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No. of Recommendations: 6
Hi everyone,

This is the 5th and FINAL section (Yey!!!) of a 5 segment piece on Arch Capital Group Holding Ltd. (ACGL), in this case devoted to price targets and exit conditions.

Updated values and quick summary:

Framework structure:

1) Valuation

2) Operational Reality

3) Company History/Background

4) Operational Growth/Risk

5) Establishing Price Target and/or exit conditions

1) Valuation

Trailing P/E = 7.59
Trailing FCF/EV = 1.69

Analysts Growth Est. (5yr) = 20%
Past Growth (5yr) = 8.9%
Industry predicted growth (5yr) = 12.4%

Pondered growth average (20+8.9+10.95)/3 = 13.77% <- This one is the one I'll be using

We will try and justify how reasonable this growth is in section 4 - Operational growth and risk

FCF/EV/G = 0.12

2) Operational Reality

I will subdivide this section into:

(1)- Industry
(2)- Company operations
(2.1)- Small description
(2.2)- Management
(2.3)- Operational metrics
(2.4)- Company's equity makeup and balance sheet

This section's content can be found on a previous post:

http://boards.fool.com/Message.asp?mid=21234279

3) Company History/Background

This section's content can be found on a previous post:

http://boards.fool.com/Message.asp?mid=21243246

4) Operational Growth/Risk

This section's content can be found on a previous post:

http://boards.fool.com/Message.asp?mid=21258550

5) Establishing Price Target and/or exit conditions

I will opt for several price target formulas:

Industry P/E - At what price would the company have a P/E equal to the industry average
Industry P/BV - At what price would the company have a P/BV equal to the industry average
Industry PEG - At what price would the company have a PEG equal to the industry average (using growth rate determined in the "Valuation" section)
DCF with CAPM - Discount cash flow price target assuming a discount rate calculated through CAPM using a predicted future beta, a pre-determined 5 year growth rate and a 0% growth rate after that.

Current Price (by market close 2004-08-27) - \$36.13

Industry P/BV - \$36.82
Industry P/E - \$60.17
Industry PEG - \$64.2
DCF with CAPM - \$164.90

I will take this opportunity to comment on the analysts covering ACGL.
Analyst coverage is a good sample on how the investment community looks at ACGL.
Of the 10 analysts covering it there is a high degree of polarization. 5 are issuing Strong Buy orders, 4 are issuing Hold orders (1 is issuing a Buy). Essentially, this can be interpreted has there being 2 opinions regarding ACGL's valuation:

The first opinion is that ACGL should be valued in accordance to the industry average P/B (both are currently at 1.3) there by making the current price a fair valued assessment of ACGL's intrinsic value.

The second opinion is that ACGL's huge FCF will undoubtedly contribute to a rapid growth in both book value and "insurance float" and that ACGL has the conditions to withstand the "soft" cycles and maintain a fair profitability while excelling in "hard" cycles.

I really don't believe that the risks associated with the equity structure are being inputted into these reasonings. I have little doubt that ACGL will grow at a satisfying rate. I'am however fearful in how common stockholders will be treated in relation to preferred shares owners. ACGL's board and executive management amount to 60% ownership of the company, and since the buyback of the preferred shares is a paramount obligation by the company before any other equity related transaction (excluding stock options), there is no guarantee that the common stockholder won't be wronged in the price at which preferred shares are bought back in the future. Let us hope that the management's past proof of honesty will play a role in that decision.

My price 12 month price target: \$45.00
Risk to the common shareholder: 30%

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Summing up:

Valuing an insurance company is difficult for many reasons. The industry itself is not only cyclical but subject to "events" that greatly affect earnings and cash-flow. The investment community as defended itself by valuing re(insurance) companies in relation to their book value and insurance "float". Still, there is room for value investors to try and find those companies that, thanks to a good growth momentum and large ability to generate cash-flow, are positioned to accumulate value. I think that ACGL is in such position, but that comes with a hefty price.

ACGL can hardly be called a public company. More than half of the equity is in non-tradable preferred shares to which the company reserves the right to buy back at and undisclosed price. Those preferred shares are property of two funds who must agree to a price previous to the buy back. Unfortunately, additional rights associated with the preferred shares are unknown.

Some mitigating circumstances are the management's pass activities at organizations with high ethic standards. As well as management's clear effort to keep the shareholders well informed of the business activities by issuing extremely detailed Quarter and Annual reports, as well as periodic "no-nonsense" press releases. The low share dilution related to stock options is also a fair indicator of management's goodwill (heck, they even show the impact that stock options would have on earnings if they were expensed!).

All and all any investment will always be about discovering and assessing risk while figuring out how to quantify it.

ACGL's numbers, growth and potential are clear. The risk is not. Risk is, in this case, a hunch which I did my best to quantify.

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Acknowledgements:

Jacko2
iceber0
educateidiot
owekrj
PaulEngr

Regards,

DCFnewbie