Pricing ACGL, a financial stock, can be difficult since these insurance businesses have cash flows that are affected by regulations that are not imposed upon other sectors. For example, insurance companies are required to hold more capital to reduce the risk to shareholders. Examining factors like book values, in addition to the return and cost of equity, may be useful for computing ACGL’s valuation. Below I’ll take you through how to value ACGL in a reasonably accurate and simple way. See our latest analysis for Arch Capital Group

Why Excess Return Model?

Financial firms differ to other sector firms primarily because of the kind of regulation they face and their asset composition. Strict regulatory environment in Bermuda’s finance industry reduces ACGL’s financial flexibility. Moreover, insurance companies usually do not possess large portions of physical assets as part of total assets. 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.

The Calculation

The central assumption 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 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)

= (10.05% – 9.33%) * $71.94 = $0.52

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)

= $0.52 / (9.33% – 2.47%) = $7.54

Putting this all together, we get the value of ACGL’s share:

Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share

= $71.94 + $7.54 = $79.48

Given ACGL’s current share price of $84.27, ACGL is priced in-line with its intrinsic value. Therefore, there’s a bit of a downside if you were to buy ACGL today. Pricing is one part of the analysis of your potential investment in ACGL. Analyzing fundamental factors are equally important when it comes to determining if ACGL has a place in your holdings.

Next Steps:

For insurance companies, there are three key aspects you should look at:

1. 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.

2. Future earnings: What does the market think of ACGL going forward? Our analyst growth expectation chart helps visualize ACGL’s growth potential over the upcoming years.

3. Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether ACGL is a dividend Rockstar with our historical and future dividend analysis.

For more details and sources, take a look at our full calculation on ACGL here.
To help readers see pass 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.