PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 263oped using a simplified formula based on (i) projected after-taxnet operating profits in the first year after the forecast period, (ii)the perpetual growth rate, and (iii) the hurdle rate.whereTerminal value =1Xx=n+1OE x ¡ (C x¡1 £ g)(1 + h) x= OE n+1 ¡ (C n £ g)(h ¡ g)(1 + h) n ,n = the number of periods in the forecastperiod;C n = the capital at the end of the last periodof the forecast period;g = the expected perpetual growth rate ofcapital and of after-tax operating earnings;h = the hurdle rate;OE n+1 = after-tax operating earnings in the periodafter the forecast period; andOE n+1 ¡ (C n £ g) = free earnings, equal to after-tax earningsless amounts needed to be retained in thecompany to grow the capital at rate g.This terminal value calculation gives credit for earnings intothe future in perpetuity. Sometimes a higher hurdle rate is usedfor the terminal value than for the forecast period to reflect theincreased uncertainty associated with operating earnings manyyears in the future. A discussion of considerations related to theselection of the hurdle rate is provided in Section 4.The terminal value can be thought of as the present value ofthe free earnings (in the period after the forecast period) multipliedby a price to earnings (P/E) ratio. The P/E ratio is determinedby the hurdle rate, h, and the growth rate, g, and is equal