Insurance stocks such as AEL 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 like book values, as well as the return and cost of equity, may be suitable for computing AEL’s intrinsic value. Today I will take you through how to value AEL in a fairly effective and simple method.
Why Excess Return Model?
Financial firms differ to other sector firms primarily because of the kind of regulation they face and their asset composition. AEL operates in United States which has stringent financial regulations. Furthermore, insurance companies usually do not hold substantial amounts of tangible assets on their books. While traditional DCF models emphasize on inputs such as capital expenditure and depreciation, which is less useful for a financial stock, the Excess Return model focuses on book values and stable earnings.
How Does It Work?
The central belief for this model 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)
= (13.25% – 9.2%) x $30.82 = $1.23
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)
= $1.23 / (9.2% – 2.9%) = $19.56
These factors are combined to calculate the true value of AEL’s stock:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $30.82 + $19.56 = $50.39
This results in an intrinsic value of $50.39. Relative to the present share price of US$35.86, AEL is currently priced beneath its true value. This means you can buy AEL at a discount to its value of $50.39. Pricing is one part of the analysis of your potential investment in AEL. Analyzing fundamental factors are equally important when it comes to determining if AEL has a place in your holdings.
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 AEL going forward? Our analyst growth expectation chart helps visualize AEL’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether AEL is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on AEL 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.