UAE Banks Estimation: Dividend Discount Modelling

A brief and comprehensive summary of the proposal

The United Arab Emirates has emerged as a safe haven for investors and businesses as the state has successfully implemented its trade, fiscal and monetary policies, which cultivate major financial inflows and revenue. The UAE includes oil-rich countries such as Abu Dhabi and Dubai, which also offer great opportunities in property investment and tourism. The recent upsurge in oil prices and property hype have created ample liquidity in the market, which has, in fact, pushed the existing banks to generate exceptional growth and also has attracted new banks to the market.

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The UAE banking sector constitutes national (local) and foreign financial institutions operating as commercial, investment and Islamic banks. The banking sector offers security and financial soundness with gigantic deposit escalation on the back of moderate low-interest rates and diverse credit facilities. The high liability to asset ratio funds the bank’s earnings with further expectations of growth as the major world economies are faced with a credit crunch, and the UAE offers a better deal as a whole.

The region has two stock markets, namely Abu Dhabi Securities Market (ADX) and Dubai Financial Market (DFM), allowing only national banks to enlist their shares. This thesis will examine the banking sector’s perspective with its major participants, perform a valuation of banks’ fair values and financial analysis, recommendations for various banking stocks, and finally drawing conclusions on the intrinsic values of the banking sector in the UAE.

The subject area for this research is interesting as the global financial systems are being criticised for their weaknesses and have been blamed for triggering economic depression across the economies. Through this research, we would be able to develop grounds for determining the performance of UAE banks by carrying out PEST and SWOT analysis of banks under consideration and also predict their future performances in light of the unleashed problems and challenges which lie ahead.

Introduction

The UAE financial market has remained conservative, with various restrictions on the operations of banks until recently. With the relaxation of the regime’s policies banking sector has emerged as one of the most elements of the economy. Through this thesis, we would be able to understand and draw our conclusions regarding the fundamental values of national banks enlisted on the UAE stock exchanges. Furthermore, this report would entail analysis of the industry’s norms and practice, critical evaluation of success factors for these banks, factors pivotal to investors’ decision and finally, making recommendations for various banking stocks.

The objective of this thesis is based on the fundamentals of the UAE stock exchanges, which came into existence in early this century. The equity markets still lack investors’ confidence in its principles and operations as many IPOs and subsequent stock trading has shown tremendous volatility, and its credibility has to some extent been affected by the uncertainties revolving around these markets.

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The UAE capital markets, when compared to global markets such as NYSE, LSE and even BSE, are still a long way before they realise their true potential for investors. The understanding of valuation methodologies would assist in determining the fair values of a bank’s stocks and develop a basis for investors’ decisions keeping in view the uncertainties and lack of information in these equity markets.

Relation to previous research

The UAE includes the countries of Abu Dhabi, Dubai, Ajman, Ras Al Khaimah, Fujairah, Sharjah and Umm Al-Quwain (CIA, 2008). The state enjoys a strategic demographical location which is the highlight of its success. The UAE offers secured opportunities for businesses and attracts investors, which bring major cash inflows into various market sectors. The UAE has major oil fields in Abu Dhabi and Dubai, which has been the major source of income for many years and ample liquidity in the economy is boosted by recent price hikes. Furthermore, Dubai has opened its avenues for foreign direct investment by promoting property rights and tourism opportunities.

The need for high-quality banking in such an activity-based economy is vital for handling and utilising large funds pouring into its financial system. The banking sector became the biggest beneficiaries as the UAE faces economic turnover in the last 15 years or so with increased spending on both governmental and private levels. Banks deposits showed healthy growth of CAGR 35%, whereas credit rose by 42.4% in the period 2004-2007 (Marfatia & Ali, 2008).

The banking sector is dominated by national banks has a total of 48, including 21 local and 27 foreign banks, which are limited to only 8 branches throughout the state (Zawya, 2008). The WTO is pressuring the UAE government to allow foreign banks to compete with local banks, but the government is still reluctant to do so. The local banks are investing in expanding their business network to face up future challenges. With growth expectations of 60% in GDP from US$185bn at present to US$294bn by the year 2012, UAE poses itself as a major player in the global financial market (AME Info, 2007).

However, it is also argued that while the banking sector is still in a strong position, it faces greater challenges in the future as the lack of prudential regulations may result in banks exceeding their loan-to-deposit ratio. This would jeopardise the strong financials which banks have been able to post during the last few years (AME Info, 2007). At the same time, Islamic banking offers opportunities that could be far rewarding than conventional banking. The demand for a formal market where stocks of major companies could be traded lead to the establishment of two exchange markets, ADX and DFM.

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However, in the early 2000s, only national banks are allowed to be listed on these stock markets. These markets are still to achieve efficiency in their opportunities offerings, operations and information flow. Furthermore, the credit shortfalls in major economies are causing panic across the globe, which is surely affecting market performance in the UAE. The world’s financial system has been greatly affected by liquidity crises, and banks are facing the most difficult time to regain market confidence and avoid major collapses.

The equity markets setting low records of indices and investment highlights the graveness of the current issues the worlds’ economies are facing. The asset side of the UAE banks heavily invested in providing finance for the property market is subject to the market risk as panic sweeps around the globe.

The dividend discount modelling states that the bank’s stock returns can be high if the future earnings growth is higher; its expected returns are low or a combination of both (Castren, O., Fitzpatrick, T. & Sydow M., 2006). The concept of DDM uses a multifactor approach and has been widely used for determining expected returns from a bank’s stocks. Earlier studies predicted that the profitability of banks is directly related to the expected stock returns (Haugen & Backer, 1996).

However, recent dynamic models indicate that there is no uniform explanation for determining stock returns. It is observed that news related to the bank expected returns or those related to market-wide components tend to affect stock indices. Furthermore, the effect on stock indices due to news cash flow news is related to the bank’s size, i.e., the larger the size, the higher is the sensitivity (Vuolteenaho, 2002).

Also, volatility in banks stock returns varies with their leverage level as banks tend to have short term deposits against long term loans and also with non-interest income of banks (Cooper, Jackson & Patterson, 2003). The higher the leverage is, the better returns are expected. In addition to the described, the business cycle and diversification in products banks offer also affects the returns in the equity market.

Proposed methods

The primary objective of the current thesis is to apply various valuation methodologies to form grounds for arriving at the fair value of stocks of banks. The scope of the study is limited to the selection of four banks from ADX and DFM. We will select two banks from each equity market; however, we aim to select banks with different classifications. The different classifications will include commercial and Islamic banks. The banks under investigation for this report include Abu Dhabi Commercial Bank, Dubai Islamic Bank, Mashreq Bank and National Bank of Abu Dhabi. The purpose of such selection is to allow detailed analysis and comparative approach deriving the fair values of banks’ stocks listed and traded on the UAE stock markets.

The valuation methodology will involve the implementation of a cash flow approach represented by the Dividend Discounting Model (DDM). The DDM model will be constructed for this study based on assumptions regarding banks future performance and creating forecasts for four accounting periods. The dividends for the forecast periods and the terminal values are then discounted back at the cost of equity to arrive at the total net present value.

The variable factors suggested by previous studies and current market conditions would form the basis for formulating expected returns. The competitor analysis will involve the market approach represented by Peer Group Valuation. This will be done by comparing the price to book value multiples enjoyed by other banks listed on these securities markets. The reason for using this approach is that the number of listed banks is limited, and it will extend the study results to understand the performance of the banking sector in a wider aspect.

The study will also involve financial statement analysis highlighting banks’ performance in the last four years, drawing conclusions on their growth and asset and liability composition with further cost-based analysis. The report will also incorporate PEST and SWOT analysis of the banks under consideration, and assumptions would be drawn for building future forecasts for the application of DDM. Furthermore, current issues in the global financial system will be part of this report with its implications and expected impact on the UAE banking sector would also be discussed with conclusions on what is to be learnt from the crisis scenario and what steps should be undertaken to overcome this.

The information required for carrying out the study on the fair values of selected banks will be drawn from both primary and secondary resources. The primary resources will be based on a positivist research approach, including telephonic interviews from banks’ managers (including those of general banking and credit department or others) and market participants, including brokers. This will provide data regarding the future market expectations of the banks’ progress.

Due to the limitations of perceived hostility of this method, a detailed questionnaire will be prepared and sent to the designated manager in the selected banks. The secondary resources which will be used for this study will be drawn from banks’ financial reports available from their websites and also from the investors’ section of the two exchange markets. The existing research will also be accessed for valuable information.

Reflections

The current thesis will cover different aspects of valuation methodologies and fundamental research enabling conclusions regarding the fair values of bank’s stocks. The study will include a detailed analysis of the banking sector, and in particular, the national banks enlisted in the Abu Dhabi Securities Exchange (ADX) and Dubai Financial Market (DFM). There are certain issues and limitations with such a study which we have to underline here to define the scope of the current thesis and set out the basis for the results, which this report will conclude upon.

Firstly, there are two stock exchanges listed in the UAE, and these markets have their separate entity, structure, regulations and listed companies. Therefore, we would cover both stock markets in our research and their progress over the last few years. However, it is imperative that the two financial markets are considered to be new markets, and the data available regarding these markets is limited. The existing research on these financial markets is available from certain resources; however, attempts will be made to ensure that the current thesis is based on the latest information regarding these financial markets and financial reports available.

Secondly, the number of local banks in the region is increasing on a YoY basis, and the conditions in the banking sector are continuously evolving. Therefore, it is practically unfeasible to study and analyse the data of all banks, as there would be no justice to the study, and it would be out of scope. For the purpose of providing a clear and comprehensive view and recommendations in this report, the study would be confined to the four principal local banks in the region. The selection methodology will be part of the main thesis; however, for the purpose of this proposal, we would select two banks from each stock exchange and carry out a detailed analysis of them and draw common factors along with recommendations for investors.

Thirdly, the data used for the current thesis would be drawn from first-hand information collected from primary resources, including interviews and questionnaires and also from secondary resources, including existing research, magazines, newspaper, financial reports and others sources. The current study is therefore subject to the limitations inherent to these methods of collecting data, and it is important to understand the subjectivity, validity and limited scope of these resources.

Fourthly, an ethical issue pertaining to this study covers the recommendations which would be carried out after detailed fundamental research. The primary objective is to discuss and implement suitable valuation methodologies using the data available from the bank’s financial reports. Therefore, the results are subject to the understanding of the writer, and any recommendations made through this report are subject to the market risk, and this information should be viewed in light of its limitations and subjectivity.

Finally, the researcher’s position in the political field should also be considered. The performance of the securities market and its participants are considered to have an influence on the political scenario in the country. However, the researcher hereby undertakes that all such issues will be covered in the report, which would not promote hidden agenda and a true and fair view of the results and industry overview would be furnished keeping in view the researcher’s understanding and approach to the subject.

Conclusion

The assigned topic and a brief proposal description would form the basis for the main body of the thesis. Once the proposal of the thesis is approved, further investigation related to the subject will be made. In the coming days, a detailed review of the prescribed literature along with an understanding of the various valuation methodologies will be carried out. The research will be initiated by preparation of questionnaire and carrying out interviews with the selected participants.

The information from the financial reports of the selected banks would be thoroughly examined, and the sections which would be relevant to this analysis would be reviewed and retrieved. Comparison with previous years and with the international banking sector would also be part of this report. Therefore, the collection of data in this perspective would be an important part of the research. With the support of the thesis, instructor/professor, the draft writing will be initiated with chapter wise completion and integration of these chapters with each other.

Thus, through this research, we would be able to derive the fair values of selected banks based on the dividend discount modelling and perform an analysis based on comparison with other institutions in the banking sector. Furthermore, we would also develop a scenario based on the current developments in the global financial systems and their impact on the banks under research and finally draw some predictions regarding the future prospects of these banks.

References

Abu Dhabi Securities Exchange. Publications. Web.

AME Info. (2007). U.A.E. banking sector strong, says IMF. Web.

AME Info. (2007). U.A.E. set for 60 per cent growth by 2012 says IMF. Web.

CIA World Fact Book. (2008). “United Arab Emirates”. Web.

Cooper, M. J., Jackson W. E., & Patterson G. A. (2003). Evidence of Predictability in the Cross-Section of Bank Stock Returns. Journal of Banking and Finance, 27, 817-850.

Dubai Financial Market, PSJC. (2008). Investors Relations. Web.

Marfatia, M. J. & Ali, B. (2008). Financial Services Banks U.A.E. The National Investor. Web.

Vuolteenaho, T. (2002).What Drives Firm-Level Stock Returns? Journal of Finance, 57(1), 233.264.

Zawya – Middle East Business Information. (2008). U.A.E. Banking System is Safe and Sound. Web.

Further Reading Abu Dhabi Commercial Bank. Investors Relation. Web.

Castren, O., Fitzpatrick, T. & Sydow M. (2006). What Drives EU Banks Stock Returns – Bank Level Evidence Using the Dynamic Dividend Discount Modelling. European Central Bank.

Damodaran, A. (2002). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Published by John Wiley and Sons.

Dickens, R. N., Casey, K. M. & Newman, J. A. (2003). Bank Dividend Policy: Explanatory Factors. Quarterly Journal of Finance and Accounting. Web.

Dubai Islamic Bank. (2008). Investor Relations. Web.

Erik L., Lüders-Amann, I. & Schröder, M. (2004). The Power Law and Dividend Yields. Centre of European Economic Research – Discussion Paper No. 04-51.

Frary, R. B. (2001). A Brief Guide to Questionnaire Development. Virginia Polytechnic Institute and State University. Web.

Fridson, M. S. & Alvarez, F. (2002). Financial Statement Analysis: A Practitioner’s Guide. Published by John Wiley and Sons.

Global Investment House KSCC. (2007). U.A.E. Banking Sector Report Core Earnings to Lead Growth. Web.

Gregoriou , G. N. (2008). Encyclopaedia of Alternative Investments. Published by CRC Press.

Haugen, R.A. & Baker, N.L. (1996). Commonality in the Determinants of Expected Stock Returns. Journal of Economics 41, 401-439.

Hitchner, J. R. (2002). Financial Valuation: Applications and Models. Published by John Wiley and Sons.

Istance, H. (2001). Research Methods. De Montfort University, Department of Computer Science. Web.

Kodres, L. (2008) Credit Crisis Is Broadening, IMF Warns. International Monetary Fund IMF Monetary and Capital Markets Department. Web.

International Monetary Fund. (2008). Global Financial Stability Report – Financial Stress and Deleveraging Macro-Financial Implications and Policy. Web.

International Monetary Fund. (2007). IMF Executive Board Concludes 2007 Article IV Consultation with the United Arab Emirates. Web.

Mashreq Bank. (2008). Financials. Web.

National Bank of Abu Dhabi. (2008). Investor Relations. Web.

Rozeff, M. S. (1990). The Three-Phase Discount and the ROPE. Journal of Portfolio Management, pp. 36-42.

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