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Insurance stocks such as RSA are hard to value. This is because the rules banks face are different to other companies, which can impact the way we forecast their cash flows. Industry-specific factors, such as gross written premiums are crucial in understanding how insurance companies make money. Looking at data points such as book values, in addition to the return and cost of equity, is suitable for determining RSA’s value. Below I will show you how to value RSA in a reasonably useful and uncomplicated approach.
Why Excess Return Model?
Financial firms differ to other sector firms primarily because of the kind of regulation they face and their asset composition. United Kingdom’s financial regulatory environment is relatively strict. Furthermore, insurance companies tend to not have large portions of tangible assets on their books. Therefore the Excess Returns model is appropriate for deriving the true value of RSA as opposed to the traditional model, which puts weight on factors such as capital expenditure and depreciation.
Deriving RSA’s Intrinsic Value
The main assumption 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 in excess of cost of equity is called excess returns:
Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)
= (0.14% – 8.2%) x £4.06 = £0.23
Excess Return Per Share is used to calculate the terminal value of RSA, which is how much the business is expected to continue to generate over the upcoming years, in perpetuity. This is a common component of discounted cash flow models:
Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)
= £0.23 / (8.2% – 1.2%) = £3.26
These factors are combined to calculate the true value of RSA’s stock:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= £4.06 + £3.26 = £7.32
This results in an intrinsic value of £7.32. Given RSA’s current share price of UK£5.45, RSA is currently priced beneath its true value. This means there’s an upside to buying RSA today. Pricing is one part of the analysis of your potential investment in RSA. There are other important factors to keep in mind when assessing whether RSA is the right investment in your portfolio.
For insurance companies, 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 RSA going forward? Our analyst growth expectation chart helps visualize RSA’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether RSA is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on RSA here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.