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

264 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESto 1=(h ¡ g). 10 If the hurdle rate is 15% and the growth rate is5%, then the P/E ratio = 1=(:15 ¡ :05) = 10.In practice, the P/E ratio underlying the terminal value calculationcan be selected by reviewing sale prices of recent insurancecompany transactions relative to earnings. Relating that P/Efactor to an implicit growth rate and hurdle rate may make theprice-to-earnings ratio more intuitive.2.2. Economic Value AddedThe value of a company can be written as the sum of theequity invested and the expected excess returns to investors fromthese and future investments.Value = Initial capital invested+ PV of expected “excess returns” to equity investors.The expected “excess returns” in each period are defined as(rate of return on capital invested ¡ hurdle rate) £ capital invested= after-tax operating earnings ¡ (hurdle rate £ capital invested):The general expression of EVA is1XValue = SC 0 + [OE x ¡ (h £ C x¡1 )] £ (1 + h) ¡x ,wherex=1SC 0 = Starting capital, which is equal to the sum of free capitaland required capital at time 0 (FC 0 and C 0 , respectively,as defined in the DCF discussion); andOE x , C x ,andh have the same definitions as in the DCF discussion.10 The expected growth rate will typically be between 0% and the selected hurdle rate.If, however, the growth rate g were less than 0%, the resulting P/E ratio would decrease(as h ¡ g increases).