Business decisions associated with financial services may be challenging especially for those seeking to acquire stake or possible association with financial service providers. Analysts, investors and entrepreneurs face difficulties in deciding the ideal valuation to rely on when evaluating companies offering financial services. There are three main attributes of financial services that complicate the valuation process as we detail them in this article:
- Differentiating Debt from Reinvestment
- Estimating Cash Flows
- Regulatory Requirements
Differentiating Debt from Reinvestment
The first problem you will encounter as you attempt to value financial service providers is the difficulties in differentiating debt from reinvestment. The Little Book of Valuation indicates that debt in financial services is a raw material and not a composition of its capital. Valuation of other businesses looks at debt and equity as part of their capital composition different from financial firms.
The definition of debt is challenging for financial companies with some of its components difficult to distinguish from debt. For instance, would one consider customer deposits debt? Also, majority of financial services rely on debts to finance their operations compared to other businesses and hence creating a difference in financial leverage measure. This has created a complication in the valuation process limiting abilities of individuals to define operations and their composition based on debt and reinvestment.
Estimating Cash Flows
The difficulties in defining debt and reinvestment have given birth to another problem in valuing financial services. This is the estimation of the cash flows of the companies. Regulations have constrained financial services in their investment and the approaches or means with which funding is invested as explained also by the Little Book of Valuation.
Working capital and net capital expenditures are essential component of understanding reinvestments or the cash flow decisions and options of financial services. However, measuring either of working capital and net capital expenditure for financial service providers is a challenge. These pose questions on ideal estimations of the cash flows of these businesses further complicating the process.
Lastly, the regulatory requirements of the financial service providers have also contributed to difficulties in conducting and understanding of the valuation of firms offering this nature of services. The application of both accounting standards and other regulatory provisions have restricted valuation with different laws and policies needed to be considered for adequate and accurate valuation. Whilst Singapore accounting standards follow closely to international financial rules, considerations such as loss provisions and smoothing out of the earnings of the companies is worth factoring in, which adds to the complications of valuing businesses in this field.
The combination of these points makes it problematic to value financial services with both investors and analysts struggling to find a reliable working formula. A relative valuation system may help solve the above problems though not definitive in approach. With this approach, the differences in regulatory environments and the proper differentiation of debt from reinvestments is possible.
All in all, conducting valuation for financial companies is a challenging affair and should in almost all cases, be left to qualified valuation professionals in determining so.
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