This is the third in a series of articles that have been designed to provide investors greater insights into the proper understanding and utilization of the PE ratio as a valuation measurement tool. With this iteration we're going to look at Aflac (AFL) as our example for using the PE ratio to identify significant undervaluation. The first article in this series looked at Amazon (AMZN) as an example of overvaluation. Our second article looked at SCANA Corp. (SCG) and Darden Restaurant Group (DRI) as examples of fairly valued companies; however, we further introduced the concept of the earnings growth rate as a relative component of future return.
For clarification, this article and the two previously mentioned are written in order to provide deeper insights and a greater understanding of the PE ratio as an investment tool. Additionally, they are also focused on the proper utilization of the PE ratio as a valuation metric. In that vein, these articles are not offered as in-depth analysis of the respective companies being discussed. Instead, these articles are offered as intellectual exercises that reveal the mathematical investing principles and realities that the PE ratio is reflecting, assuming that the estimates and assumptions are correct. Therefore, we ask that the reader accept that the estimates being used are accurate or at least within a reasonable range of probability. In other words, we want the reader to understand the relevance of the PE ratio and its application relative to an accurate assessment of past, present and future earnings growth.
The PE Ratio: Proper Perspectives
In order to accomplish this goal we are going to properly utilize the PE ratio as a relative measuring stick. As previously pointed out in the first two articles in this series, looking at the PE ratio in a vacuum is an ineffective and mostly irrelevant way to use it. The PE ratio only brings value to security analysis when it is applied and looked at relative to the past, present and future earnings power of the company or companies being analyzed. The PE ratio is a measurement of current valuation in the static sense, but it is a more relevant measurement of valuation when looked at dynamically relative to the future growth potential of the underlying business (earnings growth). Because only when the future growth of the business is correctly ascertained does the PE ratio draw a true picture of valuation.
The PE Ratio Defined
In our first article in this series we provided three extensive definitions and explanations of the PE ratio. Here is a link to that article for those interested in digging a little deeper into the definitional side of the PE ratio. In our second article, and repeated here, we offer three condensed versions of our PE ratio definitions.
- The simplest definition of the PE ratio is the mathematical formula: PE = Price divided by Earnings.
- This second definition relates to the PE ratio as a measurement of the cost of earnings: PE= How many dollars you must pay to buy one dollar's worth of a company's earnings.
- This final definition relates the PE ratio to the time use of money: PE = How many years in advance you are paying for this year's earnings.
Aflac Inc. (AFL): The Thesis for Growth
However, for those who are interested in Aflac as a current investment idea, we direct you to our previous article that provided a comprehensive dissertation on Aflac by an independent third party. Here is a link to that article, (note that the discussion of Aflac is deep into the article): Additionally, the following excerpts from Zacks Investment Research dated October 27, 2011, and one from The Value Line Investment Survey dated October 14, 2011, provide additional third party corroborations for future earnings growth:
Excerpt from Zacks Investment Research Dated October 27, 2011:
"V aluation"
"Aflac has historically traded at a premium valuation to other health insurers, reflecting its higher growth prospects, consistent earnings record, superior ROE and strong financial position. Over the years, the company has been significantly focusing on strengthening its insurance operations through successful product launches and expansion of its distribution system. Moreover, AFLAC has strong earnings potential in 2011 and beyond, which will help in mitigating risk related to the constitutional capital, while also enhancing the company statutory earnings. Hence, we expect some upward potential pressure on the performance of the stock in the medium to long term once the global economy rebounds to its historical highs. Although fundamental outlook for AFLAC remain strong, the near-term outlook remains cautious due to interest and exchange rate fluctuations, investment in hybrid securities, catastrophe losses, low payroll accounts, rating downgrades and volatile economic cues. Therefore, we are maintaining our recommendation on Affleck at neutral, waiting to clear the smog around stock."
Excerpt from Value Line Investment Survey Dated October 14, 2001
"These neutrally ranked shares have above-average long-term capital appreciation potential. We think that AFL's recent price reflects renewed fears of large asset write-offs. But business in Japan should grow as that country further restricts free healthcare services. And in the US, AFLAC's customers account for well under 20% of its target small to midsized business market.
Sigourney B. Romaine October 14, 2011"
Aflac (AFL) Trading at Half its True Worth ™
The following 15-year historical earnings and price correlated F.A.S.T. Graphs™ clearly shows that the market has traditionally provided a modest valuation premium on Aflac's shares relative to its earnings justified valuation line (the orange line). Aflac has achieved a consistent above-average earnings growth rate of 17.1%. Therefore, since calendar year 1997, and up through calendar year 2008, Mr. Market applied a normal PE ratio of 18.6 on Aflac's shares. However, the great recession of 2008 changed all that, yet, even after earnings have rebounded strongly in years 2009, 2010 and expected to continue for 2011, Mr. Market stubbornly applies a current PE ratio that is less than half its historical norm (See Red Circle on Graph).
Even when considering today's significant undervaluation of Aflac's shares, their long-term shareholders have been handsomely rewarded in excess of the general market as measured by the S&P 500. Aflac is a Dividend Champion, and on October 26, 2011 the Board of Directors of Aflac announced a 10% dividend increase marking their 29th consecutive year of dividend increases. The dividend cash flow table on the performance graph below illustrates how powerful Aflac's growth yield™ (yield on cost) has historically been (See Purple Circle).
Aflac (AFL): Interpreting the Estimated Earnings and Return Calculator
The F.A.S.T. Graphs™ estimated earnings and return calculator is designed to offer short, intermediate and long-term estimates of a company's earnings growth potential. The graph contains one year of historical price correlated to earnings, then an actual forecast number for the current year (note that since there only two months left in the current year this forecast is, more likely than not, to be very accurate). Then the actual consensus forecast for the next year's earnings is plugged in, and then from that point, future earnings are grown by the five-year consensus estimated earnings growth rate.
Therefore, in our Aflac example we show earnings of $6.37 for calendar/fiscal year 2011, followed by $6.60 for calendar/fiscal year 2012 which represents approximately a 5% growth rate. From this point, future earnings are compounded at the 9% consensus estimate by 20 analysts reporting to Capital IQ. Although these are analyst's estimates, we also want to point out that these numbers are consistent with the guidance that Aflac's management has provided. The following excerpt from an Aflac's press release on October 26, 2011 presented management's guidance that coincides with our forecast graph:
"With three quarters of the year complete, we continue to believe we are positioned for another year of solid financial performance. Throughout the year, both Aflac Japan and Aflac U.S. have continued to do a very good job managing our operations, including expense control. As we have stated previously, our expectation was to increase spending in the last half of the year, particularly on marketing and IT initiatives in the fourth quarter. Despite our expectation for higher spending in the fourth quarter, I am confident we will achieve our 2011 objective of growing operating earnings per diluted share at 8%, excluding the impact of the yen. If the yen averages 75 to 80 to the dollar for the last three months of the year, we would expect reported operating earnings for the fourth quarter to be in the range of $1.45 to $1.52 per diluted share. Under that exchange rate assumption, we would expect full year operating earnings of $6.30 to $6.37 per diluted share.
"Looking ahead, I want to reiterate our expectation that 2012 operating earnings per diluted share will increase 2% to 5% on a currency neutral basis. Furthermore, once the effects of our proactive investment derisking program and low interest rates have been integrated into our financial results, we believe the rate of earnings growth in future years should improve."
Remember that the reader is asked to assume that these estimates are accurate for the purposes of this article. However, as an interesting aside, the consensus of leading analysts reporting to Zacks expect Aflac to grow earnings at 10.5%, and Zacks itself forecasts 11% growth, while the Value Line Investment Survey forecasts earnings growth of 13%. Consequently, a strong case can be made that the forecasts on the following graphs are conservative representations for Aflac's future earnings growth. Once again, assuming that they are, this implies a potential five-year estimated annualized total return of 25.9% (See Brown Circle on Top of Graph). Of course, this also assumes that Aflac meets our targeted estimates, and that the market applies a normal PE of 15, or twice what it currently applies.
The following EYE (earnings yield estimates) table mathematically articulates how undervalued Aflac's stock really is. At today's valuation, Aflac offers an earnings yield of 14% and a 5-year future earnings yield over 20%, (Note the brown cell on the table coincides with the five-year estimated earnings growth). Applying a stock market normal PE ratio of 15 implies extremely attractive long-term share price appreciation potential as depicted by the white column titled Target PRC Est Tot Ret. Furthermore, note that the blue dividend columns and the green earnings columns reflect returns in excess of the riskless 10-year Treasury bond for all years.
Final Perspectives on Aflac
When properly utilizing the PE ratio to evaluate our Aflac example, today's current blended price earnings ratio of 7.4 makes no logical sense. The only way it could make sense would be if future earnings were expected to be significantly lower than they are today, not greater as consensus now expects. Yet, since Aflac's historical record and the expectations for its future record are both strong and above average, the rational thinker must assume extreme undervaluation is present today. To state this as clearly as possible, we believe that a fair value PE ratio for Aflac (AFL) should be at least 15, which suggests that the price should be double what it currently is trading at.
Furthermore, the rational thinker would also logically assume that there exists a significant opportunity for a price earnings ratio expansion in the future. Growing earnings and the rational expectation of PE expansion augurs extremely well for significantly above-average future long-term returns. Moreover, today's extreme low valuation also implies a lower than historical normal level of risk.
As Warren Buffett has said: "Investing is most intelligent when it is most business like." And the future business prospects for Aflac appear very promising. Consequently, we believe that all Aflac shareholders need to do today is exercise a little bit of intelligent patience and the rewards should be great and the risks manageable to low.
Concluding Remarks on the Proper Use of the PE Ratio
This concludes the series of articles on the PE ratio and its significance as an investor's tool for making sound valuation judgments. It's important to add that the perspectives on the PE ratio that this series of articles has addressed are primarily relevant to long-term investing. The PE ratio at its core deals with measuring the value of a company's earnings. Therefore, it is more of a business valuation tool than it is a stock market trading vehicle. Therefore, it is also implied that the principles underpinning the PE ratio's relevance take time to manifest. When dealing with ascertaining the proper valuation of a business, it's only appropriate to conduct this measurement as it pertains to a normal business cycle (3 to 5 years).
Furthermore, it's also important that the reader recognizes that a stock can be overvalued and still go higher, and conversely, become undervalued and still go lower. Therefore, understanding when a PE ratio represents fair valuation is not necessarily a perfect market timing tool. Instead, it is a valuable measurement when used and looked at properly that can alert the investor to precisely recognize the time when markets may begin mispricing a stock, over or under.
Therefore, one of the greatest values that the proper understanding of the PE ratio offers investors is the ability to recognize the level of risk they are taking based on fundamentals when making buy, sell or hold decisions. What the investor does with this information is up to them, but at least their decisions are being made with the clear understanding of the risk levels they are assuming. When used properly, the PE ratio is an important and beneficial measuring tool for the prudent stock investor.
Disclosure: Long AFL at the time of writing.
