Insurance agents and brokers have good reason to feel slighted. Like being stuck outside the New Year's party without an invitation, agents have had many reasons for envy as investors in other sectors congratulated themselves for another incredible year. The Dow Jones Industrial Average increased by a whopping 68% from 1996 to 1998, which was its strongest two-year performance since 1955. Even the insurance companies got invited to the party, with property and casualty insurers enjoying a 64% increase in value during the past two years.
But according to recent custom, the independent agent once again got snubbed. Due to poor market conditions and highly competitive insurance pricing, agency values have continued to move sideways. Over the past two years, the public insurance brokers have increased in value by only 7.4%. For the typical privately held agency, (for which reliable industry-wide information on values is not available), the results are probably even more frustrating.
Most agency owners don't view their agency stock in the same way as they view their other assets. Their agency is different: it is at the same time their place of employment, their platform for community involvement and their greatest source of both enjoyment and stress. In short, it's their baby.
As a result, few actually hold their agency investment to an objective set of performance standards. What would happen if they did? In light of agency valuation trends and the host of alternative investments available, are insurance agencies still a wise investment?
On the surface, they don't appear to be. Based upon their experience in performing fair market valuations of a large number of agencies each year, we estimate that the value of a typical agency's stock is increasing by between 0% to 5% per year. For our clients the figure this year was 8.9%. These results are higher because of the opportunity that we have to work with many of the leading agencies in the U.S. and, hopefully, the positive contributions that we have been able to make to them. Zero percent to 5%, or even 8.9%, obviously does not compare favorably with the widely known fact that, over the past 50 years, stock market investors have been able to earn a total return of approximately 12% per year. On the surface, the return of the overall market, especially over the past two years, is beating the pants off the hapless local agency owner.
However, a deeper look paints a very different picture: That 'hapless' local agency owner may quietly be one of the wisest investors in town. Why? Because investment performance is not accurately measured by focusing exclusively on stock value appreciation. There is another critical component that must also be considered, namely dividend yield. An agency's dividend yield is a pretty simple calculation if you can get a handle on two basic variables: Pro Forma Pretax Profit and Agency Fair Market Value.
An agency's Pro Forma Pretax Profit is the sum of reported pretax profits plus the amount paid to the owners in the form of excess compensation and perks, with 'excess' defined as the amount over the compensation and perks that a non-owner employee who performs the same functional role would be paid. Pro Forma Pretax Profits are determined by eliminating or adjusting expenses or income to levels that would be expected if the agency were owned by someone else. Pro Forma Pretax Profits are the profits that would be expected by an agency buyer and, as such, are a key determinant of value used by both appraisers and the most active agency buyers in the marketplace. For most agencies, the Pro Forma Pretax Profit falls into a range of 10% to 25%.
Once your agency's Pro Forma Pretax Profit is established, you simply divide it by the agency's fair market value and the resulting percentage is the dividend yield. So, for example, for an agency that generates a Pro Forma Pretax Profit of 15% of annual revenue and has a fair market value of 1.2 times annual revenue, the dividend yield is actually 12.5% (15% divided by 1.2).
Let us offer one point of clarification: Any portion of your profits and, in turn, your Pro Forma Pretax Profits that are retained in the corporation should be excluded from your computation of the dividend, due to the fact that the retained portion will be appropriately included in the appreciation of the value of your stock.
With these basic pieces of information, you can now measure the total return on your agency stock. If your agency's dividend yield is less than 10% and your agency's stock value is moving sideways, your agency is probably falling short of the long-term trend of the stock market. On the other hand, here's a staggering fact. Across all size categories, the average Pro Forma Pretax Profit of the agencies participating in the Best Practices Study this year was an impressive 19.5%.
If those agencies have a value, on average, equal to 1.2 times their annual revenues, they are generating a dividend yield of over 16%. What does this mean? It means that without any appreciation in their agency stock value, the Best Practices Agencies are materially outperforming the long-range average of the stock market. And if their stock is appreciating by an assumed average of, say 5%, their total annual returns are in excess of 20%. When all things are considered, even the 'average' owner whose agency is generating a decent profit each year is not faring too badly from an investment standpoint.
So if you're an agency owner standing outside the party feeling dejected, take heart: You may be doing better than you think. And remember if a 1987-style market 'correction' wipes out $1 or $2 trillion in stock market value in a single day, your agency stock will remain largely unaffected. Given the fact that an increasing number of analysts are suggesting a major correction could soon occur, outside the party may be the very best place to be.