Investors that read my articles know that I am a big believer in American International Group (NYSE:AIG) which is a high conviction investment of mine. Many consider the stock as undervalued as I do. But how can this be illustrated for a range of outcomes?
Since the P/B value is often used to evaluate the attractiveness of an insurance company investment, I have put a few things together to develop a valuation matrix (see below) that basically shows what the implied forward discount to book value could look like based on assumptions regarding a range of P/B multiples and a constant book value per share growth rate. Now this model is certainly not perfect as it does not take into account share buybacks that we can expect to be implemented soon and which will have a (positive) impact on AIG's book value per share.
In addition investors have different expectations with regard to book value growth and profitability and catastrophes can quickly render any valuation model meaningless. However, the matrix below depicts a range of forward discounts to book value and implied annual returns for the investor who manages to initiate a share position at today's prices. In terms of transparency, there are two fundamentally important assumptions underlying my model which I want to disclose right of the bat to avoid misunderstandings.
1. Growth rates will be constant. In reality they are not. And they don't have to be. For the sake of extrapolating book value I assume constant book value per share growth. A more differentiated view in terms of growth rates probably did a better job but the range of scenarios would increase exponentially and be impractical to present at last. In order to accommodate different opinions about growth rates I have incorporated a scenario analysis that allows investors to pick a growth rate they feel most comfortable with. The highest growth rate in the model is 10% where investors practically bet that AIG will outperform its aspirational goal to earn a 10% return on equity by 2015 (formulated in AIG's 1Q 2011 10Q filing). Again, share repurchases, cat-losses and other book value impacting financing decisions are beyond the scope of the model. Instead, investors can pick a lower growth rate. Also, I grow the full beginning year equity balance forward as represented by book value per share and not average equity which proponents of the return on equity measure might favor.
2. Premium multiple modeling. AIG competitor Travelers (NYSE:TRV) currently trades at 1.2x book value, Prudential (NYSE:PRU) at 1.03x and Metlife (NYSE:MET) at 0.87x bringing the peer group average to 1.03. Morningstar states the industry average at 1.0x book for a larger peer group. From a conservative book value metric point of view those companies are trading at fair value. Since I am generally bullish on insurance and financial firms (here and here) I assume that AIG shares can trade at least at a multiple of 1x BV at the end of 2016 which is three and a half years from now. This is not an aggressive assumption. If history repeats itself, which I believe it will, AIG can trade at a premium to book value as it did in the past, that is pre-2008. Reaching a premium valuation is therefore a real possibility.
What information does the valuation matrix contain?
Starting with the 2012 audited BVPS of $66.38, constant growth assumptions range from 5-10% based on scenario type. For instance, assuming AIG can grow its BVPS by 7% a year until 2016 in the base case scenario, the estimated BVPS would turn out to be $87.01. An investor who purchases AIG today at $46.53 and expects AIG to trade at 1.1x book at the end of 2016 buys AIG at an implied forward discount to BV of 51.4% compared to 30% now and locks in a 19.76% annual capital appreciation return.
Investors who are more bullish and believe AIG can grow BV by 10% yearly (roughly consistent with a 10% return on equity assumption) until 2016 and think that industry conditions improve such that the market values the company at 1.4x BV could earn an annual rate of return of almost 31%.
Though the model is fairly simplistic it does help to keep the eye on the ball and to focus on what is most important: book value and discount to intrinsic value. The current discount to book value, though representing a margin of safety, does not consider future growth and therefore underestimates AIG's intrinsic value. Instead investors should be evaluating forward discounts. The range of outcomes indicates that even conservative growth and multiple estimates (g=5%, P/B=1.0) could lead to a near 15% annual return. Given the assumptions described above, AIG's current undervaluation becomes even more apparent when focusing on the future rather than the present.