The purpose of this piece is to practice calculating net present value (NPV). NPV is a useful tool for distinguishing between different 'values' in an ever-changing market. To do so I challenged myself to take two holdings and decide which of the two represents the best investment. The idea is to divorce 'feeling' entirely and to make reasonable assumptions for future growth.
What follows is an analysis of uranium giant Cameco (NYSE:CCJ) and insurance Goliath Aflac Incorporated (NYSE:AFL). The idea is to look at NPV and analyze growth potential, then determine whether these companies are worth investing in at present levels.
Aflac Inc. is the largest provider of supplemental health insurance in the US. It is also the largest life insurer in Japan. The company insures more than 50 million people worldwide.
To begin calculating NPV I want to know what AFL makes per share. Here is the earnings per share (EPS) for the last 3 years:
2010 - 5.68
2011 - 6.18
2012 - 6.54
Erring on the side of caution I have taken a three year average of 6.11. After all, AFL has over 10 years of improved EPS year on year. I want to assume a fixed level of growth of 8% for the next ten years. So:
Future EPS = 6.11 x (1.08^10) = 13.19 (EPS in 2023)
Forecasted stock price 2023 = 13.19 (EPS in 2023) x 8.14 (P/E avg) = 107.37
Now we have a future stock price, we need to factor in dividends in addition to this value. We do this by adding up the EPS over the 10 year period, like so:
Total = 101.69 (total EPS 10 years) x 0.20 (average payout ratio) = 20.34
We add the future stock price and dividend yield per share and get the following:
Future stock price with dividends = 107.37 + 20.34 = 127.71
To calculate the net present value we divide the future stock price by the expected ROI. This is the rate we require to compensate us for the risk involved in tying our capital up in the investment. That is:
Net present value = 127.71 / (1.08^10) [expected ROI] = 59.12
59.12 is slightly above the current market price. That is because I used the present price earnings, which is much lower than the historical average. What if I took an average PE based on the last ten years? Here are the PE ratios over the last 10 years:
2003 - 23.3
2004 - 15.56
2005 - 15.68
2006 - 15.38
2007 - 18.70
2008 - 16.17
2009 - 13.47
2010 - 11.29
2011 - 10.28
2012 - 8.65
Avg PE = 14.85
Forecast stock price 2023 = 13.19 (future EPS) x 14.85 (P/E avg) = 195.85 + 20.34 = 216.19
Net present value = 216.19 / 2.16 (1.08^10) = 100.09
The first net present value represents a very low PE ratio, but still turns out a net present value in line with the current stock price. The second net present value represents an average PE ratio over the last ten years.
If we average the two figures (51.21 + 92.18 / 2 = 71.69) we get a figure for NPV that is well above the current share price.
Considering EPS has grown, along with dividends over the past decade, I consider AFL a strong buy even at the recent close of $54.95. The company trades at a low multiple to earnings, has strong growth even in difficult economic times, and appears undervalued by the market.
The DDM (Dividend discount model) turns out a similar result.
Before I begin my analysis I would like to point out that I love Cameco and the idea of a comeback in uranium spot prices. I like the company and the fact that they have worked hard to build value in a very difficult market. The price of uranium has plunged to new lows and this has put pressure on margins. Yet even in this difficult climate CCJ has managed to position itself to benefit dramatically as uranium prices head north. Unlike gold I believe that uranium has fundamental utility in the world and provides mankind with a solution for carbon free power.
However, as an investor one needs to put their brain to work on figuring out whether CCJ is currently undervalued. To do so we need to use hard facts about the growth potential of the business.
Calculating Net Present Value - Cameco
Cameco is currently trading for 21.24 as of the 20th of May. Here are the historic EPS:
2003 - 0.59
2004 - 0.79
2006 - 1.04
2007 - 1.15
2008 - 1.25
2009 - 2.75
2010 - 1.27
2011 - 1.11
2012 - 0.680
You can see inconsistency in the EPS over the last decade. To figure out net present value we need to assume future growth, so that we get a value for what the business should be worth if it were to grow at a constant rate. Assuming that you have a ten year investing horizon and CCJ grows the business at an annual rate of 10% we can calculate what the EPS will be in 2023. That works out as follows:
EPS in 2023 = 0.68 (Current EPS) X 1.10^10 (compound 10% growth) = 1.764
If Cameco has an EPS of 1.764 in 2023 then we can use its average P/E ratio to calculate the price in 2023. This is based on our assumption of 10% compound growth in EPS (higher than the 8% assumed for AFL):
Price 2023 = 1.764 (EPS 2023) X 26.35 (P/E Avg 10 yrs) = 46.48
Projected Share Price = 46.48 (Price in 2023) + 2.99 (dividends per share for 10 years) = 49.47
Net present value is the projected share price divided by the expected return on investment. We will assume a 10% ROI to compensate for the risk. This is as follows:
Net present value = 49.47 (Price 2023) / (1.10^10) (Expected ROI) = 19.07
The net present value (19.07) is lower than the current price of 21.24. This already factors in ambitious estimates for growth at 10% per year.
If we wanted a margin of safety equal to 15%, then we would be looking for CCJ to be priced at 16.21 for an entry position.
By taking away all of the other factors and focusing on the business as an asset that earns a return for me, I can see that CCJ is currently over-valued. The EPS for CCJ would need to increase more than fourfold by 2023 to justify a sound investment.
I will be watching for three factors before investing in CCJ:
(1) the spot price of uranium holds above $40/ pound and recovers above that level
(2) EPS increases over the next year. With an average PE of 26.351 over the last ten years the stock historically trades at a premium. Why rush in over speculation of rising uranium prices?
(3) The price comes down to around 16.01
The purpose for comparing these two companies is to put into perspective the relative risk of one holding versus another. I have attempted to show how AFL has significantly more earning potential and a much stronger track record of delivering growth.
Additional disclosure: Sold CCJ 24-04-2013