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Goldfard: Insurance company valuation (Key definition (g Growth, k…
Goldfard
: Insurance company valuation
Dividend Discount Model (DDM)
Determination of the growth rate for the dividends in the terminal value calculation
• Extrapolate growth rates during the explicit forecast horizon
Based on the dividend payout ratio, representing the portion of earnings paid as dividends, and the ROE, which represents the profit per dollar of reinvested earnings
The plowback ratio is used to refer to that portion of earnings retained and reinvested in the firm and the firm’s ROE . The growth rate is then calculated as
g= plawback x ROE
When estimating the terminal value, the growth rate should reflect the steady-state perpetual growth rate and should not reflect any bias resulting from higher than normal short-term growth estimates
In order to account for the uncertainty or riskiness of future cash flows, one can either risk-adjust the cash flows or the discount rates. It is more common to adjust the discount rates, a discount rate higher than Rf will diminush the discounted value
A practical way to determine the discount rate is via the Capital Asset Pricing Model (CAPM), which describes the relationship between the risk of an equity investment and the return investors expect to earn on that investment. The risk is defined as the investment’s beta, a measure of systematic risk
The beta selected for valuation purposes can be measured by the
target firm’s beta
directly or by using an industry-wide beta.
Industry-wide betas
should be interpreted carefully and adjustments may be required to reflect factors such as Mix of business and Financial leverage
Although it would likely be more accurate to use a different risk-free rate for each time period, it is more common and simple to use one single rate
Growth rates and discount rates are not independent of each other, growth rates are typically higher when assuming more risk (i.e. higher discount rate) and are lower when assuming less risk
Limitations
The actual dividends are difficult to predict
The definition of dividents is not clear for all stockbuyers, some may change it to creat value for the stock
Key definition
g
Growth
k
expected or required equity return
rf
risk-free rate
E(rm)
expected market return
E(rm) - rf
expected equity market risk premium
B
mesure of systematic market risk
BV
book value
A
asset value
N
CDF of the standars normal distribution
Discount Cash Flow (DCF)
The free cash flow is defined as all cash flow that
could
be paid as a dividend (event the cash flow that is reinvested )
Free cash flow is net of funds required for reinvestment in the company to support normal operations and financial growth
The implicit assumption in this method is that the free cash flow not paid as a dividend is invested to earn an appropriate (risk-adjusted) return
Two variations of this approach
Free Cash Flow to the Firm (FCFF)
FCFF represents the cash that could be paid to all sources of capital, including both the debtholders and equity holders
Uses a discount rate that reflects the overall risks to both debtholders and equity holders (a so-called weighted average cost of capital, WACC)
Discounting FCFFs gives total firm value; subtracting the market value of the debt from the firm value gives the total equity value of the firm
shortcoming of FCFF
This would imply that a distinction in the leverage from issued debt and policyholder liabilities would have to be made
The presence of policyholder liabilities makes it difficult to estimate the WACC
Free Cash Flow to Equity (FCFE)
FCFE represents the cash generated by the firm, over and above its reinvestment and debt financing costs, which could be paid to the shareholders of the firm. It uses a discount rate that reflects the risk to the equity holders only
definitions
Working Capital Investments
reflects net short term non-cash assets held to facilitate company operations, such as inventory , accounts receivable, Capital injections made in order to satisfy minimum capital requirements
Capital Expenditures
typically refer to investment in property, plant, equipment and other physical items
The FCFE can also be calculated as the difference between the ending GAAP equity and the minimum required capital
Definition of free cash flow
Net income - net capital investement - capital expenditures + borowing + non-cash charges
Weaknesses
Plusieurs ajustements sont faits pour forecast les net income, puis estimer les free cash flows.
Il sera diffcile d'evaluer la reasonableness des forecasts.
Weakness
It has a large terminal value. Thus it puts a lot of weight on expected growth rate and discount rate.
Abnormal Earnings (AE)
Abnormal earnings are less likely to continue in perpetuity and are more likely to decline to zero as new competition is attracted to business with positive abnormal earnings, unlike DDM or DCF
Accounting rules that distort estimates of earnings will also distort the estimates of book value and will eventually reverse themselves. i.e. si une décision vient reduire la book value, elle va augmenter les abnormal earnings et la valeur finale va etre la meme.
Usually DCF method assumes the free cash flow grows in perpetuity, this is unlikely given competitors will enter
the market and squeeze the profit. Abnormal earnings method, instead, only assume the abnormal earning exist
for a period of time, which is more realistic.
An additional benefit of this approach is that it de-emphasizes the importance of the terminal value estimates and the assumptions that drive those
May be relevant to adjust the reported book value to reflect tangible book value, by removing intangible assets such as goodwill
Earnings in excess of the investors’ required earnings are referred to as the “abnormal” earnings
DDM and DCF both adjust the account-based net income measure into a cash flow measure, such as dividends paid or free cash flow, whereas AE does not require a cash flow measure
According to this method, if the firm can earn a return on equity capital equal to a “normal” return demanded by its shareholders, then the market value of the firm’s equity should exactly equal its book value
Option Pricing Theory
Real options
(DEACE)
Abandonment option :
The ability to terminate a project early and sell the investment at its liquidation value less closing-down costs. Valued as an American
put
on the value of the project with a strike equal to the net liquidation proceeds
Expansion option:
The option to expand the scope of a project and capture more profits. Valued as an American
call
option on the (gross) value of the additional capacity with a strike price equal to the cost of creating the capacity
Contraction option :
Opposite of expansion option. Valued as an American
put
on the (gross) value of the lost capacity with a strike equal to the cost savings
Option to defer :
The option to be able to hold off on a project until more information is known. Valued as an American
call
on the value of the project
Option to extend:
Option to extend the life of a project by paying a fixed amount. Valued as a European
call
option on the asset’s future value
Key valuation considerations
Valuing the underlying business cash flows
Time to option maturity
Exercise type: Black-Scholes formula prices European options, while real options are usually American-style. Adjustments are required.
Appropriate valuation formula: Black-Scholes formula’s assumptions may be inappropriate for the option to price
Value is created only when assets can be purchased at less than their fair value or when the firm has exclusive access to opportunities
Call option:
After taking debt D, if at time T the value of the firm is V then either the owners pays the debt back (D) or go into bankrupty :
max(V-D,0)
.
Reason this is not recommended: policyholder liabilities are included and we need a single expiration date which we do not have.
Relative valuation using multiples
Transaction multiples: Based on M&A prices or IPOs
One advantage of transaction multiples is that typically the price in these transactions is based on a complex negotiation with sophisticated parties on both sides. As a result, some practitioners consider these prices to be more meaningful than multiples based solely on current market prices. However, there are several reasons to be cautious (COUVE)
Control premiums
– dans les merger and acquisition (MA) transactions, le prix peut contenir un "control premium" qui reflete la willingness de la compagnie de payer plus pour gagner le controle de la compagnie et ses opperations.
Overpricing in M&A transactions
– This suggests that acquiring firms have a tendency to overpay.
Underpricing in IPO transactions
– Il a ete documenté que les IPO tendent a etre underpriced
Reported financial variables
The reported multiples will be based on either the prior period’s financial statements or some published analysts’ estimates of next period’s financial statements. The prices themselves may have been based on different forecasts, as a result, the multiples may not accurately reflect the buyer’s underlying assumptions about growth rates, ROE assumptions and discount rates
Underlying economic assumptions
– Key valuation variables that are embedded in these multiples, such as interest rates, industry growth rates and industry profitability outlooks, may no longer be appropriate
The net effect of all assumptions from other valuation methods can often be summarized as a “multiple” to be applied to a selected financial measure, such as next-period’s earnings, cash flow or book value
Market multiples: Based on market price of firm shares or most recent financial statement values
Price-Earnings (P-E) ratio
The ratio can be presented using the estimated future period’s earnings or the prior period’s actual earnings. When using future earnings, we call it the
forward P-E
ratio (or leading P-E ratio). When using actual earnings, we call it the
trailing P-E ratio
Price to Book Value (P-BV) ratio
Is commonly preferred over the P-E ratio when valuing banks, insurance companies and other financial services firms with substantial holdings in marketable securities