Cigna's Real ROA Misdiagnosed By GAAP

| About: Cigna Corp. (CI)


CI’s adjusted return on assets is projected to fall from 2014 8% levels to 6% in 2015 – still higher than the traditional sub-cost-of-capital ROA most financial databases report.

One culprit behind this major distortion is GAAP accounting for goodwill, which amounted to $6.0bn – this large figure leads to a significant distortion of the firm’s economic reality.

Another reason behind Valens’s significantly higher ROA' is CI’s adjusted cash from operations of $3.34bn, much higher than as-reported cash flow from operations of only $1.99bn.

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Performance and Valuation Prime™ Chart

The PVP chart above reflects the real, economic performance and valuation measures of Cigna Corporation (NYSE:CI) after making many major adjustments to the as-reported financials. The four panels explain the company's corporate performance and valuation levels over the past 10 years plus best estimates for forecast years based on quarterly financials and consensus estimates.

The apostrophe after the ROA', A', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liabilities, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.

Under Generally Accepted Accounting Principles (GAAP), as-reported financial statements and financial ratios of Cigna Corporation do not reflect economic reality. The traditional return on assets computation understates the company's profitability by incorrectly including certain items. In the case of CI, the inclusion of goodwill ($6.0bn) inflates their assets, resulting in a distortion of performance measures.

After adjusting for those issues and a host of other GAAP-based mis-categorizations, Valens calculates CI's adjusted return on assets as 8% in 2014. In contrast, most financial databases show a traditional ROA of only 4%. Additionally, analysis shows that CI's as-reported cash flow from operations was $1.99bn for 2014 when, in economic reality, CI's adjusted cash from operations was almost twice that at $3.34bn. The profitability of CI's operations is therefore not what traditional metrics might suggest.

The problem with GAAP is that they create inconsistencies when comparing one company to another, and from comparing a company to itself from year to year. By making adjustments, we aim to remove the financial statement distortions and mis-categorizations of Generally Accepted Accounting Principles. Some of these can be automated through consistently applied formula; however, many must be made manually. Manual adjustments that cannot be automated include mergers and acquisitions accounting, special charges, business impairments, and others. The practice of creating consistent, apples-to-apples comparable measures of financial performance is often considered either tedious or overly complex by even seasoned financial analysts.

Return on Assets Prime: Real Economic Profitability in the ROA'

The top panel of the chart shows ROA' (ROA prime, a.k.a. Adjusted Return on Assets.) This measure is comparable from year to year and across peers as it "cleans up" the aforementioned GAAP accounting issues to provide consistent analysis.

As was discussed earlier, Cigna's Adjusted Return on Assets (ROA') is at 8% in 2014. This is not only above cost of capital but also twice that of the traditional ROA of the firm, indicating that CI is more profitable than what traditional metrics might suggest. That is a major difference in context and concept for evaluating Cigna's situation.

Growth in Business Assets - A'

In the second panel of the four-panel chart, Asset' growth stands for "Asset Prime Growth" and is the real annual growth rate of the cleaned-up and properly adjusted asset base of the company. This metric shows the management team's propensity to reinvest or divest over time. When viewed in context of the ROA', the growth rate explains a lot about management's intended strategies and even performance incentives.

Before and during the Great Recession, Cigna and its peers were facing industry turmoil as the number of uninsured increased, coming about even before companies went through massive lay-offs during the financial crisis. Managed healthcare companies like CVS (NYSE:CVS) did not see demand growth in the near term, lessening their appetite for investment, as reflected by sustained Asset' shrinkage from 2006-2008. However, in 2009, the U.S. Congress enacted the American Recovery and Reinvestment Act (ARRA) of 2009, which gave healthcare insurance companies like Cigna the confidence to drive growth as the government began subsidizing health insurance policies. Afterwards, Asset' began shrinking again in 2012-2013 before growing by 2% in 2014.

Valuation Relative to Adjusted Assets V/A'

The third panel of the four-panel chart shows the Adjusted Value to Assets ratio. V/A' is a calculation comparing the enterprise value (V) of the company to the adjusted asset level (A'). The V is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt. The A' reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. V/A' can be thought of as a "cleaned-up" Price-to-Book metric. The A' is the same as the denominator of the ROA' calculation and the Asset' growth panel.

The firm's 8% ROA', when the as-reported ROA is 4%, may indicate that a V/A' of 1.7x may be too high. That said, a V/A' of 1.7x is lower than the firm's traditional P/B of 3.0x. Even though V/A' is lower than traditional valuations, considering the elevated valuation relative to profitability, CI may currently be overvalued.

Valuation Relative to Adjusted Earnings V/E'

In the fourth panel, we have a third perspective of valuation to help triangulate the market's embedded expectations for company performance. We are seeking to determine "what's priced-in" to the stock price. In this case, Valens evaluates the enterprise value of the firm relative to the expected adjusted earnings (E') for the current year. The E' is the adjusted earnings resulting from the company's core business operations, regardless of how it is financed, and adjusted to its current dollar value. This is adjusted to eliminate accounting distortions and shenanigans, enhance comparability across different companies, industries and globally, to determine potential mis-pricings. The value numerator is the same as that in the adjusted value to assets ratio.

Cigna's as-reported P/E is at 16.7x, indicating that the market views the firm's equity as fairly valued (since long-term P/E ratios average at around 15x to 17x). Our analysis, however, finds that CI has a 24.3x V/E' (Valens's cleaned-up Enterprise Value to Adjusted Earnings ratio, also known as an "economic P/E"). This appears to further confirm that CI is overvalued.


As-reported financial statement information and financial ratios, which make up most of the publicly available financial databases, do not consider the extent to which distortions, mis-categorizations, and misclassifications cause as-reported financial statements to depart from economic reality. Even the venerable "statement of cash flaws" - pun intended - is horribly distorted, as many items in the statement of cash flows are actually non-cash related. What is deemed cash flow from operations, investing, and financing activities are inconsistently booked from company to company and even just from year to year at an individual company. The distortions are material and directionally changing, and the mis-measurements that result are decision-changing issues.

A far better picture of the economic reality of Cigna Corporation can be seen once those distortions are removed. The firm is generating returns twice what most financial databases report and has a V/A' that is lower than the traditional P/B ratio. However, the firm's V/E' multiple is higher than the traditional P/E metric and V/A' is too high versus profitability. With that context of corporate performance and market valuation, we have a far better means for evaluating CI's prospects for the future of its stock. To better understand the PVP chart and the above discussion, please refer to our guide here.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.