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.

1. The simplest definition of the PE ratio is the mathematical formula: PE = Price divided by Earnings.
2. 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.
3. 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%