Archive for the ‘Valuation’ category

Free Download of Valuation and Common Sense Book

December 19, 2013

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

Equity Premium

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.

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Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

  1. Tables (with all calculations) and figures are available in excel format in: http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html
  2. We have added questions at the end of each chapter.
  3. 5 new chapters:

Chapters

Downloadable at:

32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:

Chapters

Downloadable at:

     Table of contents, acknowledgments, glossary http://ssrn.com/abstract=2209089
Company Valuation Methods http://ssrn.com/abstract=274973
Cash Flow is a Fact. Net Income is Just an Opinion http://ssrn.com/abstract=330540
Ten Badly Explained Topics in Most Corporate Finance Books http://ssrn.com/abstract=2044576
Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case http://ssrn.com/abstract=743229
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions? http://ssrn.com/abstract=274972
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories http://ssrn.com/abstract=256987
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation http://ssrn.com/abstract=296945
8   WACC: Definition, Misconceptions and Errors http://ssrn.com/abstract=1620871
Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications http://ssrn.com/abstract=2117765
10 How to Value a Seasonal Company Discounting Cash Flows http://ssrn.com/abstract=406220
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches http://ssrn.com/abstract=270833
12 Equity Premium: Historical, Expected, Required and Implied http://ssrn.com/abstract=933070
13 The Equity Premium in 150 Textbooks http://ssrn.com/abstract=1473225
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers http://ssrn.com/abstract=2084213
15 Are Calculated Betas Good for Anything? http://ssrn.com/abstract=504565
16 Beta = 1 Does a Better Job than Calculated Betas http://ssrn.com/abstract=1406923
17 Betas Used by Professors: A Survey with 2,500 Answers http://ssrn.com/abstract=1407464
18 On the Instability of Betas: The Case of Spain http://ssrn.com/abstract=510146
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2191044
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2217604
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina http://ssrn.com/abstract=2176728
22 1,959 valuations of the YPF shares expropriated to Repsol http://ssrn.com/abstract=2226321
23 Internet Valuations: The Case of Terra-Lycos http://ssrn.com/abstract=265608
24 Valuation of Internet-related companies http://ssrn.com/abstract=265609
25 Valuation of Brands and Intellectual Capital http://ssrn.com/abstract=270688
26 Interest rates and company valuation http://ssrn.com/abstract=2215926
27 Price to Earnings ratio, Value to Book ratio and Growth http://ssrn.com/abstract=2212373
28 Dividends and Share Repurchases http://ssrn.com/abstract=2215739
29 How Inflation destroys Value http://ssrn.com/abstract=2215796
30 Valuing Real Options: Frequently Made Errors http://ssrn.com/abstract=274855
31 119 Common Errors in Company Valuations http://ssrn.com/abstract=1025424
32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

Increasing the Valuation of P/C Insurance Companies

September 19, 2010

From JP Berliet

The financial crisis demonstrated that risk management had not been working effectively in many insurance companies. As a result, investors lost confidence and reduced their exposure to the industry, thereby causing valuations of companies to decline more than market averages and their cost of capital to increase.

In addition, continuing weakness in the economic environment have been exacerbating pressures on premium rates and competition in most lines. These factors are leading investors to expect that the financial performance of many companies is unlikely to improve in the short term or might even decline, thereby generating additional pressures on valuations. At present, insurance companies thus face a double challenge to:

  • Identify and pursue opportunities to enhance their intrinsic value by increasing profitability and growth
  • Restore the confidence of investors, to reduce their cost of capital and convert financial results into higher company valuations.

The “Risk Management and Business Strategy in P/C Insurance Companies” briefing paper outlines an approach that insurance companies can use to meet this double challenge.

To enhance their intrinsic values, insurance companies need to develop sharper risk insights that they can use to:

  • Achieve loss costs and earnings volatility advantages relative to their competitors
  • Reduce both the amount and the cost of the capital they require
  • Identify and pursue opportunities to grow profitably.

Success in these areas is unlikely to be sufficient, however, to restore investors’ confidence in companies in which governance and management process weaknesses cause investors to discount expected financial results more heavily. The briefing paper implies that the crisis caused the valuation of many companies to suffer from such discounts, including:

  • Governance discounts reflecting imbalance in addressing solvency risk concerns of customers, creditors and regulators relative to value risk concerns of shareholders
  • Credibility discounts resulting from misalignment of companies’ risk management and business management processes and strategies
  • Resilience discounts due to the opaqueness of financial statements and business strategies, which prevent investors to assess a company’s risk of financial distress.

To reduce governance, credibility and resilience discounts imposed by investors, insurance companies need to restore investors’ confidence by remedying underlying weaknesses in their risk and value management frameworks.

The following sections suggest how insurance companies should go about this as well as enhancing their intrinsic value, thereby creating for shareholders value enhancements that compound each other.

Increasing intrinsic value

Insurance companies can use data about risk exposures and analytics to develop and implement underwriting, pricing, claim settlement and renewal strategies that provide an economic advantage relative to competitors and increase their intrinsic value by:

  • Achieving favorable risk selection, i.e. building portfolios with lower expected losses and lower loss volatility
  • Reducing the capital required to support risk assumption activities
  • Lowering their cost of capital.

Since risk insights are not directly observable, they cannot be easily duplicated by competitors and can provide a more sustainable competitive advantage than improvements in products or service that can be readily emulated. Risk insights can help companies achieve margin increases that increase their intrinsic value. However, strategies that increase financial performance and intrinsic value will not necessarily increase company valuations and realized returns for shareholders. For valuations and realized returns to increase, intrinsic value enhancements need to be seen by investors as consistent with their investment objectives and risk tolerance.

Establishment and maintenance of the risk data infrastructure, analytical tools, decisions rules and reporting mechanisms required for companies to compete on analytics is arduous, slow and costly, but can lead to value creation breakthrough and opportunities for continuing growth. Conversely, companies that do not set out on this path should expect to be trapped in strategic stalemates and to experience declining financial performance. There are few less stark choices for Management and Board of Directors to contemplate.

Reducing governance discounts

Shareholders of insurance companies lost billions of dollars in value as a result of the financial crisis. They doubt that risk management fixes and tightening of prudential regulations can address their concerns about risks to the value of their investment in insurance companies. From their point of view, these fixes and tighter regulations appear to be designed to address risks of insurance businesses that can cause insolvency and are of primary concerns to customers, other creditors and regulators.

Investors believe that many of the weaknesses in risk governance frameworks and risk management revealed by the crisis result from:

  • Failure effectively to manage differences in risk concerns of shareholders and other stakeholders
  • Misalignment of risk tolerances, risk policies, risk limits and risk management strategies
  • Management By Objectives frameworks, policies and processes that rest on aggressive, but inappropriate, performance targets and generate moral hazard.

Investors readily conclude that these weaknesses are likely to continue to hamper the financial performance of many insurance companies and that they need to impose a “risk governance” penalty on companies’ results and prospects when assessing their value.

Even though the existence and magnitude of this risk governance discount have not been formally confirmed by research, observations of investors’ response to the crisis suggest that this discount has been contributing significantly to the relative decline in the valuation of insurance companies. The associated valuation penalty should not be expected to decrease until risk management becomes demonstrably more central to strategy development and execution and is seen to address value risk concerns of shareholders more effectively.

In companies where risk management has been a peripheral, compliance driven activity, the needed change in perspective and management processes will be challenging.

Reducing credibility discounts

The crisis demonstrated that there were significant disconnects between insurance companies’ risk assessment capabilities and their business decisions. It revealed that, in many if not even most companies, risk management frameworks:

  • Focus predominantly on financial risks and the resulting solvency risk concerns of customers, rating agencies and regulators, customarily over a one year horizon
  • Are designed to assess and ensure a company’s capital adequacy but not to help manage its cost of capital
  • Are not capable of integrating the impact of operational risks and strategic risks that can expose shareholders to significant losses in the value of their holdings
  • Assume that companies can raise funds in the capital market as needed to support their ratings and continue writing business on competitive terms
  • Understate the amount of capital required to support a company’s value as a going concern
  • Ignore systemic risk.

Investors understand that these weaknesses of risk and management frameworks prevent insurance companies to meet the risk tolerance concerns of their stakeholders, especially shareholders. They have lost confidence and have been adding a significant penalty, in the form of an implicit “credibility discount” to the terms on which they now make capital available to companies.

Insurance companies need to address each of the weaknesses identified above. It will take some time, probably years, for companies to demonstrate that the required framework and process enhancements improve risk and business management decisions, consistently. Insurance companies that do will benefit from a reduction of their credibility discount that will enhance their valuation.

Reducing resilience discounts

Companies that need to raise capital during a financial crisis can suffer crippling losses in value through dilution of shareholders interests and can become vulnerable as acquisition targets. Companies can rapidly lose their ability to control their destiny, especially if and when investors lose confidence and impose a “resilience discount” on their valuations. Companies are not defenseless, however, because they can bolster their inherent resilience in anticipation of potential crises by:

  • Maintaining enough capital to remain solvent and protect their ratings under conceivable stress scenarios, at a high confidence level. Ideally, they should ensure that their capital is large enough to provide i) a buffer against the incidence of risks that are difficult to measure or unknown and ii) a strategic reserve to take advantage of unforeseen opportunities (e.g. acquisitions)
  • Achieving a high valuation and a sustained record of meeting shareholders’ return expectations. This creates a virtuous circle in which a higher valuation earned as a reward for good financial performance mitigates the resilience discount, thereby increasing valuation further. Companies with a sustained record of good performance have the credibility needed to raise capital on acceptable terms when markets recover. Meanwhile, companies without such a record and credibility may not be able to do so or may have to accept more onerous terms.

It is thus important for an insurance company to:

  • Demonstrate that it can be relied on to achieve shareholders’ earnings expectations, while also meeting their earnings volatility constraint
  • Increase the transparency of its risk, capital and strategy decisions.

Doing so will help an insurance company persuade investors that it is resilient and, over time, reduce its resilience discount.

Conclusion

Although risk is the primary driver of value creation in insurance businesses, risk can also destroy value. Ideally, management must balance these opposing effects of risk.

The “Risk Management and Business Strategy” briefing lays out how a company should accomplish a desirable balance between risk and return by:

  • Focusing its risk governance framework and risk management processes on meeting both the solvency risk concerns of customers, creditors, rating agencies and regulators as well as the critical value risk concerns of shareholders
  • Using analytics to develop tools that lead to sharper risk insights, tighter alignment of risk and business decisions and strategies that increase its financial performance and valuation.

In the aftermath of the crisis, however, insurance companies are facing skeptical investors, many of whom have lost confidence in the industry. To overcome this skepticism and get the full valuation benefit from strategies that increase their intrinsic value, insurance companies need to:

  • Meet shareholders’ return expectations and risk tolerance constraints consistently, by utilizing risk insights from well developed risk management frameworks and processes that can integrate Enterprise Risk Management and Value Based Management more tightly
  • Correct weaknesses in governance frameworks, management processes and capabilities that are perceived as creating risks for investors.

Insurance companies can regain investors’ confidence, and might shorten the time needed to do so by using the framework presented in the briefing to develop their priorities and action plan. Once progress is demonstrated, reductions in investors’ discounts will increase the companies’ valuation multiples and compound returns from enhancements in intrinsic value for shareholders.

Jean-Pierre Berliet

(203) 247-6448

jpberliet@att.net

Why the valuation of RMBS holdings needed changing

January 18, 2010

Post from Michael A Cohen, Principal – Cohen Strategic Consulting

Last November’s decision by the National Association of Insurance Commissioners (NAIC) to appoint PIMCO Advisory to assess the holdings of non-agency residential mortgage-backed securities (RMBS) signaled a marked change in attitude towards the major ratings agencies. This move by the NAIC — the regulatory body for the insurance industry in the US, comprising the insurance commissioners of the 50 states – was aimed at determining the appropriate amount of risk-adjusted capital to be held by US insurers (more than 1,600 companies in both the life and property/casualty segments) for RMBS on their balance sheets.

Why did the NAIC act?

A number of problems had arisen from the way RMBS held by insurers had historically been rated by some rating agencies which are “nationally recognized statistical rating organizations” (NRSROs), though it is important to note that not all rating agencies which are NRSROs had engaged in this particular rating activity.

RMBS had been assigned (much) higher ratings than they seem to have deserved at the time, albeit with the benefit of hindsight. The higher ratings also led to lower capital charges for entities holding these securitizations (insurers, in this example) in determining the risk-adjusted capital they needed to hold for regulatory standards.

Consequently, these insurance organizations were ultimately viewed to be undercapitalized for their collective investment risks. These higher ratings also led to lower prices for the securitizations, which meant that the purchasers were ultimately getting much lower risk-adjusted returns than had been envisaged (and in many cases losses) for their purchases.

The analysis that was performed by the NRSROs has been strenuously called into question by many industry observers during the financial crisis of the past two years, for two primary reasons:

  • The level of analytical due diligence was weak and the default statistics used to evaluate these securities did not reflect the actual level of stress in the marketplace; as a consequence ratings were issued at higher levels than the underlying analytics in part to placate the purchasers of the ratings, and a number of industry insiders observed that this was done.
  • Once the RMBS marketplace came under extreme stress, the rating agencies subsequently determined that the risk charges for these securities would increase several fold, materially increasing the amount of risk-adjusted capital needed to be held by insurers with RMBS, and ultimately jeopardizing the companies’ financial strength ratings themselves.

Flaws in rating RMBS

Rating agencies have historically been paid for their rating services by those entities to which they assign ratings (that reflect claims paying, debt paying, principal paying, etc. abilities). Industry observers have long viewed this relationship as a potential conflict of interest, but, because insurers and buyers had not been materially harmed by this process until recently, the industry practice of rating agencies assigning ratings to companies who were paying them for the service was not strenuously challenged.

Further, since the rating agencies can increase their profit margins by increasing their overall rating fees while maintaining their expenses in the course of performing rating analysis, it follows that there is an incentive to increase the volume of ratings issued by the staff, which implies less time being spent on a particular analysis. Again, until recently, the rated entities and the purchasers of rated securities and insurance policies did not feel sufficiently harmed to challenge the process.

(more…)

Myths of Market Consistent Valuation

October 31, 2009

    Guest Post from Elliot Varnell

    Myth 1: An arbitrage free model will by itself give a market consistent valuation.

    An arbitrage-free model which is calibrated to deep and liquid market data will give a market consistent valuation. An arbitrage-free model which ignores available deep and liquid market data does not give a market consistent valuation. Having said this there is not a tight definition of what constitutes deep and liquid market data, therefore there is no tight definition of what constitutes market consistent valuation. For example a very relevant question is whether calibrating to historic volatility can be considered market consistent if there is a marginally liquid market in options. CEIOPs CP39 published in July 2009 appears to leave open the questions of which volatility could be used, while CP41 requires that a market is deep and liquid, transparent and that these properties are permanent.

    Myth 2: A model calibrated to deep and liquid market data will give a Market Consistent Valuation.

    A model calibrated to deep and liquid market data will only give a market consistent valuation if the model is also arbitrage free. If a model ignores arbitrage free dynamics then it could still be calibrated to replicate certain prices. However this would not be a sensible framework marking to model the prices of other assets and liabilities as is required for the valuation of many participating life insurance contracts Having said this the implementation of some theoretically arbitrage free models are not always fully arbitrage free themselves, due to issues such as discretisation, although they can be designed to not be noticeably arbitrage free within the level of materiality of the overall technical provision calculation.

    Myth 3: Market Consistent Valuation gives the right answer.

    Market consistent valuation does not give the right answer, per se, but an answer conditional on the model and the calibration parameters. The valuation is only as good as these underlying assumptions. One thing we can be sure of is that the model will be wrong in some way. This is why understanding and documenting the weakness of an ESG model and its calibration is as important as the actual model design and calibration itself.

    Myth 4: Market Consistent Valuation gives the amount that a 3rd party will pay for the business.

    Market Consistent Valuation (as calculated using an ESG) gives a value based on pricing at the margin. As with many financial economic models the model is designed to provide a price based on a small scale transaction, ignoring trading costs, and market illiquidity. The assumption is made that the marginal price of the liability can be applied to the entire balance sheet. Separate economic models are typically required to account for micro-market features; for example the illiquidity of markets or the trading and frictional costs inherent from following an (internal) dynamic hedge strategy. Micro-market features can be most significant in the most extreme market conditions; for example a 1-in-200 stress event.

    Even allowing for the micro-market features a transaction price will account (most likely in much less quantitative manner than using an ESG) the hard to value assets (e.g. franchise value) or hard to value liabilities (e.g. contingent liabilities).

    Myth 5: Market Consistent Valuation is no more accurate than Discounted Cash Flow techniques using long term subjective rates of return.

    The previous myths could have suggested that market consistent valuation is in some way devalued or not useful. This is certainly the viewpoint of some actuaries especially in the light of the recent financial crisis. However it could be argued that market consistent valuation, if done properly, gives a more economically meaningful value than traditional DCF techniques and provides better disclosure than traditional DCF. It does this by breaking down the problem into clear assumptions about what economic theory is being applied and clear assumption regarding what assumptions are being made. By breaking down the models and assumptions weaknesses are more readily identified and economic theory can be applied.



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