Q&A: How Do I Value Banks & Insurance 101

What It Covers

Andrew Sather explains how to value banks and insurance companies, two financial sectors where standard metrics like price-to-earnings and free cash flow statements fail. The episode covers balance sheet-focused valuation, loan book risk assessment, insurance float mechanics, combined ratios, and key red flags signaling value traps in financial stocks.

Key Questions Answered

• •Bank Valuation Formula: Replace free cash flow with Book Value Per Share multiplied by a 5-to-10-year average Return on Equity to estimate long-term profitability. Multiply that figure by 0.9 to account for the roughly 10% regulatory reserve requirement banks must hold, then run a standard discounted cash flow model using this adjusted number instead of cash flow statement data.
• •Loan Book Risk Hierarchy: When assessing bank risk, credit card loans carry the highest default probability, followed by auto loans, then mortgages, with commercial working capital lines generally the safest. Banks disclosing customer credit score distributions — such as "60% of borrowers have 800-plus scores" — provide more reliable risk analysis than proprietary internal scoring systems that require taking management at their word.
• •Insurance Float Mechanics: Insurance companies collect premiums before paying claims, creating a capital pool they can invest freely during the interim period. Profitable insurers earn returns on this float through bonds, equities, or real estate. Berkshire Hathaway's roughly 19-20% compounded annual return over 60 years demonstrates how combining disciplined underwriting with aggressive float investment creates exponential compounding unavailable to non-financial businesses.
• •Combined Ratio as Underwriting Profitability Signal: For insurance companies, the combined ratio measures underwriting profitability independently from investment returns. A lower combined ratio signals the insurer is selecting lower-risk customers and paying out fewer claims relative to premiums collected. Evaluate this metric alongside the investment portfolio composition — bond-heavy portfolios indicate conservative management, while equity-heavy portfolios signal higher risk tolerance similar to Berkshire's approach.
• •Fast Growth as a Red Flag: In both banking and insurance, unusually rapid growth often signals excessive risk-taking rather than competitive advantage. Banks accelerating loan volume by loosening credit standards — as occurred pre-2008 — and insurers expanding premiums into high-risk categories can appear highly profitable until losses materialize. Prioritize long-term ROE consistency over short-term earnings acceleration when screening financial sector stocks.