ACE Ltd (NYSE:ACE) is a leading company providing property and casualty insurance, reinsurance, and commercial property worldwide. The Zurich, Switzerland-based company operates in four segments: the Global Reinsure segment, the Insurance-North American segment, the Insurance Overseas General segment, and the Life segment. The company serves more than 170 countries with a physical presence in 53 countries. With its financial strength, the company is rated AA- by Standard & Poor’s.
As of Sept. 1, ACE stock was trading at $63 with a 52-week range of $53.76-$69.83. It has a market cap of $21.2 billion. Trailing-twelve-month P/E ratio is 8.6, and forward P/E ratio is 8.4. P/B, P/S, and P/CF ratios stand at 0.9, 1.3, and 5.5, respectively. The 3-year annualized revenue and EPS growth stand at 4.2% and 6.0%, respectively. Operating margin is 18.7%, and net profit margin is 15.5%. The company has a low debt-to-equity ratio of 0.1. ACE has a yield of 2.1% for its shareholders.
ACE has a 4-star rating from Morningstar. While its trailing P/E ratio is 8.6, it has a 5-year average P/E ratio of 9.1. Out of 22 analysts covering the company, 16 have buy, 3 have outperform, and 3 have hold ratings. Wall Street has diverse opinions on ACE’s future. The bottom line is -7.6% growths, whereas the top-line growth estimate is 23.7% for the next year. Average five-year annualized growth forecast estimate is 11.9%.
What is the fair value of ACE given the forecast estimates? In this article, the 17th in the series, I will show a step-by-step calculation of ACE’s fair value using discounted earnings plus equity model.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E_{0} + E_{1 }/(1+r) + E_{2 }/(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5 }+ Disposal Value
V = E_{0} + E_{0 }(1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own due diligence.
ACE’s Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.
Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $7.44 along with the mean estimate of $7.46 for the next year.
E_{0 }= EPS = ($7.44 + $7.46) / 2 = $7.45
Wall Street holds diversified opinions on ACE’s future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 11.9%. Book value per share is $71.35.
The rest is as follows:
Fair Value Estimator | ||
V0 | E_{0 } | $7.45 |
V1 | E_{0 }(1+g)/(1+r) | $7.51 |
V2 | E_{0}((1+g)/(1+r))^{2} | $7.57 |
V3 | E_{0}((1+g)/(1+r))^{3} | $7.63 |
V4 | E_{0}((1+g)/(1+r))^{4} | $7.69 |
V5 | E_{0}((1+g)/(1+r))^{5} | $7.76 |
D | E_{0}(1+g)^{5}/[r(1+r)^{5}] | $70.52 |
BV | Equals | $71.35 |
Fair Value Range | Lower Boundary | $116.13 |
Upper Boundary | $187.48 | |
Potential | 197.59% |
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for ACE is between $116.13 and $187.48 per share.
As of Sept. 1, ACE was trading at a price of $63. I like ACE as a company. It has strong financial health, successful business strategy and operations. I see great growth potential, as well. The market does not seem to appreciate ACE’s growth potential. The current price of $63 indicates the stock is deeply undervalued. Based on my FED+ fair value estimate, ACE is significantly cheaper than my fair-value range. The stock has 197.59% upside potential to reach the upper boundary of its fair value range.
O – Metrix Confirmation
If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:
O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5
- Dividend Yield: Higher is better.
- EPS Growth: Higher is better.
- P/E Ratio: Lower is better.
The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.
What is the O-Metrix Score?
- ACE has a yield of 2.1%. Therefore the yield is 2.1.
- Growth estimate is the same as the discounted earnings model and is equal to 11.9%.
- Since we are at the middle of the year, taking the average of ttm (8.6) and forward (8.4) P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 8.5.
O-Metrix = [(11.9 + 2.1) / (8.5] * 5 = 8.24
Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. ACE's O-Metrix score of 8.24 is in the higher-than-average fair-value range. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. At a price of $63, the company is trading within the A-Grade, excellent-return zone.
Summary
ACE’s stock has always been priced at a discount due to the risks of insurance sector. The average P/E ratio in the last 5 years was 9.1. However, it is trading with a lower P/E ratio of 8.6, and forward P/E ratio of 8.4. With a profit margin of 15.54%, ACE offered 2.1% dividend yield last year. In the last 5 years annualized EPS growth was 22.46%. With a market cap of $21.2 billion, I expect the growth to keep its pace.
As of Sept. 1, ACE was trading at $63, lower than my fair-value range of $116.13 and $187.48. The stock has pretty low total debt/equity ratio of 0.1 and Beta of 0.69. The stock has 197.59% upside potential based on 11.9% EPS growth estimate. The average target price is $76.47, implying there is a strong upside potential in the stock. I would prefer this stock. It pays substantial dividends and priced with an extremely low P/E ratio. I think the current price offers a suitable entry point.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.