Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

QUESTION AND ANSWER SESSION

Question: In the world of insurance companies and banks, half their books are accruals. Can this type of analysis be used there?

Sloan: They do have assets and liabilities, but it is more difficult to distinguish what I call “proprietary assets” and “proprietary liabilities” from the marketable securities and debt that represent a standard source of financing, such as bonds or commercial paper issued by a bank. What you must do is identify the proprietary assets and liabilities and focus on them.

For insurance companies, you must focus on the spread between the reinsurance receivables and the reinsurance payables and also the liability for claims reserves; these are the proprietary assets and liabilities. One of the important areas we’re focusing on lately concerns companies in the financial sector that are issuing loans, particularly residential loans and consumer loans, and then securitizing and selling them while holding a residual interest in these loans.

These residual interests hold most of the risk because they are the first not to be paid in the event of a default. They are a small chunk of the balance sheets of these companies because the residual interests are small in dollar magnitude, but the risk is enormous. So, you could take $1 billion of receivables, hold a residual interest in $20 million, and basically have the risk of $1 billion of loans concentrated in $20 million of receivables.

If we see a downturn in the housing market and people ...