Pricing bank stocks such as FRME is particularly challenging. Given that these companies adhere to a different set of rules relative to other companies, their cash flows should also be valued differently. The tiered capital structure is common for banks to abide by, in order to ensure they maintain a sufficient level of cash for their customers. Focusing on elements such as book values, in addition to the return and cost of equity, can be practical for estimating FRME’s value. Below I will show you how to value FRME in a reasonably effective and easy way.
What Is The Excess Return Model?
Two main things that set financial stocks apart from the rest are regulation and asset composition. Financial firms operating in United States face strict financial regulation. Furthermore, banks generally don’t have significant amounts of physical assets on their balance sheet. Excess Returns overcome some of these issues. Firstly, it doesn’t focus on factors such as capex and depreciation – relevant for tangible asset firms – but rather emphasize forecasting stable earnings and book values.
Calculating FRME’s Value
The main assumption for Excess Returns is, the value of the company is how much money it can generate from its current level of equity capital, in excess of the cost of that capital. The returns above the cost of equity is known as excess returns:
Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)
= (0.11% – 11%) x $32.8 = $0.081
Excess Return Per Share is used to calculate the terminal value of FRME, which is how much the business is expected to continue to generate over the upcoming years, in perpetuity. This is a common component of discounted cash flow models:
Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)
= $0.081 / (11% – 2.9%) = $0.99
These factors are combined to calculate the true value of FRME’s stock:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $32.8 + $0.99 = $33.79
This results in an intrinsic value of $33.79. Compared to the current share price of US$41.85, FRME is currently overvalued. This means FRME isn’t an attractive buy right now. Valuation is only one part of your investment analysis for whether to buy or sell FRME. There are other important factors to keep in mind when assessing whether FRME is the right investment in your portfolio.
For banks, there are three key aspects you should look at:
- Financial health: Does it have a healthy balance sheet? Take a look at our free bank analysis with six simple checks on things like bad loans and customer deposits.
- Future earnings: What does the market think of FRME going forward? Our analyst growth expectation chart helps visualize FRME’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether FRME is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on FRME here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.