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Why Use the Excess-Return approach?
This company operates in the financial-services sector, so traditional free-cash-flow DCFs break down:
- Invisible reinvestment. Net capital spending and working-capital swings are hard to pin down because most “investment” is buried in operating expenses and balance-sheet flows.
- Debt is raw material. Deposits and repos behave like inventory, so defining leverage and a cost of capital is murky.
- Regulatory constraints. Capital-ratio rules and product limits dictate growth and leverage, making long-range cash-flow forecasts speculative.
- Reliable anchor. Book equity is regulator-verified and often marked to market; value therefore hinges on the single spread ROE − cost of equity, which the Simple and Two-Stage Excess-Return models convert directly into intrinsic value.
Why we don’t export these models to other sectors
- Observable cash flows. Manufacturers, retailers and tech firms can measure cap-ex, working capital and debt, so cash-flow-based DCFs remain more informative.
- Book equity mismatch. Their book values reflect historical cost and depreciation, diverging sharply from economic capital; anchoring value to book equity would therefore mislead.
Reference: https://pages.stern.nyu.edu/~adamodar/pdfiles/papers/finfirm09.pdf
