One of the most difficult industry to value is insurance, given that they adhere to different rules compared to other companies. Industry-specific factors, such as gross written premiums are crucial in understanding how insurance companies make money. Focusing on factors like book values, with the return and cost of equity, can be suitable for calculating AFL’s intrinsic value. Below I’ll take you through how to value AFL in a fairly accurate and easy way.
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Why Excess Return Model?
Two main things that set financial stocks apart from the rest are regulation and asset composition. Financial firms operating in United States face strict financial regulation. Moreover, insurance companies tend to not have large portions of tangible assets on their balance sheet. As traditional valuation models put weight on inputs such as capex and depreciation, which is less meaningful for finacial firms, the Excess Return model places importance on forecasting stable earnings and book values.
How Does It Work?
The central belief for this model is that equity value is how much the firm can earn, over and above its cost of equity, given the level of equity it has in the company at the moment. 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)
= (0.14% – 9.2%) x $33.07 = $1.65
Excess Return Per Share is used to calculate the terminal value of AFL, 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)
= $1.65 / (9.2% – 2.9%) = $26.45
Combining these components gives us AFL’s intrinsic value per share:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $33.07 + $26.45 = $59.52
This results in an intrinsic value of $59.52. Given AFL’s current share price of US$43.40, AFL is priced beneath its true value. Therefore, there is potential room to profit from mispricing if you bought AFL at $59.52. Pricing is only one aspect when you’re looking at whether to buy or sell AFL. Analyzing fundamental factors are equally important when it comes to determining if AFL has a place in your holdings.
Next Steps:
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 AFL going forward? Our analyst growth expectation chart helps visualize AFL’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether AFL is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on AFL 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 editorial-team@simplywallst.com.