Aflac: A Crisis Of Confidence

| About: Aflac Incorporated (AFL)
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Summary

Aflac's earnings look good, but many people are not convinced of its growth potential.

For me risk-adjusted return is key.

I remain long Aflac, since it's still the best based on risk-adjusted ROE.

On July 29 Aflac (NYSE:AFL) released their second quarter earnings report. EPS came in at $1.32 per diluted share and annualized Return on Equity was 10.3%. But despite continuing good operating results this year, some Seeking Alpha contributors I follow are selling long held positions. Read Ray Merola's and Casey Hoerth's take on Aflac for opposing points of view. I believe I can summarize their arguments as: "Aflac used to be valued at a P/E ratio of 15 to 20. Since 2009 it has been in a range from 8 to 12. It may not return to 15 in the near future."

This crisis of confidence is understandable. Those figures are correct and it has been 7 years since the financial crisis in 2008 - 2009. Perhaps people see Aflac and all financial companies as riskier now, and won't pay high prices for them. I don't like investing in risky assets either. I say take your money to Vegas if you want to play around with it. Whether you make money or lose it, you can do it faster there and get a free drink too.

After reading these discouraging articles, I needed to know whether I should increase the discount rate I use to value AFL. Currently I use 8%, but a higher rate would drastically lower the value of Aflac's future earnings. Additionally a riskier company is more likely to go bankrupt, so a shorter lifetime should be used to estimate its value.

Stability of ROA, ROE

There is a measurement I have recently been using to quickly determine a company's skill at allocating capital. It is not a substitute for in depth analysis, but it can reveal those companies whose operations provide an excellent return for a given amount of risk. A "Return On Risk" you might call it.

It is simply a company's average ROE (or ROA) over a period, divided by the standard deviation of the ROEs over that period (or ROA). This way, companies that have a huge ROE one year and negative ROE the next (I'm looking at you oil and mining stocks) are appropriately penalized for their unpredictability. If you want to add risk, you can always add more leverage to a stable company.

Here is the ROE and ROA data for AFL over the past 7 years. The risk-adjusted return is on the left side:

Avg/Std Dev 2009 2010 2011 2012 2013 2014 2015
ROE 5.77 19.89% 24.07% 15.99% 19.44% 20.64% 17.90% 14.05%
ROA 7.19 1.83% 2.53% 1.80% 2.31% 2.50% 2.45% 2.13%

Here is the same data with comparisons from Aflac's competitors in the insurance industry.

Risk-Adjusted Aflac Prudential (NYSE:PRU) Allstate (NYSE:ALL) MetLife (NYSE:MET) Principal Fin. (NYSE:PFG)
ROE 5.77 1.16 2.42 0.73 4.47
ROA 7.19 1.21 1.92 0.86 12.99

As you can see, Aflac beats all of them by a wide margin except for Principal Financial Group. PFG has really low variability in its ROA, which gives a risk-adjusted metric of 13. I have never seen one so high and am a bit suspicious it could be due partly to rounding errors. In any case, PFG has the highest leverage of all the comparable companies, which adds a hidden level of risk. Clearly AFL is the best in the risk-adjusted return category.

Valuation

Current prices ($72) only price in a growth rate of 1% assuming a corporate lifetime of 25 years and an 8% discount rate. That's way too low. Aflac has grown earnings at a rate of 10.4% since 2009 and at 7.9% over the past 10 years. For this valuation I assumed they would grow at only 6% over the next 5 years, and at 2% for the following 20 years:

EPS 6.09
Growth Rate 6.00%
Years 5
Terminal Growth Rate 2.00%
Terminal Years 20
Discount Rate 8.00%
Valuation $93.03

This means AFL is about 23% undervalued now under conservative assumptions. If you believe that Aflac is a good company, you should buy and wait for the market to recognize it. As long as they keep making money, a low share price will allow them to buy back shares at a discount. Don't run from a sale, take advantage of it.

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Disclosure: I am/we are long AFL.

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.