Study compares the accuracy of valuation methods of insurance companies

February 1, 2012

A study by Columbia Business School Professor Doron Nissim, Ernst & Young Professor of Accounting & Finance, reveals a better understanding of how investors value insurance companies. Two alternative approaches are typically used when estimating a company's equity value: fundamental valuation and relative valuation. Academic research and teaching tends to emphasize fundamental valuation models, although relative valuation models – which typically involve price multiples, or ratios used to compare a company to a group of similar companies – are much more common in practice. Unlike most prior studies, this research, forthcoming in the Review of Accounting Studies, examines the impact of industry-specific adjustments on the precision of estimated value relative to stock price.

Although book value multiples tend not to be an accurate measure when valuing non-financial firms, these multiples perform relatively well when valuing , the study shows. In fact, over the last decade, book value multiples have performed significantly better than earnings multiples. Contributing factors include the financial nature of the majority of insurance company assets and liabilities, the relatively small size of unrecognized intangibles, and the role of capital-related regulation.

Analysts often exclude Accumulated Other Comprehensive Income (AOCI) from book value, a practice that is unique to the insurance industry. This is usually seen as a way to reduce the volatility of book value and mitigate accounting distortions. However, excluding AOCI tends to worsen, rather than improve, the accuracy of valuation, the study shows. AOCI measures unrecognized economic gains and losses that increase net invested assets, and should therefore be included in book value.

In another surprising finding, the study also showed that excluding realized investment gains and losses from earnings does not improve valuation accuracy. An exception occurred during the recent financial crisis, most likely caused by an increase in "gains trading," or the selective realization of gains.

Consistent with common industry practice, the study finds that conditioning the price-to-book ratio on return on equity significantly improves the valuation accuracy of book value multiples. In contrast, incorporating proxies for growth, earnings quality and risk does not consistently improve out-of-sample predictions.

Two methodological issues relevant for the use of price multiples are the definition of industry group and the measurement of shares. The study finds that, for insurance companies, limiting peers to the same sub-industry (as opposed to using all insurance companies) improves valuation accuracy, and that adjusting with respect to potentially dilutive shares improves earnings-based valuations but not book value-based valuations.

The sample used in the study includes information from all insurance companies available in the intersection of three databases: IBES, CRSP, and COMPUSTAT. Market-related data, such as price, stock returns, shares, and adjustment factors, were extracted from CRSP and Yahoo! Finance (for recent data).

Explore further: Study suggests disaggregate earnings better predict stock prices than aggregate earnings

Related Stories

Women on company boards face stockmarket prejudice

August 13, 2009

( -- Companies with female board members fare worse on the stock market, despite performing as well on all other measures as those with all-male boards. This is the finding of a new study by the University of ...

Andreessen says no new high tech bubble

June 2, 2011

Netscape co-founder turned Silicon Valley venture capitalist Marc Andreessen on Wednesday rejected recent speculation about a new high-tech bubble.

Recommended for you

Who you gonna trust? How power affects our faith in others

October 6, 2015

One of the ongoing themes of the current presidential campaign is that Americans are becoming increasingly distrustful of those who walk the corridors of power – Exhibit A being the Republican presidential primary, in which ...

Ancient genome from Africa sequenced for the first time

October 8, 2015

The first ancient human genome from Africa to be sequenced has revealed that a wave of migration back into Africa from Western Eurasia around 3,000 years ago was up to twice as significant as previously thought, and affected ...

The hand and foot of Homo naledi

October 6, 2015

The second set of papers related to the remarkable discovery of Homo naledi, a new species of human relative, have been published in scientific journal, Nature Communications, on Tuesday, 6 October 2015.

Mexican site yields new details of sacrifice of Spaniards

October 9, 2015

It was one of the worst defeats in one of history's most dramatic conquests: Only a year after Hernan Cortes landed in Mexico, hundreds of people in a Spanish-led convey were captured, sacrificed and apparently eaten.


Please sign in to add a comment. Registration is free, and takes less than a minute. Read more

Click here to reset your password.
Sign in to get notified via email when new comments are made.