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AUTHOR
DATE
SUBJECT
5
member
5/26/10 6:56AM
RE: GAAP
4
David
To be clear GAAP financials are still produced. The EV calculation is an additional disclosure. The point I wanted to make is nobody looks at GAAP.
There are numerous reasons for this including
1) An investment is a discounted cash flow. The EV is essentially a discounted cash flow of the existing business and future business. If I gave you these expected cash flows why would you ignore them and rely on GAAP numbers?
2) Internal models on whether to write insurance or loans are all based on DCF calculations. Again cash-in cash-ouy calculations trump GAAP. By focusing on EV and cash flows you get amazing insights into the business versus the opaque view using GAAP.
You are right that EV is a mark-to-maybe and hopefully you did not fall for the GOS tricks. The key difference is that all the assumtions on which the DCF are disclosed in addition to sensitivities for different ranges.
These assumptions can get complicated when it comes to insurance companies, but, are a doodle when it comes to businesses that sell installment loans.
I do not think that Appraisal Values are better than GAAP, and I can see immediately why Appraisal Value will never be adopted in the US. Between FASB and the SEC, the utility of GAAP is to present a picture in time of the financial condition of a company. It makes no attempt to project what values will be in the future, and for good reason. Appraisal value relies on a number of assumptions, such as discount rate and mutliples, that are subjective.
I appreciate your comments on embedded value and appraisal value. Part of the reason for the write-up was to introduce the concept to VIC because I have never understood why this methodlogy is not popular in the US. I would like to encourage debate on this.
The funny thing is that I am aware of a US insurance companies which is to be sold in the private market. The bids for the company are all based on AV so it seems that in the real world AV is important and that it is only analysts who mostly live in lala land who find gaap reporting interesting.
I could have gone into the gory details that analysts love to focus on, but, I wanted to move straight in to the valuation. I also wanted to focus on the economics of the business model which seems to fly over the heads of most GAAP analysts I know .ie sell side pointlessly trying to predict next years EPS.
I also stongly disagree with your comments that GAAP EPS is of any value. Come on!! If you were buying a business that lent our $10 000 a year (money out) and received back a PV of $20 000 would you would be foolish to use GAAP to value the business. Let me put it another way how could you possibly use gaap to get to a value. I am all ears.
I did take some short cuts on the calculation of EV which understated the amount I calculated. You are correct that EV = NAV + VIF. I assumed the NAV to be zero and focused only on the VIF. Value in Force (VIF) represents the present value of cash flows from existing business portfolio.
The above step gives me a value for the existing business or a value the tooth fairy would give you for the current portfolio of existing business. But, everyday the workers in the business go out to generate new loans and I have to put a value on this. This is technically the Value of Future New Business.
Added together I get an appriasal value.
I have justc come back from meeting managment and to my astonishment find that the loans they are currently writing have a swap ratio of 2.5 times versus 2 that I used in the model. Assuming the bank lend out R10bil over 12 months implies that they will expect to receive back R25bil. Subtract bad debt of R2.5bil and operating expenses of R1.0bil means that they will earn R11.5bil in PV terms from 1 years work.
Assuming Ellerines is worth R10bil you are only paying R14bil for the bank stub. The stub will generate R11.5bil in PV a year in value.
This write-up is academic, full of assumptions, and very reliant on management statements. There is very little in the way of real analysis and unfortunately, I still have very little sense of African Bank's actual operations and profile. What's its personality and competitive edge? How many employees? What about branches or distribution? Who are the key leaders? Are they buying stock? I know none of this after reading your write-up.
And I'd love clarification, but I thought embedded value, which is primarily used for European insurance companies, included the present value of future profits plus NAV, net asset value (or tangible book value if you prefer). I've never heard of "appraisal value" before. Furthermore, as I understand it, most European banks do not use EV or AV. African Bank is presumably a bank, so doesn't NAV or a P/E ratio make sense?
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