Using price-to-earnings ratio as a valuation tool can help find great values for long-term investors, notes Julie Carnevale of F.A.S.T. Graphs.
Let’s look at Aflac (AFL) as our example for using the P/E ratio to identify significant undervaluation. In order to accomplish this goal, we are going to properly utilize the P/E ratio as a relative measuring stick.
As previously pointed out, looking at the P/E ratio in a vacuum is an ineffective and mostly irrelevant way to use it. The P/E ratio only brings value to security analysis when it is applied and looked at relative to the past, present, and future earnings power of the company or companies being analyzed.
The P/E ratio is a measurement of current valuation in the static sense, but it is a more relevant measurement of valuation when looked at dynamically relative to the future growth potential of the underlying business (earnings growth). Because only when the future growth of the business is correctly ascertained does the P/E ratio draw a true picture of valuation.
Trading at Half its True Worth
Aflac has achieved a consistent above-average earnings growth rate of 17.1%. Therefore, since calendar year 1997 and up through calendar year 2008, the market applied a normal P/E ratio of 18.6 on Aflac’s shares.
However, the great recession of 2008 changed all that. Yet even after earnings have rebounded strongly in 2009 and 2010, and expected to continue for 2011, the market stubbornly applies a current P/E ratio that is less than half its historical norm (see red circle on graph below).
Even when considering today’s significant undervaluation of Aflac’s shares, their long-term shareholders have been handsomely rewarded in excess of the general market (as measured by the S&P 500).
Aflac is a Dividend Champion, and on October 26, the Board of Directors of Aflac announced a 10% dividend increase marking their 29th consecutive year of dividend increases.
NEXT: Interpreting the Estimated Earnings and Return Calculator