Residual income model
Sector Deep DivesValuing a bank as its book value plus the present value of returns earned above the cost of equity.
Also written: excess return model
A standard unlevered DCF cannot be applied to a bank, because debt is raw material rather than financing and free cash flow has no clean meaning. The residual income model works with that instead of against it.
It values equity directly as current book value plus the present value of future excess returns, where excess return is the amount by which return on equity exceeds the cost of equity, applied to the equity base.
The intuition is compact: a bank earning exactly its cost of equity is worth its book value and no more, because it creates nothing beyond what shareholders required. Earning above it creates a premium, and below it a discount.
That is what sits behind the justified price to tangible book formula: return on tangible equity less growth, divided by cost of equity less growth. It crosses 1.0x exactly where returns equal the cost of capital.
Worked example
A bank has 8,000 of tangible equity, earns 14% ROTCE, has a 10% cost of equity and grows 3%.
Justified price to tangible book is 14 less 3 over 10 less 3, so 1.57x, giving an equity value of about 12,570.
Drop ROTCE to 8% and the ratio falls to 0.71x, or about 5,710. The bank trades below book because it earns below its cost of capital, not because the assets are suspect.