Excess Returns Model
Excess Returns · Residual Income · Bank Valuation via Excess Returns
A valuation method for banks that prices the ability to generate returns above the cost of equity — an alternative to the Gordon model for fast-growing or transitioning banks.
What it is
The Excess Returns Model (residual income model) values a bank as the sum of:
1. Book value (TBV) The starting point — tangible equity today.
2. Present value of excess returns (explicit phase) Over 10 years, we explicitly project how much value the bank creates above the cost of equity:
ER_t = (ROTEt − COE) × BV{t−1}
where:
- →ROTE_t = return on tangible equity in year t
- →COE = cost of equity
- →BV_{t−1} = tangible equity at the start of year t
Every year ROTE > COE, the bank "creates" value. Every year ROTE < COE, it destroys it.
3. Terminal value After year 10 (perpetuity): TV = (ROTE_terminal − COE) × BV_10 / (COE − g)
Resulting equity value = TBV + Σ PV(ER_t) + PV(TV)
This model is the banking equivalent of DCF — instead of FCF it discounts "economic profit" (return above the cost of capital).
Why track it
The Gordon model P/TBV ≈ (ROTE − g) / (COE − g) assumes ROTE is constant both today and in the future. For banks where:
- →ROTE changes significantly over time (rate transitions, restructuring, growing bank)
- →The explicit transition period matters (the bank is investing and ROTE temporarily declines)
- →The timing of reaching "steady state" is important
...the Excess Returns Model is more accurate.
Relationship to the Gordon model: If ROTE is constant in all years, the Excess Returns Model gives the same result as the Gordon model — they are equivalent approaches under the same assumptions.
Watch: how does the P/TBV implied by the model change across ROTE scenarios? Sensitivity to ROTE in years 1–3 is key — the market discounts distant returns more heavily.
Real-world example
Fast-growing bank (model example):
- →TBV today: €10bn, COE: 10%, g: 3%
- →Years 1–5: ROTE 8% (below COE — bank growing, investing in distribution)
- →Years 6–10: ROTE 13% (above COE — scaling, profitability rising)
- →Terminal ROTE: 14%
Gordon model would use current ROTE 8% → fair P/TBV < 1×. Excess Returns Model sees the transition phase and correctly prices P/TBV > 1× thanks to future ROTE of 14%.
Result: The model implicitly prices the "path to profitability" — value that the simple Gordon formula misses.
Watch out for
The model is sensitive to terminal ROTE and COE — just as DCF is to terminal growth and WACC. A small 1% change in ROTE_terminal at COE 10% and g 3% can shift the resulting equity value by 15–20%.
Do not project ROTE that has never been historically achieved without a compelling fundamental reason (new business mix, rates, regulation). The Excess Returns Model is a powerful tool — but garbage in, garbage out applies doubly here.