There is a 28% upside in the current stock price of AFSI. Currently the stock is trading at $38.47 with a PE ratio (trailing 12 months) of 9.26.

Company

AmTrust Financial Services Inc. (AFSI, Financial) provides insurance services and specializes in providing Property & Casualty (P&C) insurance contracts. It operates through three primary segments, Small Commercial Business, Specialty Risk, and Extended Warranty and Specialty Program. Through its insurance subsidiaries, the company is licensed to provide specialty risk and extended warranty coverage in 50 states and the District of Columbia, Ireland, United Kingdom and other European Union (EU) member states.

Business Model

The premiums are AmTrust's primary source of revenue. The other sources of revenues are from service and fee income, net investment income, and net realized gain on investments. Here is a brief summary of geographic mix, product mix in the three segments and the invested assets.

Source 2013 Annual report

Business strategy

AmTrust's goal is to become a growth company in the small and mid-sized business insurance space. It aims to achieve its growth objective through strategic acquisitions in niche customer segments that are usually underserved in the insurance market. Through this strategy, it aims to achieve profit growth and superior returns to shareholders. Its competitive advantage is its vertically integrated proprietary IT platform that enables them to serve a high volume of policies and claims, and achieve higher underwriting efficiency and maintain lower level of loss (claims cost).

Acquisitions

In late 2013 and early this year, Amtrust completed seven acquisitions to expand its operations with new insurance products and services, additional distribution network, and unique management talent. The total cost of acquisition of nine companies from July 2012 to January 2014 has cost Amtrust $616 million, $474 million of which was recouped in premiums and service fees revenue. AmTrust executives say that they approach acquisitions conservatively, taking modest integration and balance sheet risk. So far there does not seem to be any major write-off from acquisitions that would suggest that Amtrust overpaid for its past acquisitions. Amtrust is able to achieve higher earnings growth and higher total shareholder returns, suggesting Amtrust is creating shareholder value and its opportunistic acquisition strategy is on target.

Management & Compensation

AmTrust's CEO Barry D. Zyskind has been with the company since its inception in 1998 when he joined as a director. He owns 10.6% of the outstanding stock. Nearly 59% of the outstanding stocks are owned by four individuals -- George Karfunkel, his wife, brother and son-in-law Barry Zyskind. Hence, they have the power to control all the matters requiring approval from stockholders. Here is the summary of executive compensation.

Source Morningstar

Growth & Profitability

From 2007 to 2013, AmTrust experienced significant growth in net premium, earnings and dividends, through internal organic growth and its acquisition strategy. From 2007 to 2013, the earnings growth was 16.2%, and if we expect AmTrust to meet the analyst forecast of $4.86 in EPS by the end of 2014, the earnings growth rate would be 22%. The growth rate of 22% also seems to be consistent with the average historic ROE (Return on Equity) of 21.5%. The following table includes the growth percentages for the company from 2007 to 2013.

AFSI has also performed better than the P&C (Property & Casualty) Insurance industry in terms of growth and returns to shareholders. Here is a comparison of AFSI to industry average comprising of 53 P&C Insurance firms.

Valuation

I have based the valuation of AmTrust on a dividend discount model (DDM) in which we value the stock as the present value of the expected dividends. The dividends are based on the earnings growth, and hence the expected earnings growth is the key factor to determine the future expected growth rate in earnings. The proportion of dividends (payout-ratio) that AmTrust pays to its shareholder has been fairly uniform ranging from 7.4% in 2007 to 15% in 2013. The expected growth in EPS is the product of retention ratio (1 – payout-ratio) and ROE. From this the expected earnings growth is 19.5%, which is greater than the average Insurance (P&C) expected five year earnings growth of 14.5%. After the growth period, I tend to select conservative estimates for terminal growth to be 4% perpetual growth in earnings and ROE of 14.5% (historic ROE of Insurance (P&C)).

The DDM model I am using gradually adjusts the payout-ratio and expected growth rate during and after growth phase. From this input, the value per share is $49.77. The current market price as of Sept. 24 is $38.62.

The following are the valuation numbers.

Source Damodaran DDM model

Comparable P/E analysis of AmTrust and its competitors shows that AmTrust is valued on the lower side of P/E ratings, while it’s average ROE in the highest in the group.

Source Google finance

Operations

Underwriting expertise is fundamental to the success of an insurance company, and it’s worth looking into the underwriting efficiency measures of AmTrust. In the following table, we examine loss ratio (actual losses incurred to premiums earned), net expense ratio (expense incurred in underwriting to the premium written), combine ratio (sum of loss and expense ratio that measures the underwriting profitability of the firm), and lastly the operating margins (operating expenses for every dollar of sale).

The loss ratio is a significant proportion of the combine ratio, ranging from 62% to 67%. In recent years, the loss ratio of P&C insurance companies has been fluctuating in the range of 50% and 70%. AmTrust’s net combine ratio of less than 100 suggests that premiums on insurance are sufficient to cover losses and expenses. However, AmTrust’s operating ratio has grown steadily from 72% to 89% and that questions the efficient cost structures that the management claims in the 2013 annual report. The operating ratio is the measure of AFSI overall operational profitability from underwriting and investment activities. I believe in the future, AmTrust operating performance should also be viewed through the lens of the above metrics.

Risk

AmTrust's principal insurance subsidiaries are rated “A” (Excellent) by A. M. Best Company (provides news, credit ratings and financial data products and services for the insurance industry). The “A” rating is the 3rd highest of the 16 ratings levels. This means that AmTrust has the financial strength to meet its ongoing insurance policy and contract obligations.

Capital structure

As you can observe from the table above, the debt-to-capital ratio is 42%, compared to the P&C insurance industry average of 26%.

Over the years, to fuel its growth AmTrust has been generating significant cash inflows through its financing activities. However, the cash flow from operating activities has always been positive, above the cash inflows of its financing activities. This simply means that it can generate higher returns on the cash it is using.

The number of outstanding stocks has been increasing steadily throughout the years but the book value per share has increased from $6.40 in 2007 to $20.40 in 2013.

Conclusion

Based on the fundamentals I have discussed, I still believe the stock price has another 28% upside to it, given its current stock price of $38.47. This stock price has fallen from $43.50 to $38.47 in the past three weeks, and it is beyond my expertise to know the factors causing this downward pressure. I believe this makes the stock even more attractive to potential investors.