Aflac: A Valuation Conundrum? Fairly Valued Dividend Aristocrats: Part 1 of 7
Aflac (AFL) is a Dividend Aristocrat that has increased its dividend for 35 consecutive years. However, it is only one of seven Dividend Aristocrats that I consider attractively valued in light of the current bull market. Therefore, this will be the first in a series of seven articles where I will cover these seven attractively valued Dividend Aristocrats.
True value investors are a rare breed, because it takes a special mindset and/or psyche to successfully implement a value investing strategy. This is especially true during major bull markets like we’ve experienced since the 1st quarter of 2009. Common sense would dictate that it is much harder to find attractively valued companies during strong bull markets. Consequently, value typically only manifests during bull markets when a specific company is facing a negative situation. The secret is to determine whether the situation the company is facing is temporary or permanent.
If temporary, low valuation can represent an extraordinary long-term opportunity. If the problem represents a permanent deterioration of fundamentals, then a value trap exists. Value investors attempt to exploit opportunities while avoiding value traps. During our most recent bear market Warren Buffett quipped that “we should be greedy when others are fearful and fearful when others are greedy.” When dealing with fundamentally strong companies, this is truly sage advice. On the other hand, when dealing with fundamentally weak companies, being greedy can lead to catastrophic long-term results. In other words, greed only works when it is applied to fundamentally strong businesses that the market is temporarily mis-appraising.
Therefore, I believe it only logically follows that successful value investing strategies require investing in extremely high quality companies when they can be purchased below their intrinsic value. Moreover, successful value investing requires the willingness to focus more on long-term fundamental strength and less on short-term price volatility. But perhaps most importantly, value investors - by trusting fundamentals over price - are able to maintain the patience to give the price the time to inevitably revert to the mean.
Additionally, value investors purchasing high-quality companies are prepared to walk through short-term price declines while the company is temporarily out of favor with most investors. In fact, successful value investors understand that finding a perfect bottom is impossible notwithstanding luck. Therefore, accomplished value investors are prepared for and even expect to experience short-term underperformance - unless, of course, they get lucky. As Warren Buffett also once quipped “you can’t buy what’s popular and expect to do well.” However, I believe Warren Buffett was referring to long-term results not short-term results when offering that advice.
This belief is based on the reality that value investing implies a long-term perspective which Warren Buffett obviously embraces. Value investors are made up of tortoises racing against the hares. Value investors embrace the reality that investing is a marathon and not a sprint. But more to the point, value investors understand that it takes time for a business to generate operating results, and they understand the auction nature of the stock market over the short run. In other words, short-term market returns tend to be emotionally generated (fear or greed) while long-term returns are driven by successful business results (growth of earnings, cash flows and dividends).
Aflac: Measuring Business Value versus Market Value
When the prudent long-term investor buys a stock, they are really buying the business. Therefore, I believe that knowing how well the business behind the stock you are considering has historically performed on an operating basis is an important first step in the investment process. Later in the video portion of this article I will present an earnings and price correlated FAST Graph reviewing Aflac Inc., its business and how the market has priced its business since the beginning of calendar year 1998. There are a couple of important points that I believe this long-term graphic vividly reveals. First and foremost, as the video analysis will reveal, Aflac had achieved a very strong record of historical earnings growth (the orange line) up through 2012 averaging 12.9%. However, since 2012 earnings growth has been low at less than 2%.
As you will see in the video, this change in Aflac’s growth dynamic represents a critical consideration regarding shareholder returns. On the other hand, this slowing of growth that Aflac is experiencing is effectively counterbalanced by the lower-than-normal valuation that the market has applied to Aflac shares since the Great Recession. As previously suggested, growth is an important driver of long-term returns. However, unjustified low valuation can produce attractive long-term returns even when growth is muted. Of course, the trick is to identify opportunities where the market has overreacted to the company’s situation. I will illustrate how this works in the video below.
Second, we discover that up to the Great Recession of 2008, Aflac's stock price had not only tracked earnings, but even more importantly, that the stock had typically commanded a premium valuation. The blue line on the graph represents the normal PE ratio of 19.5 that the market historically applied to Aflac. Moreover, we also will see that the stock price rarely fell below its earnings justified valuation (the orange line) representing a P/E ratio of 15. However, since the Great Recession, the market has not been as kind as it historically had been to Aflac as the stock market has clearly been valuing Aflac much lower at a normal P/E ratio of approximately 10 since 2009. On the other hand, the fact that earnings growth has slowed considerably and considering that financials and financially related companies have been chronically out of favor since the Great Recession, a significantly lower valuation could be considered justified. However, a justifiably lower valuation and significant undervaluation are two different matters altogether.
Clarifying Remarks on the Proper Use of the PE Ratio
Moreover, I believe it’s critical to recognize and understand the proper utilization of the PE ratio and its significance as an investor's tool for making sound valuation judgments. Furthermore, it’s important to add that the perspectives that the PE ratio provides 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. As a result, 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 at a minimum to a normal business cycle (3 to 5 years) and the longer the timeframe - the better.
In this respect, 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 in the shorter run. 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 and utilization of the PE ratio offers investors is the ability to recognize the level of risk they are taking based on earnings values when making buy, sell or hold decisions. What the investor does with this information is up to them, but at least their decisions will be made with the clear understanding of the valuation risk levels they are assuming. When used properly, the PE ratio is an important and beneficial risk measuring tool for the prudent long-term oriented stock investor. Of course, the P/E ratio is not the only valuation metric that value investors should appropriately consider. Valuation is a puzzle, and it takes all the pieces to paint a complete picture of a company’s true value. The P/E ratio is just one of many valuation puzzle pieces.
Aflac: FAST Graphs Analyze Out Loud Valuation Analysis
The following analyze out loud video will present a quick overview of Aflac, Inc. based primarily on price relative to earnings and cash flow. However, as discussed above, I will also evaluate several other metrics. For any reader concerned with the current valuation of Aflac, this video is a must watch. Furthermore, although I will be only providing a cursory, or a pre-more comprehensive due diligence analysis, I believe you will find the video enlightening and hopefully entertaining.
As an aside, this is the third article I’ve written on Aflac. On November 9, 2011 I authored an article titled “Aflac’s Fair Value P/E Ratio Should Be Double, And So Should Its Price.” Although I still believe my premise that Aflac deserved a higher P/E ratio was valid, the stock has yet to reach my target P/E ratio of 15. However, although the P/E ratio has yet to double, it has increased significantly above where it was when I wrote the article. Consequently, performance has been strong even though the company’s growth rate has slowed considerably. Double-digit performance came primarily as a result of P/E ratio expansion coupled with a growing dividend.
My second article was written on August 2, 2012 titled “Aflac Stock Research And Dividend Analysis Fails Compelling Value.” As a testament to the importance of valuation, Aflac’s performance since the second article has also been strong in spite of the fact that earnings growth did not manifest as analysts were forecasting. Nevertheless, it was once again primarily P/E ratio expansion and dividend growth that generated strong results. Proving to me at least that investing in an undervalued stock produces strong results at lower risk even when earnings growth did not pan out as expected.
Summary and Conclusions
Legendary investor Ben Graham has taught that the stock market is a voting machine in the short run, but a weighing machine in the long run. This lesson means that emotionally-driven stock values are merely a function of investors' short-term attitudes which can be very mercurial and, therefore, change very quickly. However, longer term, the strength of the business is what ultimately matters the most. I believe that Aflac is a very strong business and a high-quality company with a strong balance sheet. However, the conundrum is whether or not the market is currently mis-appraising the business or not.
Based on the undeniable reality that the market has been applying a normal P/E multiple of approximately 10 on Aflac over the past decade or so would indicate that Aflac is currently overvalued on that basis. On the other hand, based on a more market neutral P/E ratio of 15, Aflac could be considered undervalued. However, this chronic undervaluation has persisted since 2009 until the P/E ratio began increasing since the beginning of this fiscal year (2017).
Nevertheless, I leave it up to the reader to draw their own conclusions. Do you believe Aflac is finally, after many painful and excruciating years, reverting once again towards a mean P/E ratio of 15 indicating that it is currently undervalued? Or do you believe that Aflac will revert to its more recent normal P/E ratio of 10 indicating that it is currently overvalued? Although either scenario may prove to pan out in the future, investors should also strongly consider the significant slowdown in growth that Aflac has been experiencing in recent years. But more importantly, expectations for future growth continue to be lower than average. Caveat emptor, in other words, determining fair value for Aflac is a conundrum.
Long AFL at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.