Banks and other financial intermediaries often are very profitable and recently on average have earned significant economic profits; however, their performance fluctuates regularly and may decline over the long term.
Although it has been pointed out that under standard equilibrium models banks would earn no profits and would become redundant institutions (something we do not consider likely in the foreseeable future), we believe that one way of embedding a margin of safety (during good times) or a sense of realism (in bad times) into valuation is by assuming that current and near term performance approaches an average, or a level that could be assumed to represent an equilibrium. Alternatives for such an equilibrium level of profitability include:
- A stipulated level of future stable-state industry profitability
- The long-run average of a particular institution, the industry or the economy overall
- The cost of capital, as an average or as it fluctuates over time
We have used all of the foregoing and other alternatives, and have drawn similar conclusions from them, so do not believe it useful to spend too much time choosing among them. Using the cost of capital as equilibrium level is probably the most consequent implementation.
