Our valuation is based on two DCF techniques. Relative valuation is not appropriate in AIB’s case: sales-based metrics like P/S are impossible to use because there is no disclosure about the nature of sales for peers on Reuters where we obtain these consensus estimates (i.e. is it gross interest income, net interest income, interest revenues plus non-interest revenues?); EBITDA-based metrics are also out of the question because of the unique nature of financial sector businesses (i.e. little depreciation, interest being part of operating income and costs); and finally, the P/E metric is simply irrelevant now because the banking sector is expected to report losses in the short run.
We forecast that AIB will report significant loss in FY2010 due to NAMA transfer-related impairments (we assumed a 43% NAMA discount), after which we expect the bank to return to profitability as the recession ends (it should, eventually) and normal economic activity resumes. Besides, the balance sheet will be cleansed of problem assets and impairments should return to normal levels.
AIB performance forecast:
Source: company reports, analyst estimates.
Since financial institutions are very different from other types of businesses, our DCF valuation will be based on two techniques: the Dividend Discount Model (DDM) and the Excess Return Valuation, as described by A.Damodaran in his book Investment Valuation.
Dividend Discount Model
Historically, AIB regularly paid a dividend, which averaged at 32.5% of net income attributable to ordinary shareholders between 2004-2007. We assumed that the bank will not pay a dividend in FY2010 and will resume paying dividends in FY2011 at a modest payout ratio of 8.1%, returning to the historical rate by FY2014. We assumed that the payout ratio will remain at this level indefinitely and that net income growth will slow down to 2% by FY2019 (the assumed long-term growth rate). Discounting the expected dividends by the estimated cost of equity of 15.4% results in a price of €0.63 per share, assuming issuance of approximately 4.7 billion new shares in 2010 to supplement regulatory capital with €5 billion (through conversion of €3.5 billion of preferred stock and issuance of an additional €1.5 billion worth of stock at the current market price). We assumed that the remainder of the €7.4 billion required to strengthen the equity will come from other sources (sale of assets, optimisation of debt etc.). There is residual dilution from outstanding warrants that were issued with the €3.5 billion preferred stock. Adjusting for this dilution, the estimated value of AIB’s shares is €0.60.