ISSUES IN VALUING FINANCIAL SERVICE FIRMS

Up until this point in this chapter, we have emphasized the similarities between financial service firms and other firms. In this section, we will consider some of the special issues that arise in the context of valuing financial service firms and how best to incorporate them into the value.

Provisions for Losses

Banks and insurance companies often set aside provisions to meet future losses. These provisions reduce net income in the current period but are used to meet expected losses in future periods. Thus, a provision for bad debts reduces a bank's income in the current period but allows the bank to cover bad debts when they do occur. In general, while the actual bad debts that occur in any year will not match the provision set aside for that year exactly, the cumulative provisions over time should be equal to the cumulated bad debts over the same period. If this is the case, the provisions smooth out earnings over time, making them lower than the true earnings in years when the economy does well—and default rates are lower—and higher than true e....