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Business Valuation. From an Underwriter’s perspective. Financial Underwriting Matters. Financial Underwriting Involves the developments and Interpretation of financial information
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Business Valuation From an Underwriter’s perspective
Financial Underwriting Matters • Financial Underwriting Involves the developments and Interpretation of financial information • It attempts to analyze the motivation behind the purchase of insurance and the ability to continue to pay renewal premiums
Financial Underwriting Matters – cont. • Businesses can afford to pay higher premiums • Life insurance premiums are often a deductible business expense
Financial Underwriting Matters – cont. • According to the National Institute on Mental Health, suicide was the 10th leading cause of death in 2007 • According to the High Face Amount Mortality Study, published by the Society of Actuaries in April of 2012, suicide represented 40% of the non-medical causes of death for term insurance and the third leading cause of death
Product Type: Number of Claims by Cause of DeathPolicy Size ≥ $1M
Definitions • Book Value – Total assets minus total liabilities • Capitalization of earning – future earnings ÷ capitalization rate • Discounted Cash Flow – present value of a company’s future cash flow • Terminal Value – present value at a future point in time of all future cash flows when we expect stable growth rate forever
Definitions – cont. • Discount Rate – represents the total expected rate of return that an investor would likely require from a potential investment. The discount rate is directly related to the level of risk inherent in the investment • The Capitalization Rate – more often used in valuations where the cash flows are stable or in situations where the future cash flows are not available. It’s derived by subtracting the growth rate from the discount rate.
Fair Market Value The probable price at which a willing buyer will buy from a willing seller when: 1.) both are unrelated 2.) both parties know the relevant facts 3.) neither party is under any compulsion to buy or sell
Basic Approaches to Valuation • Asset • Market • Income
The Asset Approach • Restating the balance sheet using the fair market value of assets and subtracting the fair market value of the liabilities
The Market Approach • Entails direct comparison of the company being valued to similar companies. Comparisons to publicly traded companies or use actual sales transaction for similar businesses • Results are often expressed in ratios • Price-to-earnings ratio • Price-to-revenue ratios • Price-to-EBIDTA
Income Approach • Focuses on the analysis of the future economic benefits of an entity. • Capitalization of earnings • IBDT÷ Cap rate
Example of Capitalization of Earnings • Annual of earnings = $100,000 • Capitalization Rate = 25% • Growth rate = 0 • Valuation = $100,000 ÷ 25% = $400,000
Capitalization of Earnings – example 2 • Annual of earnings = $100,000 • Capitalization Rate = 25% • Growth rate = 5% • Valuation = $100,000 ÷ (25% - 5%) = $500,000
Capitalization of Earnings – example 3 • Annual of earnings = $100,000 • Capitalization Rate = 20% • Growth rate = 10% • Valuation = $100,000 ÷ (20% - 10%) = $1,000,000
Discounted Cash Flow • DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 ...+ CFn/(1+r)n + PV of terminal valueWhere:CF1 = cash flow in period 1CF2 = cash flow in period 2CF3 = cash flow in period 3CFn = cash flow in period nr = discount rate (also referred to as the required rate of return)
Gordon Growth Model • Price = I ÷ (R-g) • Where • I = the annual cash flow at the end of the discrete period • R = Discount rate • g = growth rate
Valuation Reports • Cover • Valuation Summary (including assumptions and limiting conditions) • Valuation Assignment • Economic outlook • Industry outlook • Business overview • Conclusion