Insurance stocks such as SUN 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. Focusing on line items such as book values, in addition to the return and cost of equity, may be practical for estimating SUN’s value. Below we will look at how to value SUN in a fairly effective and easy method. Check out our latest analysis for Suncorp Group
What Model Should You Use?
There are two facets to consider: regulation and type of assets. SUN operates in Australia which has stringent financial regulations. Furthermore, insurance companies generally don’t possess substantial portions of physical assets on their books. So the Excess Returns model is suitable for determining the intrinsic value of SUN rather than the traditional discounted cash flow model, which places emphasis on factors such as depreciation and capex.
Deriving SUN’s Intrinsic Value
The central 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)
= (9.07% – 10.66%) * A$10.99 = A$-0.17
Excess Return Per Share is used to calculate the terminal value of SUN, 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)
= A$-0.17 / (10.66% – 2.76%) = A$-2.22
These factors are combined to calculate the true value of SUN’s stock:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= A$10.99 + A$-2.22 = A$8.78
Given SUN’s current share price of A$13.72, SUN is overvalued. Therefore, there’s no benefit to buying SUN today. Pricing is one part of the analysis of your potential investment in SUN. Analyzing fundamental factors are equally important when it comes to determining if SUN 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.