J. K. Dietrich - FBE Fall, 2006 Performance of Financial Services Firms Week 2 – August 31, 2006

J. K. Dietrich - FBE Fall, 2006 Stock Performance: Market Rate of Return u Most important to investors u Increase in wealth is focus –Can be measured by share price changes –Standard way is to look at rate of return u Definition: u Interpretation: Dividend Yield + Gain

J. K. Dietrich - FBE Fall, 2006 Assessing Performance u Interpretation must be careful –Market performance –Comparable firm performance –Risk and return must be considered u Compare biggest banks since 1990 u What are the best firms in banking? –Answer in terms of market rate of return –Future may not be like past

J. K. Dietrich - FBE Fall, 2006 Bank Share Performance

J. K. Dietrich - FBE Fall, 2006 Performance since 2000

J. K. Dietrich - FBE Fall, 2006 Bank Performance – ONE and MEL

J. K. Dietrich - FBE Fall, 2006 Alternative Valuation Measures u Price-earnings multiples (P-Es) –Related to cash payouts, growth, risk-adjusted discount rate –Think of a price of a dollar of earnings –Effect of differing P-Es on acquisitions u Book-to-market ratios u Cash flow to price (price of a dollar of cash flow) u Liquidation value (Assets – Liabilities) u Discounted cash flow (DCF) methods u Value Line examples

J. K. Dietrich - FBE Fall, 2006 Cost of Equity u CAPM estimates –Source of betas –Problems with CAPM –Alternatives (APT, 2-factor models) u Average historical returns u Growth methods based on dividend yield and return on equity times retention rate u Necessary to evaluate future cash flows to equity

J. K. Dietrich - FBE Fall, 2006 Accounting Performance: Return on Equity u Analysis for financial firms must be tailored to specifics of their operations –Deposit-taking –Insurance –Securities firms –Asset management firms –Others u Analysis proceeds in stages

J. K. Dietrich - FBE Fall, 2006 Steps to Financial Analysis u Step 1 - Obtain data u Step 2 - Simplify financial statements u Step 3 - Basic ratio analysis u Step 4 - Segment analysis u Steps 5 and 6 - Benchmarks and analysis u These steps required for Part 1 of project

J. K. Dietrich - FBE Fall, 2006 Bank Income Statement (WFC)

J. K. Dietrich - FBE Fall, 2006 Bank Balance Sheet (WFC)

J. K. Dietrich - FBE Fall, 2006 Bank Ratio Analysis (WFC)

J. K. Dietrich - FBE Fall, 2006 Dupont Analysis u Relate balance sheet to income statement u Simple spreadsheet PV-FSI.xls follows text discussion u Analysts all follow somewhat different approaches –Breakdown of categories (e.g. fees, expenses) –Use of quarter-ending, annual ending, averages u Objective is to project future performance

J. K. Dietrich - FBE Fall, 2006 Simplify financials: Example, WFC

J. K. Dietrich - FBE Fall, 2006 Calculate Ratios

J. K. Dietrich - FBE Fall, 2006 Valuation of Financial Firms u Best approach is based on discounted cash flows and, following Copeland et al, we use cash flows to equity u Spreadsheet PV-FSI is abbreviated but captures more complete models u You are free to change the spreadsheet –Add product lines (we will discuss NEWPVFSI briefly but it is available) –Change forecast and continuing value periods

J. K. Dietrich - FBE Fall, 2006 Valuation and Projections u Dividendable cash flows correspond to cash flows to equity u Spreadsheet has two years of history and a five year explicit forecast horizon u Continuing value captured with multipliers of fifth year values –Book-to-market –Price-earnings

J. K. Dietrich - FBE Fall, 2006 PV-FSI - Overview

J. K. Dietrich - FBE Fall, 2006 Past Analysis and Assumptions

J. K. Dietrich - FBE Fall, 2006 Projections: Cash Flows

J. K. Dietrich - FBE Fall, 2006 Valuation and Ratios

J. K. Dietrich - FBE Fall, 2006 Case Discussion: AIG u Introduction to insurance industry u Assessment of financial performance performance u Application of analysis of financial information to understand reasons for performance variations u Think about valuation issues in terms of insurance application to PV-FSI

J. K. Dietrich - FBE Fall, 2006 For Next Two Weeks u Prepare AIG case for discussion on September 7 – see questions in objectives for Week 3 u Organize team and choose firms for your segment of financial services industry u Prepare to discuss Chapter 8 during class Week 4 –We will discuss underlying economics of value creation in financial services and specifically in credit-related services discussed in Chapter 8 u Part I of project is due in class of Week 4