Capital market firms such as TROW are hard to value. This is because the rules they face are different to other companies, which can impact the way we forecast their cash flow. Asset managers, for example, must hold certain levels of capital in order to maintain a safe cash cushion. Examining elements such as book values, in addition to the return and cost of equity, may be useful for determining TROW’s true value. Below I will take you through how to value TROW in a relatively effective and straightforward method. Check out our latest analysis for T. Rowe Price Group
What Is The Excess Return Model?
Financial firms differ to other sector firms primarily because of the kind of regulation they face and their asset composition.
United States’s financial regulatory environment is relatively strict.
In addition,
capital markets
generally don’t
hold
substantial
amounts
of physical assets
on their books.
Excess Returns overcome some of these issues. Firstly, it doesn’t focus on factors such as capex and depreciation – relevant for tangible asset firms – but rather emphasize forecasting stable earnings and book values.
Deriving TROW’s True Value
The main belief for Excess Returns is, the value of the company is how much money it can generate from its current level of equity capital, in excess of the cost of that capital. The returns above the cost of equity is known as excess returns:
Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)
= (27.84% – 8.59%) x $29.23 = $5.63
We use this value to calculate the terminal value of the company, which is how much we expect the company to continue to earn every year, forever. This is a common component of discounted cash flow models:
Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)
= $5.63 / (8.59% – 2.95%) = $99.8
Putting this all together, we get the value of TROW’s share:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $29.23 + $99.8 = $129.03
This results in an intrinsic value of $129.03. Given TROW’s current share price of US$116, TROW is fairly priced by the market. Therefore, there’s a bit of a downside if you were to buy TROW today. Valuation is only one side of the coin when you’re looking to invest, or sell, TROW. There are other important factors to keep in mind when assessing whether TROW is the right investment in your portfolio.
Next Steps:
For capital markets, there are three key aspects you should look at:
- Financial health: Does it have a healthy balance sheet? Take a look at our free bank analysis with six simple checks on things like leverage and risk.
- Future earnings: What does the market think of TROW going forward? Our analyst growth expectation chart helps visualize TROW’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether TROW is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on TROW here.