Hi Hei123, very good question from u.

There are constraints in every valuation model. Pe model basically measure the relationship between price change n it' s eps, it doesnt take into account of what is happening to the balance sheet. if we add in provision we will distort the pe ratio n they will become volatile. As I have mentioned in my post yesterday when bank increase their provision it will push down the eps n resulted to higher pe ratio n once the bad debts are settled they will write back the provision n thus resulted to a low pe but these accounting entries have no direct relation to its core performance becos the provisions are already accounted in the balance sheet. 

Hence to safe guard ourselves against any unexpected contraction in business activities (example further rise in provision) which will lead to downward revision of valuation we will need to apply a margin of safety from its valuation when  we buy. 

What I suggest is after u have applied the pe model on DBS u can try it on scb (standard charted bank), a more risky bank n u will see the correlation between stock price n operating earning. Becos when u look at scb, it' s last year operating earning contract by about 50% (net profit loss) n u will see how it' s valuation move in line with its operating income. 

Another way to value a firm is the cashflow n balance sheet method which I share quite a number of time. We will still add back/exclude (depending on the item) the provision, non cash items, non recurring items to its cashflow but the provision will be deducted from its balance sheet. Reason being is apart from being a non cash item provision is also considered as a non recurring item becos as I mentioned we can have the bank increasing their provision for this year due to bad economy n they can also write back their provision in the following year. 

However, when we deduct the provision from the bank balance sheet it is not advisable to take the provision amount given by the bank. Not becos that we can' t trust them, it is for conservative reason, just in case there are further bad debt down the road. Thus my own practice is whatever amount the bank provide I will increase it by 100% n this amount is referring to the accumulated provision stated in the balance sheet n not the new provision for the year stated in the income statement. Thus it is a very conservative scenario.

to summaries what I just said in case I have confuse u..for the pe method becos of it' s constraint of not able to take into account of the balance sheet we can provide a margin of safety to protect ourselves in the short run just in case more bad news arises n pushes down the stock price further but over time the valuation will move in line with its operating income. As for cashflow n balance sheet method it is more straightforward, increased the bank provision n deduct it from the balance sheet but add it back in the cashflow otherwise u will over or understate the valuation which I have xplained in my post yesterday.

feel free to write to me if u have further queries :)

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