Chapter 2 Capital Injections and Market Capitalization – Valuation of Indian Life Insurance Companies

CHAPTER 2

Capital Injections and Market Capitalization

Introduction

2.1.In this chapter and all the following chapters, we will analyze the published accounts of three companies: HDFC Life (HDFC Life), ICICI Prudential Life (ICICI Pru), and SBI Life (SBI Life). ICICI Pru was the first company in the life insurance private sector to have an IPO, in 2016, followed by HDFC Life in 2017 and then SBI Life in 2017.

2.2.We start by looking at the capital injected in each of these three companies from inception to the date of the IPO and then compare the accumulated value of this capital with the IPO price to get the internal rate of return (IRR). We, therefore, deal only with what has happened in the past and look at only one aspect of the business—the capital injected into the company. We will also calculate the share price assuming the capital had accumulated at a rate different from the IRR to get a different picture to the one presented by the IPO.

2.3.You may ask now, who looks at how much money has been put in to start a business, and more importantly, you may want to know the answer to the question in the following section.

Is the capital injected into the company relevant today?

2.4.Generally, the capital put into the company is rarely considered when analysts place a value on the share. Indian private insurance companies, however, started operations only in 2000, when the insurance sector was privatized, so because we are talking of a time span of less than 20 years (2000 to 2017), the capital invested to start the companies is very much relevant today. This amount can then be the figure we first start with and we can use this as an indicator of the value of the company.

How do we get the net capital movement in each year?

2.5.The total capital in the company at the end of any financial year is the sum of the share capital account and the share premium account. The capital injected over the year is then the difference between the end year and beginning year figures of the sum of the share premium and share capital accounts. Subtracting the dividend paid over the year from this gives us the net capital movement during the year. The dividend here is the proposed dividend, including any interim dividend in the profit and loss account, and not the actual dividend paid. Since the annual reports and accounts are unavailable for the earliest years, I have assumed that the capital injected in those years was done on the first day of operation.

Now that we have this figure for each year of operation, what do we do with it?

2.6.We look at the company as a single entity and try and equate the capital movements to the market capitalization of the company. The connecting factor is the IRR, and this is the rate of return assumed to be earned year on year on the capital, so that the total equals the market capitalization.

How is the IRR calculated?

2.7.Multiplying the IPO share price with the number of shares in the Balance Sheet as on that date will give us a figure for the total market capitalization of the company. The accumulated capital value is then equated to this market capitalization of the company at a rate of interest allowing for the dates of capital movement. The rate of interest that equates the accumulated value of the capital injected in each year to the market capitalization on the eve of the IPO is the IRR. This is a simple calculation using an excel spreadsheet. We now calculate the IRR for all the three companies (Tables 2.1, 2.2, and 2.3).

Table 2.1 IRR for HDFC LIFE

Table 2.2 IRR for ICICI Pru

Table 2.3 IRR for SBI Life

What do the IRR figures mean?

2.8.HDFC Life has an IRR of 31.6 percent for a share price of Rs 275, ICICI Pru has a 22.4 percent IRR for a share price of Rs 300, and SBI Life has a 36.4 percent IRR for a share price of Rs 700.

2.9.Let us analyze the results in more detail. Are these IRRs justified? What have these companies done with the capital to achieve the value indicated by the IRR? To answer this question, we first need a benchmark rate of return.

2.10.The rate of return expected on a particular share is the sum of the following:

  1. The risk free rate or the rate of return if you invest in gilts for, say, 10 years.
  2. The risk associated with the industry. In our case, it is the insurance industry in India.
  3. The risk associated with this particular company.

2.11.The risk free rate can be assumed to be around 8 percent. This rate, plus a rate of another 7 percent for points (b) and (c), gives 15 percent. (I have assumed the same risk for all three companies; in practice, the market will use different rates.) In other words, my estimate for the return on capital for any of the companies above would be about 15 percent, or if I am being very optimistic, I would use a 20 percent rate of return.

2.12.I would then start from this rate of return and assess the results using this benchmark. Using 20 percent as the benchmark rate of return on capital, all the three companies seem to be overpriced, with SBI Life taking the lead, closely followed by HDFC Life. ICICI Pru seems more reasonably priced with the IRR at 22.4 percent.

2.13.This view, however, has one major drawback: We are only looking at the past and have not factored in the future at all. Should not the share price also reflect what profits the company is expected to make in the future? The profits expected depend on the industry first and the company second. Before we look at the future, however, let us have a relook at the past and try to guess what the share price would be if the IRR had been in line with industry norms and if we leave future expectations out of the equation. This leads us to the next question.

What will the share price be for a different IRR?

2.14.We can also perform the above exercise the other way round. We find the total value of the company and consequently the share price for a defined IRR. This is done by first accumulating the capital injected up to the IPO date at one particular rate of interest. This accumulated value is then divided by the number of shares as on that date to give the share price. The results are as given in Table 2.4.

Table 2.4. Calculated share prices for different IRRs

IRR

HDFC Life

ICICI Pru

SBI Life

15%

45.05

119.24

52.53

20%

77.80

223.40

100.34

2.15.We now find that these rates are way below the IPO price and the share price quoted in the market. How are these rates so different from the market price? At this point, you may be tempted to ask, surely an insurance company is very different from a used car? Do we find out what has been paid for an asset and then derive a value from there or do we forget the past and see what the company is expected to do in the future? Or we may rephrase this question to what is the investor paying for—the growth in the past, the expected growth in the future, or the brand name?

Composition of the share price

2.16.The share price is a combination of what has happened in the past and what is expected in the future. This means that the share price is roughly made up of three components:

  1. Past growth
  2. Future growth
  3. Goodwill

2.17.The investor has to apportion the share price into these three parts and then take a call on whether she is in agreement with what the market has priced the share. This is required so that the investor has no doubt in her mind about the value of the product she is buying, the risks associated with it, and consequently, the impact on the share price if the future is not as expected.

How do we apportion the share price into these three components?

2.18.The value calculated earlier may be assumed to be that portion of the share price which reflects the growth of the company up to the date of the IPO. There are more accurate methods of doing this calculation, however, instead of the previous ad hoc calculation. This leads us to the concepts of embedded value and appraisal value, which are unique to insurance and which will give us an idea of the different components of the share price.