Goldfarb Flashcards
Insurance company valuation methods (5)
- dividend discount model
- discounted cash flows (FCFF and FCFE)
- abnormal earnings
- relative valuation using multiples
- option pricing methods
Present value of dividends with growth into perpetuity
E[next div] / (k - g)
*remember to also discount back to time 0 if terminal value
Formula for growth rate beyond forecast horizon and alternative method for DDM
g = plowback ratio * ROE
alternative = extrapolate growth rate during the forecast horizon
CAPM required return (aka risk-adjusted discount rate, or cost of capital)
k = risk free rate + beta * (expected market return - risk free rate)
expected market return - risk free rate = market risk premium
Beta in CAPM represents
firm’s systemic/non-diversifiable risk (high beta = high risk)
Primary considerations in beta selection (2)
- mix of business
- financial leverage
Options for basis of risk free rate (3)
- 90-day T-bills
- maturity matched T-notes
- T-bonds – 20-year bonds but first remove liquidity premium (usually 1.2%)
ROE formula
net income after tax / beginning equity
Ending equity formula
= beginning equity + net income after tax - dividends paid
Limitations of DDM (2)
- dividend payments are discretionary and difficult to forecast
- may need to re-define dividend with increased use of stock buybacks
Implicit assumption of FCF methods
any FCF not paid as dividends are invested to earn an appropriate risk-adjusted return (k)
Free cash flow to the firm (FCFF) method
equity = firm value - market value of debt
Reasons FCFF method is difficult to apply to P and C companies (2)
- unclear how to deal with leverage from PH liabilities
- unclear how to discount PH liabilities–no single fixed expiration
Distinction b/w FCFF and FCFE
FCFF - reflects CFs/risk to equity and debt-holders
FCFE - reflects only CFs/risk to equity holders
FCFE formula
FCFE = net income after tax
+ non-cash charges
- net working capital investment
- increase in required capital (aka capital expenditures)
+ net borrowing
exclude reserves
Reason change in reserves is excluded from non-cash charges in FCFE equation
added as a non-cash charge, but also subtracted as a capital expenditure, so the net effect cancels out
Examples of net working capital expense (2)
- inventory
- accounts receivable
Examples of capital expenditures (3)
investments in:
- property
- plant
- equipment
in addition to changes in regulatory, rating agency, or management requirements
Differences b/w DDM and FCFE methods (2)
- growth rates - difficult to define reinvestment under FCFE method
- discount rates - FCFE pays out all free cash flow, DDM pays out only a portion and invests the rest. DDM has greater investment risk and FCFE has greater UW risk; different rates should be used but in practice they aren’t
Reinvestment rate for FCFE growth rate
reinvestment rate = change in capital / net income after tax
Horizon growth rate for FCFE method
g = selected reinvestment rate * selected ROE
Weaknesses of the DCF methods (3)
- financial statements must be forecast using specific accounting standards
- variety of adjustments are made to estimate FCFs from forecasted net income
- resulting CFs may not necessarily = plan
Book value for AE method
book value = beginning capital
AE formula
= (ROE - k) * book value
OR = net income - required return
required return = k * BV
Value of firm under AE method
value = book value + PV (AE)
Key difference b/w AE and other methods
AE does not assume constant growth in perpetuity
*instead, AE decline linearly to 0 as new competition enters the market to capture AE
decrease by 1/(n + 1) per year
Benefits of the AE method (2)
- uses assumptions more directly tied to the source of value creation vs. effect (dividends and FCFs)
- de-emphasizes terminal value (more of value reflected w/in forecast horizon)
Reasons to use relative valuation instead of other methods (3)
- insufficient data available
- difficult to obtain growth and rate adequacy estimates w/o market knowledge and planning data
- horizon used may stretch limits of forecasting ability
Uses for P/E ratios (3)
- reasonability check/validation of assumptions
- shortcut to valuation
- method to estimate terminal value
Price-earnings ratio for relative valuation
P0/E1 = (1 - p) / (k - p * ROE)
recognize that p * ROE = g
Price-book value ratio for relative valuation
|»_space; assuming growth and AE continue into perpetuity
P_0 / BV_0 = 1 + (ROE - k) / (k - g)
Total firm value under relative valuation using multiples
= weighted average of segment values
often average multiples to avoid relying on a single one
Multiple in relative valuation reflects (3)
combined effect of:
- dividend payout ratio
- growth rate
- discount rate
Advantage of using transaction multiples
often based on a complex negotiation w/sophisticated calculations on both sides
Reasons to exercise caution when using transaction multiples (4)
- control premium embedded in the price overstates the multiple
- the purchasing company usually overpays in M&As
- IPOs are historically underpriced
- economic conditions may have changed since the time of the transaction
General rule for calls/puts in real option pricing
call - options to expand/postpone
put - options to contract/abandon
