You’ve spent seven posts learning one tool. Here’s why it doesn’t work on banks — and what to use instead.
Imagine you’ve spent the past seven posts learning how to use a socket wrench. You practiced on bolts. You got the technique right. Then someone hands you a screw and says, “Now use it on this.”
Same task. Wrong tool.
That’s the situation with banks, insurance companies, and other financial firms. The goal — figuring out what a business is worth — is identical. But the tool we’ve been using, the FCFF model (Free Cash Flow to the Firm — the cash a business generates after operations and reinvestment), doesn’t work here. Not because the logic is wrong, but because the inputs don’t mean the same thing for a bank as they do for a manufacturer.
This post explains why. And it introduces the tool that does work.
The Model We Built Assumes Two Separate Worlds
When we valued Maple Ridge Manufacturing, we implicitly divided the business into two buckets:
- Operating activities — making and selling products, running factories, paying employees
- Financing activities — borrowing money, issuing shares, paying interest
Those two buckets stay separate. A manufacturer borrows money to fund the business, but the borrowing is a financing decision, layered on top of the operating business. That’s why FCFF starts by calculating what the business generates before any payments to lenders. The debt exists on the side. It’s subtracted at the end, in the equity bridge.
This separation is so fundamental to the FCFF model that it’s baked into every step: we start with operating earnings, we add back financing costs (after tax), and we subtract net debt at the end. The whole structure depends on being able to cleanly separate “running the business” from “how the business is funded.”
Banks cannot do this. For a bank, borrowing money is the business.
A Bank Borrows Money to Make Money
Here’s what a bank actually does. It takes in deposits from customers — your savings account, your checking account. Those deposits are liabilities. The bank owes that money back. Then it turns around and lends that money to other people at a higher interest rate. The spread between what it pays you on your deposit and what it charges a borrower on a loan — that’s the core of the business.
Deposits are raw material. They’re not borrowings in the traditional sense — they’re the input the business transforms into loans.
Now think about what that does to our model.
In FCFF, we separate operating activities from financing activities so we can value the core business independently of how it’s funded. But for a bank, the funding is the core business. A bank with no deposits isn’t a bank. It’s just a building.
The line we drew so carefully — “here’s the operating part, here’s the financing part” — doesn’t exist for a bank. They’re the same thing.
Two Other Problems the Model Can’t Solve
Debt as raw material is the big one, but two other features of financial firms also break the FCFF inputs:
Capital expenditures and working capital don’t translate. In Part 4, we calculated Maple Ridge’s FCFF by subtracting capital expenditures (the money spent on factories and equipment) and changes in working capital (the money tied up running day-to-day operations). For a bank, neither of these makes sense in the same way.
A bank’s “capital expenditure” is a loan it makes. Its “working capital” is the deposits it holds. Both of these are financial assets and liabilities, not the physical investments and operational inventory we modeled for Maple Ridge. You can’t apply the same formula. You’d get a number that means something entirely different.
Regulatory capital constrains distributions. Banks and insurance companies operate under rules — set by government regulators — that require them to hold a certain amount of capital as a buffer. This regulatory capital requirement means the firm cannot freely distribute cash to shareholders even if it generates it. Before a bank can pay a dividend or buy back stock, it has to satisfy regulators that it is adequately capitalized.
FCFF is designed to measure cash flows to the firm — before any distributions to either lenders or shareholders. It doesn’t account for what regulators will or won’t allow. For a financial firm, that omission matters enormously.
The Right Tool: FCFE
For financial firms, we use a different measure: Free Cash Flow to Equity, or FCFE. Where FCFF measures cash available to the whole firm, FCFE measures cash available specifically to shareholders — after all obligations are met, after reinvestment requirements are satisfied, and after regulatory capital requirements are addressed.
For banks, this ends up being closely related to dividends. A bank that retains earnings to meet capital requirements and then pays out the rest to shareholders is, in a real sense, giving shareholders their FCFE. The cash that flows to equity holders — that’s what we value.
There’s a conceptual elegance to FCFE for financial firms. Because we’re starting from net income and working down to what’s available to shareholders, we never have to separate operating activities from financing activities. We don’t need to. We start at the equity level and stay there.
The discount rate changes too. In the FCFF model, we used WACC — Weighted Average Cost of Capital — which blends the cost of equity with the after-tax cost of debt. For financial firms, we don’t compute WACC at all. We use the cost of equity alone, because we’re valuing only the equity from the start.
Which Firms This Applies To
If it holds deposits, issues policies, or uses regulatory leverage as a core business function, you need the FCFE model. That includes:
- Commercial banks — Wells Fargo, JPMorgan, regional banks, credit unions
- Savings institutions — savings banks, thrifts, mortgage-focused lenders
- Insurance companies — both life insurance (policies held for decades) and property & casualty (car insurance, homeowners insurance). Insurance firms get one additional treatment: their earnings are normalized across years to smooth out the effects of catastrophes. A bad hurricane season can make an insurer’s income look artificially low; we average across years to see the underlying business.
- Investment banks and brokerages — more variable, but the same logic broadly applies where proprietary capital is at work
The common thread across all of these: debt is operational, not financial. It’s not a side layer of funding. It’s the material they work with.
Same Goal, Different Path
Here is what hasn’t changed:
We are still discounting future cash flows to arrive at a present value. We are still projecting a high-growth period, adding a terminal value, and dividing by shares outstanding to get intrinsic value per share. We are still applying a margin of safety before making any investment decision.
The underlying logic — that a business is worth the present value of the cash it will generate for its owners — is unchanged. The inputs are different. The path is different. The destination is the same.
Think of FCFF and FCFE as two routes up the same mountain. For most businesses, FCFF is the right route. You start with operating earnings, account for reinvestment, discount at WACC, and cross the equity bridge at the end. For financial firms, the terrain is different, and you take the other route. You start with net income, account for what’s retained versus paid out, and discount at the cost of equity. Same summit. Different trail.
What Comes Next
The Valuing Financial Firms sub-series walks through the FCFE model step by step, using the exact same structure as Parts 1–7. Each post is written to pair with its counterpart in the main series — so if you’ve followed along through Part 7, you’ll see precisely what changes and why.
- Financial Firms, Part 1: What Is FCFE and How Does It Differ from FCFF? (parallels IV Part 3)
- Financial Firms, Part 2: Calculating FCFE for a Bank (parallels IV Part 4)
- Financial Firms, Part 3: Where the Growth Rate Comes From (parallels IV Part 5)
- Financial Firms, Part 4: Risk and the Discount Rate (parallels IV Part 6)
- Financial Firms, Part 5: Putting It All Together (parallels IV Part 7)
The One-Sentence Summary
Banks and insurance companies use borrowed money as their core raw material — which means the clean separation between operating and financing activities that the FCFF model depends on simply doesn’t exist, so we use FCFE instead: a measure of cash available specifically to shareholders, discounted at the cost of equity alone.
Coming up: Financial Firms, Part 1 — what FCFE actually measures, and how it differs from the free cash flow model you’ve been using.
Also in this series: Part 9 — When to Sell and Why. The buy discipline and the sell discipline are two sides of the same framework. Part 9 closes the Intrinsic Value series by covering the four conditions that should trigger an exit.
— Jim