Bank Valuation VIII

We have finally reached the end of the info packed Bank Valuation series.  Congratulations to all that have made it, I hope you were able to take away something useful. In this last article I will discuss calculating the intrinsic value of a bank. So far we covered the following::
– Net Interest Margin (NIM)
– Return On Assets (ROA)
– Loan Loss Reserve,
and losses related to the loan portfolio
– Return On Equity (ROE)
– Profit Margin
– Dividends
– Earnings
– Stock Price
& Price/Earnings
– Net Asset Value (NAV), Book Value, Price/BookValue
– Business aspects (qualitative)
– Management aspects qualitative)

To review them see Bank Valuation I, II, III, IV, V, VI & VII.

What I present here are techniques that I have found useful in evaluating opportunities in bank stocks (in particular).  They will help you to become aware of certain risks & situations affecting banks that you will have to weigh, while helping to avoid problematic ones.  There are many other techniques and methods out there as well.  In addition, many of the techniques can also be applied to non-bank/financial companies as well.

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As discussed in one of the previous articles in the series, the majority of average investors automatically believe large stock price declines of a company result in the price becoming undervalued.  Another common false belief is that when the stock price of a company has remained at a consistent level for long periods of time, that particular price is an accurate portrayal of its underlying value or worth.

What is the reason for these common myths?  People generally confuse or forget, that the current market value (price), and the true value (intrinsic value), are two different things. The price at any moment in time is dictated by what someone is willing to pay for it.  The intrinsic value (also called fundamental value) is the underlying worth of the company considering all its business aspects.  Its important to note that the intrinsic value may, or may not, be the same as the current market value at any particular point in time.  However, there are those who would argue that value is “in the eyes of the beholder” and therefore the current market value (price) is the true value.  They state that it is justified as long as there are other investors willing to pay that price, which I must disagree with.

By keeping a business mindset, it puts this into perspective.  Thinking about shares of a private business (not publicly traded on the stock exchanges) makes the notion of the intrinsic value much more clear & important.  It also becomes quickly distinguishable from the price another investor is willing to pay for the shares.

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Example: Suppose a businessman offered to sell you his ownership portion (shares) of a private business.  He also makes the same offer to one other investor.  As an investor and businessman you do not want to pay more for the assets than it is worth.  How do you know what it is worth?  Is the value of the investment worth whatever the other investor is willing to pay for it (based on their perception)?  Of course not!  Perceptions may be all that matters when dealing with home decor or clothes, but investors & businessmen should not purchase investment assets for aesthetic, sentimental, or emotional reasons.  Similarly, we should not purchase them at a price justified merely by the potential that another investor may be willing to pay a higher price in the future.  The shares of the business should be purchased based on the expected cash flows the company produces from all its business aspects combined.  That is the basis for the determining the intrinsic value of a business, project, or asset.

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The value is usually calculated using discounted cash flow valuation (DCF). Irving Fisher (“The Theory of Interest” 1930) and John Burr Williams (“The Theory of Investment Value” 1938) first formally expressed the DCF method in modern economic terms.  DCF takes the future expected cash flow produced, while considering the time value of money concept.  Therefore DCF takes the present value, of the sum of all estimated future income generated.  The discount rate used to calculate the present value is usually the cost of capital (cost or rate of obtaining investment capital), and incorporates some judgment on the risk of the estimated future cash flows.  In the simplest form the DCF formula is:

VALUE = SUM[t0..tn] (Present value of cash flow for time t)
Present Value = PVt = CFt/(1+r)^t
VALUE = SUM[t0..tn]  CFt/(1+r)^t

n = Life of asset
CFt = Cashflow in period t (year)
r = Discount rate reflecting riskiness of estimated cashflows

Note that the cash flows will vary from asset to asset (free cash flow, dividends, coupons/interest and the face value for bonds, after-tax cash flows for a real project). The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects.  Typically for most businesses (not all) we can use Free Cash Flow (FCF) for Cashflow in the formula.  FCF is operating cash flow minus capital expenditures, and represents cash that a company produces after laying out the capital required to maintain or grow its business and assets.  Buffett is also known to use FCF and the DCF when evaluating and determining the intrinsic value of businesses, as he believes that it gives clearer picture of a company’s financial performance.  From my background in accounting and finance, I must agree because earnings can be often manipulated by accounting techniques, to present a more rosy picture.  However, it is a lot more difficult to do so with FCF numbers.  Benjamin Graham’s (Buffett’s teacher) book, The Intelligent Investor, explains how earnings can be manipulated and what to look for, without knowing much about accounting statements (I recommend this book as a good starting point as well).

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Now that we understand how banks work & operate (review earlier articles in the series), we know that we cannot use FCF (wouldn’t make sense for this type of business), as cash flow is not a good metric for banks. So how do we calculate the intrinsic value?  One method is to use dividends.  Virtually all banks pay dividends from their earnings.  The dividend discount model is a specialized case of valuation, where the calculated value is the present value of expected future dividends.  We can essentially view the bank as a dividend making machine, and value it on such terms.  Ironically, we would also use the earnings ability of the banks to calculate the intrinsic value using DCF. Fortunately, even though earnings numbers can be manipulated, the other performance metrics and techniques explained earlier in this series will help raise any red flags in the earnings or other financial numbers (in which case we wouldn’t even bother to calculate the intrinsic value if the bank in question cannot pass all our other previous criteria).  That is the importance of realizing that the valuation of banks does not mean just performing DCF, but looking at all the other metrics as well!

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The discount rate that reflects the riskiness of estimated cash flows (or dividends, earnings) can be thought of as the risk free rate.  It would be the rate you would obtain from a risk free investment.  I generally like to use 10% as a conservative number, that already has a certain degree of risk assumed in the non-risk free investment.  Like Buffett, I also do not use the risk Beta, and other more complex forms of the formula.  My understanding of valuation theory, accounting, and finance, lead me to believe that Warren Buffett’s usage of the DCF in the simplest form is good enough, does not unnecessarily complicate or introduce too many variables, as well as making theoretical sense.  Buffett also reminds us that the intrinsic value is merely a conservative estimate, and that it is an adequate estimate as long as we have a large enough margin of safety. He is well known for his ability & patience, to only purchase shares of businesses at large discounts relative to their intrinsic values.  One pitfall that he does remind us of is that when estimating average free cash flow growth (or dividends, or earnings) we must be VERY CONSERVATIVE, as lofty and over optimistic estimates will lead to over optimistic intrinsic values.  Most professional analysts often fail to remain conservative.  Its not that they don’t know how to calculate the intrinsic value, its that they are way too optimistic with their estimates.  Benjamin Graham explains very well in his book, several reasons why this phenomenon occurs more often than it should.  Much of the reasons occur due to human emotion.

To learn more about valuation theory, and the principles behind the DCF, I suggest either taking Professor of Finance Aswath Damodaran’s course at New York University’s Stern School of Business.  Enrolling might be a problem, so I suggest visiting his website, downloading his book (Investment Valuation), lecture notes, problem & answer set and go through the course on your own.  Professor Damodaran is one of the leading individuals of knowledge on valuation, corporate finance, and investment management.

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Example:
I’ll go through a DCF example with Wells Fargo & Co I did a few months back as an example.  Any numbers used will probably reflect numbers from a few months back.  As an example of the process it won’t matter much, but for real analysis its better to be up to date.  We will be using its dividend in this calculation, which means we will have to estimate future dividend growth.  We will use a few metrics to do this; the Dividend Growth formula, and our own trending of WFC’s actual dividend history, to help us estimate conservatively.

Dividend Growth (G) = Plowback Ratio * Return on Equity

Payout Ratio = 0.50
(this number is usually available from financial data, review Bank Valuation III)
Plowback = (1 – Payout Ratio) = 0.50
ROE = 0.174 (from financial data)

Dividend Growth Rate = 0.50 * 0.174 = 8.70%

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Now we are going to look at the actual dividend history.  12 years of data was readily available:

YEAR DIVIDEND INCREASE
2008 $ 1.36
2007 $ 1.24 9.68%
2006 $ 1.08 14.81%
2005 $ 1.00 8.00%
2004 $ 0.93 7.53%
2003 $ 0.75 24.00%
2002 $ 0.55 36.36%
2001 $ 0.50 10.00%
2000 $ 0.45 11.11%
1999 $ 0.39 15.38%
1998 $ 0.35 11.43%
1997 $ 0.31 12.90%

Avg year to year increase = 14.66%
Avg year to year increase (excluding max & min increases) = 13.03%
Total Increase = 338.71%
Annualized Increase = 10.70% (See Bank Valuation IV for annualized increase/growth calculation)

The lowest in last 12 years was 7% increase.  In 2008 the increase was 9.68% in the midst of the economic crisis.  They have also increased the dividend yearly in the last 12 years.  We can see that the our calculated growth rate of 8.7% is showing not to be way off either, and relatively conservative.

Taking this and the economic situation into account, we can estimate the dividend growth for the next 10 years.  Its likely that they will be able to increase the dividend by at least 1% in next two years, 7% in following three years, and 10% in the years after that.  This is well below the annualized historical 10.70% increases as well as the average year to year increases.  It should be very conservative given Wells Fargo’s current financial strength.

Using a discount rate r (risk free rate) of 10% we can project the dividend, and take its present value:

YEAR GROWTH PROJECTED DIVIDEND PVt = FCt/(1+r)^t t r
2009 1.01 $ 1.37 $ 1.25 1 0.10
2010 1.01 $ 1.39 $ 1.15 2 0.10
2011 1.07 $ 1.48 $ 1.12 3 0.10
2012 1.07 $ 1.59 $ 1.08 4 0.10
2013 1.07 $ 1.70 $ 1.06 5 0.10
2014 1.10 $ 1.87 $ 1.06 6 0.10
2015 1.10 $ 2.06 $ 1.06 7 0.10
2016 1.10 $ 2.26 $ 1.06 8 0.10
2017 1.10 $ 2.49 $ 1.06 9 0.10
2018 1.10 $ 2.74 $ 1.16 9 0.10
2019 1.10 $ 3.01 $ 1.16 10 0.10

Now we need to estimate a Terminal Value with stable growth. As a conservative approach we assume that after 2019, things will slow down to a stable and slow rate.  We assume that companies can no longer sustain the higher growth past the 10 year mark.

TV = CFt / (r-g)
I usually use 6% for rate r (3% inflation + 3% GDP).  Again, you can use whatever number you see fit, but from my knowledge 6% is a good conservative & realistic number:

TV = $3.01 / (0.10-0.06) = $75.27
Calculate PV of TV with stable growth (t=10):
PVt = TV/(1+r)^t = $29.02

Calculate the Intrinsic Value:
Total sum of all PVs (including the PV of TV) = $41.21
WFC as a dividend making machine alone (based solely on dividend payments), is worth at least $41.21.

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It is highly suggested that you also calculate the intrinsic value based on earnings as well. For other stocks you may want to calculate the intrinsic value based on dividends AND also based on FCF.  Another recommendation is to change the estimates to be more pessimistic, in order to give an idea of how that affects the value, in the event of a negative future outlook! In addition, it is recommended that you also do estimates for possible share increases or decreases.  This can be done by multiplying the per share intrinsic value by the number of outstanding shares (will give intrinsic value for entire company), then divide that number by the estimated number of shares.  You can instantly see how share buybacks or share offerings increase/decrease the intrinsic value.  Its always useful to look at an asset from more than one perspective.
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What is our margin of safety? Margin of safety (or safety margin) is the difference between the intrinsic value and the market price of the investment/asset.  This is how we gauge if we are overpaying or not, as well as providing a buffer for errors in our estimates.

Current market price = $27.00
Margin of Safety = 1 – (Current Market Price / Intrinsic Value) = 34.49%

There is no set rule for what the Margin of Safety should be.  It is something the individual investor chooses when performing their own assessment.  It is whatever they may deem to be acceptable, and is often based on the level of risk present in the particular business in question.  I usually like Margin of Safety values in the area of 50%.  This way the calculation can be half wrong and I still wouldn’t have overpaid for the asset.  So assuming nothing material changes, I would wait for the price to reach a level that gives me a good enough margin of safety as well as being relatively cheap!

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Now to recap the concept at the beginning of this article:   Just because the market price of an investment drops significantly, it doesn’t necessarily mean it is undervalued.  We must calculate its intrinsic value or worth, compare the market price with the intrinsic value, and assess the margin of safety, in order to be able soundly ensure we are receiving an adequate discount.

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This wraps up the Bank Valuation series.  I hope you have enjoyed the articles.  They were packed with a lot of information, and I strongly suggest reviewing them, and also continuing to research a bit more on your own.  Each topic itself can be studied further and in more detail.

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Thanks & Happy Investing!
The Investment Blogger ©

Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.

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22 thoughts on “Bank Valuation VIII

  1. hi, i have read your bank valuation series. and obviously, i’m doing an investment research about a bank. i just want to ask about the how do you come up with the estimates you have presented particularly the dividend growth rates (increase the dividend by at least 1% in next two years, 7% in following three years, and 10% in the years after that). hoping for your reply. thanks have a good day!

  2. Remember that growth rates are estimates of how we think the business will operate in those years.

    In the estimate we try to use numbers that account for slowdowns (the 1%) and increases in business, but also try to smooth out the dips/spikes in the long run and bring that growth number inline with what we feel the business would be capable of in the long term (7% and 10% still below annualized historical low of 10.7%). We try to be conservative, while at the same time thinking about the business environment down the road.

    When and how long those numbers would be 1%, 7% or 10% is up to your own business background to come up with. Everyone’s estimates will be different and for different reasons. Since this was an example I didn’t think too long about it, but the 1% (close to no increase) for 2 years should be pretty reasonable considering the banking industry mess. And it turned out that they actually did end up reducing the dividend. Then I put an increase of 7% and 10%, for when the economy starts picking up. Even if its off by a year or two, annualized the 7% and 10% will be smoothed out. Try not to put too many different numbers in those 10 years of growth estimates. Keep it relatively simple (3 numbers max is good). After 3 numbers it starts the error in estimation will probably increase.

    Again this is just an estimation which at the end will be halved (if using 50% margin of safety) allowing you to be 50% wrong in your intrinsic value estimation.

    Also don’t forget to use the earnings ability of the banks to calculate the intrinsic value using DCF as well. Essentially you’ll have two intrinsic value estimates calculated to compare with.

    There is no golden standard for doing this. Every businessman has a different method and different reasons for their estimates. The idea is too remember that it is an estimate and to use many different techniques and look at different metrics all together. Hope that kind of answers your question?

    1. All right then thanks for your time. Another query, what do you think is the most appropriate valuation model for stocks of banks? Any suggestions?

      1. I don’t feel there is a single most appropriate valuation estimate/model for bank stocks because valuation is an estimate. I always use both dividends (unless none ever paid) and earnings. But if I had to choose one it would be earnings.

        However, earning numbers can be fudged, so don’t forget to look at the other metrics which will raise red flags if the earnings is not telling the entire story or not an accurate representation of what is happening with the bank. Remember to also dig into everything else, such as the loan portfolio. People say that it seems like a lot, but something small like that has been useful in the last few years. It captures things that are not reflected in other numbers. It also helps to give you a better picture of future earnings in upcoming quarters. Read the previous quarter’s report because they always have detailed info about how much money they need to put aside upfront to cover losses from the loan portfolio for next quarter or year etc.

      2. What do you think are the important points to consider when evaluating a bank? Considering banks are to some extent, different from other industries (like on financial statements, capital structure etc.)

      3. If you go through the list that this series of articles cover you should be alright. I usually dig further and also focus on how the bank makes money, so I look at their operating segments/divisions. They may have deposits and retail banking, loans, investment house, etc. Look at each segment’s numbers to see what and how they are doing.

  3. What can you advise if I am going to use justified p/bv valuation ( Justified P/BV = (ROE – g) / (k – g)) and will you give me some advise in forecasting bank’s financial statements ( like advises on what books or references to use, what points to consider in allocating percentage changes in future years etc.) This conversation is really helping me.

    1. I don’t really use the justified P/BV for valuation. The reason is because k is Cost of Equity, and there is a variety of ways to estimate it. The key word being estimate. Many times it is unnecessarily introducing more variables into the calculation (which leads to larger error in estimation), while leading the investor to believe they are being more accurate or precise. I stick to the DCF formula using earnings instead of CF, and use it in the most basic form. Being conservative with fewer inputs, and having a larger MoS, will lead to less error. Hope that makes some sense? Buffett had also mentioned the usage with less variables, and pitfall of estimation with formulas that use more variables.

      I usually take the P/BV as is, over a large number of years. I use that as one metric (along with others) to help determine if the price is relatively cheap or not. I don’t use it to estimate the intrinsic value.

      When forecasting the financial statements, I look at each operating division to see what they are doing, then estimate how much will that part of the business grow (in terms of both revenue and costs), then I look to see how they affect the overall earnings picture. And again, don’t try too be too precise. It is an estimate. Just remember to be conservative & cautious.

      Unfortunately I don’t recall any specific books about assessing bank numbers. But knowing how they work will open up a lot more. Especially after the financial crisis there have been many books written about the problems at banks. those books will give insight into understanding how things work (or didn’t work). Banking is very accounting & finance intensive, so increasing your knowledge in those two areas will help you understand what the annual reports are really saying about each aspect of their business. Numbers will start to stick out. Comparing banks with each other, also gives a lot of insight.

      Hope that helps!

  4. When forecasting, is it okay to just average the growth like for example averaging growth in 5 years? Or is it better to just assign a year that had been stable for that bank and use that year’s growth.

    1. If I understand your question correctly, if you are forecasting for the next 5 years for example, I would assign specific growth numbers to each of those years given what you think of the business and any conditions that may affect it within those years.

      Assigning an average growth number to each of those years, or using a number from a stable year is alright too, only if you think that those numbers are representative of how you think the bank will perform. That is the key, whatever numbers you use must be a reflection of what you think the growth of the bank will be like.

      If you are using an average number, it assumes that if the bank performs below that number within the given years that you are also expecting it to do better within those years as well, in order to average out to your average number.

      Just be aware of the limitations of the numbers you are using. Hope that makes sense.

    1. This is again where the “business you” comes into play. Everyone is going to come up with different numbers for the growth rate. You’re going to have to do some industry research to help you out, if you haven’t been following the industry. Some questions to ask yourself are:

      – What is the total deposit growth rate in the industry?
      – How competitive is the bank compared to its rivals?
      – How much market share of deposits will your bank take away from its rivals, or alternatively lose to its rivals?

      Usually bank deposit growth is determined by market forces, population, and economic conditions.

      For starters, here is a good simple resource to help you get started on determining growth rate of deposits:
      http://www.fdic.gov/bank/statistical/index.html

      There are many other resources you can easily dig up on the internet including industry magazines, journals, etc. Also other banks’ annual reports, and conference calls are great and invaluable sources of information!!

    1. I glad I could help some fellow investors, especially those who truly seek to advance their knowledge like yourself! Most people just want a quick and easy way rather than go through the steps. Keep up the good work & keep progressing your knowledge!

  5. how can you value a company that have a negative growth? and what are the other ways to compute for the GROWTH aside from G= Roe * RR?

    1. For a company that has negative growth in a particular year or for more than one year, what I find useful is to find the years in which the avg growth becomes positive at the end of it. I would use the avg growth number, and use them from across those years. I would then forecast as I normally would for the years after that. This is because, eventually the company should return to some kind of growth (if not, maybe its not the best investment), where the avg across those years would become a positive number. In doing so though we must realize the limitation with this approach, as discussed in the response to Charm on 8/29/2010 above. We would also take note of the year in which we believe we would see a positive growth avg emerge.

      There are a few ways to calculate growth but it depends on what you are going to use it for. However, I usually only compute the growth using those formulas if I want to backwards calculate some overall historical growth rate for a company. Otherwise I would calculate historical growth of the specific data set in question (cash flow, income, roe, etc).

      For forecasting, I usually dig deep into the operations of the company and calculate my growth number for each individual operation. Then I would combine them for an overall growth rate. I also forecasting from a business point of view, as if I was running the business myself. I then compare that with what management says (if they mention specific growth numbers). I also compare with the historically calculated rates to see how different they are and note the reasons for the differences. I find that to be the best way to forecast growth.

      Hope that helps!

  6. What is your opinion on the proposed implementation of basel iii? How will this affect banks especially in Asia? Have you heard of Metropolitan bank and trust co. in the Philippines? If so, I just want to know your assessment on this bank, it has been so bullish this year.

    1. The proposed implementation of Basel III is going to make things a bit difficult for some banks, but in the long run stricter rules should help make the system more stable and refrain them from taking unnecessarily high risks.

      Banks in Asia will be affected pretty much the same way as other countries. However, if a certain country had laxer rules and oversight (in general), banks in those countries may have a bit more difficult time adjusting. The capital conservation requirement won’t be in effect until 2019, so they have some time to get things in order.

      Don’t forget that the regulators are not yet finished with Basel III.

      I came across a FP article that gives a pretty good and brief commentary on Basel III impacts.
      http://www.financialpost.com/Basel+rules+good+start/3520214/story.html

      Unfortunately, I am unfamiliar with Metropolitan Bank and Trust Co. Regardless of how bullish it has been, the decision should really come down to the results of sound research and analysis. Your valuation should show if it is undervalued, and all the other metrics (including qualitative) discussed in these articles should show any obvious problems/risks.

      After that point it comes down to investor preferences and the return vs other investment opportunities available at the time. You may also want to consider the international exposure as well, versus other investments which may not give you the same global footprint.

      Hope that helps!

  7. Hi investment blogger, I have read some of your replies on the articles posted by charm, I was thinking also regarding about the implementation of basel III pertaining to what will be the adoption for the Philippine Banks especially for Metropolian Bank and Trust Co. The financial industry in Asia is somewhat known to have a capital fund above the minimum requirement.
    The thing is, the implementation is still in its rumors but, Metropolitan Bank is now adapting as an advance and still exceeding the minimum requirement. How can we know the factors that will affect them?

    1. You will never know for sure in advance all the factors that will affect a bank or any other business for that matter, but you can guess some of them, especially in this case where the rules are not finalized and subject to change.

      What you want to do is come up with one or two likely scenarios where the rules may change the capital requirements from proposal A to become B or C. Then see how the bank will look under those two operating conditions. Also think about other requirements that may not have been proposed yet, that very well might be in the near future. Take a look at how it performs under those conditions.

      The bank adopting the requirements in advance is a good move showing a proactive management rather than reactive. Being able to still exceed the minimum proposed requirement is also a good sign. Check how they do under different scenarios now.

      In general, what I do with any investment/business under consideration, is to come up with a range of scenarios (for each significant operating area) and see how it affects the business. Some scenarios are related to items/issues that are already in existence, and some that have not yet come up but may in the near future. This gives a range of different outlooks to evaluate, which helps you make investment/business decisions.

  8. Hi investment blogger.
    I am really impressed with your article. now i have a question to you. hope you will reply me.
    how banking risk such as credit risk, liquidity risk impact on bank valuation, performance and operations?

    thanks

    1. Credit risk and liquidity risk issues both require cash to handle. When a bank runs into either problem, they are forced to use their cash to address them which means there is less to reinvest into growth areas, and therefore less to enhance performance or operations. Credit risk in particular uses the loan loss reserve (cash) that has been set aside. The larger the credit risk, the more that the bank should set aside in the reserve, which again means less cash to use elsewhere. However if the bank underestimates the credit risk in their loan portfolios and the reserve is not large enough to handle the non-performing loans, like in 2007-2008, then it exacerbates liquidity problems. In the worst case, that liquidity problem would create a run on the bank. As an example of how it impacts your calculations, you need to take a look at the loan portfolio profile and then determine if enough has been set aside for reserves. Estimate the additional amounts necessary to be taken from their cash balance to place into the reserve. That will then change the intrinsic value. Do the same for other areas of the valuation.

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