return models. The CAPM measures risk in terms of the non-diversifiable variance (systematic risk) and relates expected returns to this risk measure.  

The CAPM derives the cost of equity by adding to the risk-free rate an additional premium for risk. This risk premium is a product of the investment’s beta and a market risk premium, being the reward required by investors for investing in an equity investment of average risk. The beta is a measure of relative systematic risk of the particular equity investment. The CAPM is therefore a linear combination of the risk-free rate, the equity risk premium and the company’s beta. Its simplicity is attractive and largely explains the popularity of the CAPM. The CAPM formula is E(Re) = Rf +β x E(Rp)


E(Re) = Expected rate of return on equity capital

Rf = Risk-free rate of return

β = Beta or systematic risk

E(Rp) = Expected market risk premium is the expected return for a broad portfolio of shares less the risk-free rate of return

While the CAPM is popular, it is not perfect. A key criticism raised against the CAPM is its inability to account for several equity returns, such as the small firm effect whereby smaller companies exhibit higher returns and the value effect whereby companies with low ratios of book-to-market value have higher expected returns. One response to this empirical questioning is to move away from the traditional CAPM’s linear, stationary, and single-factor features.

In South Africa, various government bonds are available as a proxy for the risk-free rate. The R157 remains the most liquid and well traded bond with the R186 in second place. It is interesting to note a general improvement in the liquidity of the market with daily volumes well above levels noted in the 2010 survey. Yields in the current survey have also declined and the gap between shorter and longer-dated bonds has increased (PwC Corporate Finance, 2012). Interestingly, the R186 has increased significantly in popularity, and now appears to be the benchmark choice among market practitioners. Other practitioners use zero-coupon curves based on the yields of RSA bonds and future rates and generally use the 10- year point on that curve. The yields of South African Government bonds, which are less influenced by the impact of large-scale asset repurchases and the ‘flight to quality’ effect observed in Germany, the United Kingdom and the United States, continue to be used by market practitioners as a proxy for the risk-free rate.

The risk-free rates in other markets are greatly influenced by short-term factors such as asset repurchases and the flight to quality. PwC has found that in certain markets, adjustments to the risk-free rate are necessary to compensate for the inconsistency of using a short-term measure of the risk-free rate and a long term estimate of a market risk premium. Beta typically measures the sensitivity of a share price to fluctuations in the market as a whole. Beta is calculated by regressing individual share returns against the returns of the market index. The formula for beta is as follows:

β= cov(Ri, Rm) = ρ(Ri, Rm)σ(Ri) σ2(Rm) σ(Rm)


cov(Ri,Rm) = Covariance between security i and the market index

σ2(Rm) = Variance of the market index

ρ(Ri,Rm) = Correlation coefficient between security i and the market index

σ(Ri) = Standard deviation of returns of security i

σ(Rm) = Standard deviation of market returns

Valuation in Dubai

            The valuation methods that are used in the valuation of Islamic banks in Dubai and the Middle East as categorized by using statistics from the Dubai Islamic bank indicate that the fair value estimate of the Dubai Islamic bank is AED 2.2 per share by the 23rd of June 2010. The study was done by pharos research and it revealed that the fair value estimate of the bank was 7.3 percent above the current market price. In their study, two valuation models were used. They included the dividend discount model and the fundamental PBV approach. In their study, they assigned equal weights to both methods to arrive at the banks fair value.

            The dividend discount model yielded a fair value of AED 2.1 yield per share. The banks expected dividends were discounted using the cost of equity method to arrive at the fair value estimate. In their calculation, they used a 14 percent cost of equity based on a six percent risk free rate a seven percent equity risk premium and a beta of 1.15. The terminal growth rate that was used for this calculation was at a rate of five percent per annum.

DDM Valuation Dubai Islamic Bank201020112012201320142015
Sum of PVs Per Share (AED)0.6
Terminal Growth5%
PV of Terminal Value Per Share (AED)1.5
Fair Value Per Share (AED02.1
Source: Pharos Research

The fundamental PBV approach as conducted by pharos research produced a fair value of AED 2.4 per share. The same cost of equity and terminal growth rate of 14percent and 5 percent were used respectively. The fundamental PBV multiple is derived from the Gordon model which stipulates that the PBV=(ROE-g)/(k-g). In this calculation, they used a sustainable RoAE of 14 percent for Dubai Islamic bank to arrive at the fundamental PBV and used their expected discounted rates for one year.

Fundamental PBV Valuation
Sustainable ROE14%
Growth Rate5%
Cost of Equity14%
Book Value per share  (AED)2.70
Discount Factor0.90
Fair Value Per Share2.40
Fair Value Estimate
Method (AED Per Share)PriceWeightValue
Fundamental PBV2.450.00%1.2
Fair Value2.2
Source: Pharos Research
Dubai Islamic Bank (Summary Income Statement)
AED m (YE 31 DEC)20082009201020112012
Interest income4022.04078.03954.04252.04753.0
Interest Expense(1778.0)(1739.0)(1657.0)(1780.0)(1982.0)
Net Interest Income2244.02339.02298.02473.02771.0
Net Fees and Commission748.2652.2664.0714.1798.2
Other Income500.0402.8313.6309.5340.3
Total Fee Income1248.01055.0978.01024.01138.0
Minority Interest0.0(4.8)(0.1)0.40.5
Dubai Islamic Bank (Summary Balance Sheet)
AED m (YE 31 DEC)20082009201020112012
Cash and Cash Equivalents6,329.011612.011092.012872.011040.0
Due from banks3,482.02557.03232.02239.04239.0
Net Loand and Overdrafts52,659.049925.052762.058807.066896.0
Investment Assets17,839.016128.016120.017267.018624.0
Other Assets3,780.03425.03536.03876.04287.0
Fixed Assets668.8657.8789.4986.71233.0
Total Assets84,757.884,304.887,531.496,047.7106,319.0
Due to Banks3,331.01449.01488.01633.01807.0
Long Term Debts2,755.06168.06168.06168.06168.0
Total Investments8,749.08,981.09577.010297.011212.0
Paid Up Capital3,445.03618.03618.03618.03618.0
Minority Interests0.
Shareholder’s Funds   8,749.00   8,981.00   9,577.00   10,297.00   11,212.00

In relation to the valuation of banks both conventional and Islamic banks in the middle east and specifically Dubai and Abu Dhabi have a PBV value of more than 0.5 with the National bank of Abu Dhabi having the highest valuation at 1.3. However, with a multiple comparison of the Price Earnings Figures in 2010, Abu Dhabi Commercial bank ranks at the highest with a PE value of 15.1 as shown in the Table below.

Multiples comparison
PBV (2010)PE (2010)
Emirates NBD (ENBD)0.54.8
Abu Dhabi Commercial Bank (ADCB)0.515.1
Union National Bank0.75.3
Dubai Islamic Bank0.89.1
Abu Dhabi Islamic Bank (ADCB)1.17.2
National Bank of Abu Dhabi1.37.6
Based on the closing price of 20th june 2010
Source: Pharos Research

Valuation in Turkey

Valuation in Argentina

Valuation in Brazil

3.0Research Methodology

            Considering that this study will consider valuation method of various financial institutions and banks, which involves a comparison of two models, it helps to determine which model gives the most-accurate share price. The most-appropriate research design to be used in this paper is case studies from banks in different areas in the world. The research methods will involve a cross-sectional application of the two models to see how accurate they apply to the considered regions such as West Africa, South Africa, South America and Arab region because the banks to be considered will be taken from Nigeria stock exchange, South Africa Stock Exchange, Brazil Stock exchange, Argentina and Dubai stock exchange. Moreover, the research will aim to determine the particular model that suits particular areas because 30 banks, 6 from each of the above-mentioned stock exchanges will be considered and five years data from each of them used for analysis using SPSS software and other appropriate statistical analysis tools.

The sources of data that were used include secondary sources of data. Various forms of secondary sources were selected from financial journals, reports and company financial statements. The use of Questionnaires was the principal source of primary data collection method that was used by scholars to obtain information that were used in the literature review of the paper. The questionnaires target the management of selected banks as well as used to collect, staff of the Various Stock Exchanges and other commissions in different countries that have the mandate in the national company stocks and Securities. Portfolio Managers and other stakeholders such as the investment public were also interviewed in the surveys in which data analysis was conducted.

3.1 -Information gathering

3.1.1 Sources of data

The paper relied on both primary and secondary sources of data conducted by different scholars in relation to the subjects under question. The data obtained from surveys conducted by several scholars to determine the similarities and differences of these valuation systems because there were very few relevant secondary sources of information regarding the Dividend discount Model and Free cash flow to Equity Model that could be used conclusively for the study. 

The primary data source for the analysis in this paper is Bankscope. It is a comprehensive, global database of banks’ financial statements, ratings and intelligence. Bankscope combines widely-sourced data with flexible software for searching and analyzing banks. It contains comprehensive information on banks across the globe. You can use it to research individual banks and find banks with specific profiles and analyse them. Bankscope has up to 16 years of detailed accounts for each bank. The sample encompasses banks from five different countries on three continents: Nigeria, South Africa, Argentina, Brazil, Dubai, France, Germany, Luxembourg, Mexico, and the UK.

3.1.2 Secondary data

      This refers to already existing data sourced from available literature such as books and periodicals relating to a particular subject under study. Literature relating to the Dividend discount Model and Free cash flow to Equity Model were evaluated to compare the accuracy between these two varying models in relation to various regions around the globe. Journals and several scholarly articles and investment reports and performance ratios were reviewed to establish the degree to which the Dividend discount Model and Free cash flow to Equity Model improve the valuation of banking and financial institutions. Data sources such as the audited financial statements of both Islamic and conventional banking institutions were reviewed and used for ratio analysis. The rates were calculated with the help of accounting and formulas. Data collected from the bank’s annual reports were from the period between 1998 and 2008.

3.2 Data collection methods and instruments

Mixed methods were used in data collection where elements of the study and are incorporated. The mixed method is a data collection method that combines elements of the survey method and unstructured interview methods (Axinn & Pearce, 2006). Survey research is the research that relies on the questionnaire and interview methods of data collection (Kothari, 2004). Data was collected through the analysis of financial information of more than 40 banks which were selected to gather this information. Non-participant observation as a method was also used in combination with the other techniques. The researcher does not interfere with the activities of the respondents, rather, he just observes at a distance. This was particularly important as a method of data collection because it ensured that a range of differing views about the valuation models could be observed and evaluated.

4.0 Results and Analysis of Results

Depending on how accurately they apply to West Africa, South Africa, South America and the Middle East. In the cross sectional analysis, both the Dividend discount Model and Free cash flow to Equity Model are evaluated to see if they fit particular regions. In the literature review, an analysis of whether any particular model fits a particular region is going to be analyzed. The analysis will be made for only financial institutions which include both Islamic and conventional banking systems with ten years of data analysis.

This is definitely the objective of this study, which aims to compare between dividend discount model and free cash flow to equity model in order to determine which gives the most accurate share price.

Stock value as stated by Pereiro (2002) is adjusted for unsystematic risk factors in terms of differences in size, control, and illiquidity that exist between quoting and non-quoting companies. CAPM is based on an assumption that data used in its calculation derive from comparable large quoting companies. However, when the company under consideration is a small, non-quoting firm, unsystematic risk must be introduced to adjust stock value.

Pereiro (2002) proposes a three-step stackable premiums and adjustments model (SPAM) for valuing private companies and acquisitions in emerging markets. Step one introduces adjustments to cash flows in volatile markets and suggests three types of cash flow adjustments.

1. Adjusting for overcompensation: salaries versus dividends. This is adjusted for according to Pereiro (2002), by finding the difference between the figure the entrepreneur actually withdraws from the firm and the market average salary for his or her managerial role and interpreting it as dividends paid in advance accruing to future profits, and not as an operating expense. Another market standard salary that is used as the benchmark can be the average salary of top executives working in a small group of quoting companies that are comparable to the company under consideration.

FCFENigerian Stock exchange
BanksCalculated share price Actual share PriceDifference
FCFEArgentina Stock exchange
BanksCalculated share price Actual share PriceDifference
FCFESouth Africa  Stock exchange
BanksCalculated share price Actual share PriceDifference

Exchange Risk: From the viewpoint of local or international US dollar investor, it is assumed that returns are computed in US dollars. Converting cash flows in the local currency to US dollars can be done by using forward or spot exchange rates.

Inflation: A common practice among analysts is factoring the risk of unexpected inflation directly into the discount rate, as part of a country-risk premium; thus not including inflation adjustment in the cash flow. Experts support the use of nominal rates of discount when cash flows are expressed in nominal terms and use of real rates of discount when real cash flows are being used.

Step two of SPAM implies computing a discount rate, such as an opportunity cost. The cost of capital is of utmost importance in fundamentals-based models for valuing many different assets. Some conceptual problems with CAPM as pointed out by Pereiro (2002) include flaws in its professed objectivity, “irrelevance” and its inability to capture unsystematic risk. Diversification imperfections, which generate unsystematic or idiosyncratic risk, lack of a single market for gauging “true” asset prices and the debatable nature of efficiency are other challenges of using CAPM in emerging markets. Based on these challenges, the application of the plain CAPM is a controversial endeavour but its use has persisted along with the use of five different CAPM-based variants, which can be applied to emerging markets. These include the global CAPM variant, local CAPM variant, adjusted local CAPM variant, adjusted hybrid CAPM variant and Godfrey-Espinosa Model. Non-CAPM based models in use include the Estrada model and Erb-Harvey-Viskanta Model. See Pereiro (2006) for a list and summary of these models. Of all these models, there is no single “right” model that is recommended. However, the choice lies with the investor or appraiser (Pereiro, 2002).

Step three of SPAM according to Pereiro (2002) involves appraising the effect of unsystematic risk components on stock value. “According to the study by Bruner et al, (1998), 86% of the leading finance textbooks in the United States suggest simply adjusting beta for the idiosyncratic risk of an investment (the remaining 14% do not even address the problem). Further, 71% of the textbooks do not address the problem of gauging specific synergies in a valuation and the remaining 29% suggest simply using a different WACC for doing so without stating how …as a result, most financial economists ignore the issue” (Pereiro, 2002: p. 176). These unsystematic risks are composed of value-affecting drivers like company size, size of the shareholding (minority versus control) appraised and liquidity of the shareholding appraised. In assumption that CAPM-based models by definition capture only systematic risk, the analyst must apply any adjustments of size, control and/or illiquidity. An analyst must choose the unsystematic risk adjustments to use, and the method to combine them (Pereiro, 2002).

According to Hoguet (2004), in the last five years before March 2004, the Morgan Stanley Capital International Emerging Markets Free index has returned, in dollars, 11.3 percentage points more per annum than the S&P 500. By the same token, emerging market bonds have returned 15% per annum over five years, as measured by the J.P. Morgan Emerging Market Bond Index – Global, handily outperforming the Lehman Aggregate’s 7.3%. “Current valuation of emerging market equities (11 times forward earnings) and nominal yields of emerging market bonds (9.6% as of June 14, 2004), suggest investors are likely to consider increasing their strategic commitment to emerging market securities” (Hoguet, 2004, p. 34). The combination of rapid growth of investment opportunities and higher volatility in emerging markets raises fundamental questions for investors about how to incorporate emerging markets in the overall investment process.

Providing analysis of valuation in an emerging market such as Nigeria is important for at least four reasons stated by Bruner (2003). First, no clear “best practice” exists for the valuation of assets and securities in emerging markets. In developed markets, practitioners and scholars agree on mainstream valuation practices. For example Bruner (1998) and Graham and Harvey (2001) document a clustering of practices around tools and concepts of modern finance. However, valuation methodology varies much more widely in emerging markets, as shown in surveys by Bohm (2000) and Pereiro (2002). Even among the writers of textbooks, substantial disagreement exists about fundamental issues, such as estimating the cost of capital.

Second, emerging markets differ from developed markets in areas specified earlier and such differences affect valuation. In fact, several researchers have argued that these issues have significant economic implications and warrant careful consideration in the application of valuation approaches (Bruner, 2003). Third, inflows of investment into emerging markets are significant. Emerging market inflows are large enough for improved valuation practices to have a material impact on the welfare of investors and their targeted investments. Improved valuation practices can enhance the flow of greater investment capital and the allocation of resources thus increasing the social welfare of emerging market populaces. Fourth, emerging markets will keep on drawing the attention of global investors. The rate of economic growth in these markets is often two or three times faster than in developed countries. The roughly 150 countries not regarded as developed account for a predominant share of the global population, landmass, and natural resources. A premise of the diplomatic policies of most developed countries is that ties of trade and investment will help draw emerging market countries into a more stable web of international relations (Bruner, 2003). All the above considerations are very valid for the Nigerian emerging market. Hence, there has to be an evaluation and management of valuation knowledge and expertise within this economy.


The discussion in this paper has given an overview of valuation approaches which are applicable to banks and financial institutions. Generally, the methodology of bank valuation is significantly difficult and insufficiently studied by scholars. A variety of valuation techniques are employed in the practical sense, and there is no single method that clearly dominates others. In fact, since each approach involves different merits and demerits, there are gains to considering several approaches simultaneously through an application of mixed methods in the valuation process. However, preliminary studies highlight the requirement of more innovative methods to detect changes in bank performance and regulation frameworks.

The impact of the global financial crisis affected many banks as they suffer from losses which significantly decreased their economic value. As a result of this, the shareholders and customers confidence in banks as investments and places to keep money secure was lost affecting the profitability of banks reducing bank performance as a result. The diminishing performance of banks resulted in reduced investments in this financial sector all over the world. Nevertheless, if financial institutions consider the growth of their economic value as a crucial part of their business strategy which might be shown by using the discussed valuation approaches, the confidence in further banking system development will be regained. For that purpose, banks should monitor management decisions and regulation framework through their impacts on the economic value of the bank.

This research reveals what the current practices in valuing companies in Nigeria are, and shows how these practices defer from recommendations in literature. This is an area that contributes to knowledge within valuation of companies in emerging markets as previous studies focusing on valuation in Nigeria as an emerging market are non-existent.

As revealed by this survey, DCF-based valuation method is the most popular valuation method in Nigeria. Valuation practices in Nigeria generally align with practices in both Argentina and the US, however with little variations from recommendations in literature, especially in the areas where valuation experts tend to disagree. This research also reveals the risk parameters that are included when valuing companies in the Nigerian market and shows that practitioners are indifferent to several risks in their valuation practices. Contrary to the practice in Argentina, analysts in Nigeria do adjust data obtained from developed markets like the US to the Nigerian market. Precisely how this is done is not revealed and results obtained in this study have been compared with available data for Argentina and the US and the differences shown as far as possible within the scope of this study.

There are several areas in which valuation knowledge needs to be increased among Nigerian valuation practitioners. Country specific issues such as market premium and country risk premium are shown to be the highest areas of uncertainty. This is not surprising since country specific issues with respect to valuation in emerging markets is an area where valuation/financial experts disagree while knowledge is still growing towards best practices in this area. This study has thus answered the questions it set out to answer while further research on related areas is inevitable as the Nigerian market continues to seek foreign direct investments.


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Table 4.31 Comparison between valuation practices in Nigeria, Argentina (both emerging markets) and the US (a developed market) QuestionsNigeriaArgentinaUS
CorporationsFinancial AdvisorsBanks and insurance firmsCorporationsFinancial Advisors and PEFs2Banks and insurance firmsCorporationsFinancial Advisors and PEFs
Frequency of use of the DCF
Uses DCF as a primary tool71 %40 %50 %89 %73 %50 %89 %10 %
Uses DCF as a secondary tool0 %0 %7 %3 %27 %17 %7 %
Primary or secondary depending on the case29 %20 %36 %3 %0 %0 %4 %
Use DCF for ongoing company valuation0 %0 %0 %21 %27 %17 %
Use DCF for specific project valuation0 %0 %0 %24 %9 %17 %
Do not use DCF0 %20 %0 %0 %0 %0 %
NA0 %20 %7 %5 %0 %33 %
What is used with DCF…
NPV (net present value)86 %60 %21 %100 %100 %100 %
IRR (internal rate of return)29 %20 %43 %87 %73 %67 %
Payback (simple)43 %0 %0 %32 %18 %17 %
Payback (discounted)14 %0 %14 %26 %18 %0 %
Profitability index43 %0 %21 %3 %0 %0 %
NA0 %0 %0 %
Which of the methods in item above is most relevant
NPV (net present value)43 %60 %21 %53 %83 %64 %
IRR (internal rate of return)0 %20 %43 %26 %33 %36 %
Payback (simple)14 %0 %0 %0 %0 %9 %
Payback (discounted)14 %0 %14 %0 %0 %9 %
Profitability index29 %0 %21 %3 %0 %0 %
Other0 %0 %0 %6 %0 %0 %
NA0 %0 %0 %24 %0 %18 %
When using DCF, how do you account for project risk
Cashflow adjustment57 %0 %14 %53 %45 %83 %
Rate adjustment57 %0 %7 %34 %64 %0 %
Get different NPV by applying sensitivity analysis29 %80 %64 %71 %73 %50 %
Get different NPV by applying decision trees29 %20 %0 %3 %0 %0 %
Other0 %0 %0 %3 %9 %0 %
NA0 %0 %7 %0 %0 %0 %
Do you use a different Beta for each investment, project or company under appraisal?
Yes14 %20 %21 %40 %75 %50 %
No86 %60 %71 %60 %0 %25 %
NA0 %0 %7 %0 %25 %25 %
Do you use a discount rate to account for the cost of capital?
Yes86 %80 %79 %95 %100 %100 %89 %100 %
Rate computed as an opportunity cost57 %40 %43 %16 %27 %17 %
WACC43 %40 %43 %74 %73 %67 %
Other0 %0 %7 %10 %18 %17 %
No0 %0 %0 %5 %0 %0 %
sometimes14 %0 %0 %7 %
NA0 %0 %7 %0 %0 %0 %4 %
When using DCF do you use a terminal value?
Yes71 %60 %29 %84 %100 %83 %
No29 %20 %64 %13 %0 %17 %
NA0 %0 %7 %3 %0 %0 %
How do you compute the terminal value
Perpetuity43 %60 %29 %91 %82 %60 %
With growth29 %40 %29 %34 %45 %20 %
Without growth14 %20 %0 %28 %9 %0 %
Others29 %0 %
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