Humana Inc. (HUM) has had stable earnings over the last few years, a trait which may attract some investors. In addition, the company is currently trading below the price Aetna (AET) will reportedly pay to acquire Humana. Such a fact prompts the question as to whether Aetna is getting a good deal. To make that determination, one must use quantitative metrics to determine the company’s intrinsic value.
Benjamin Graham, the father of value investing, taught that the most important aspect to consider is whether the company is trading at a discount relative to its intrinsic value. It is through a thorough fundamental analysis that the investor is able to make a determination about a potential investment’s merits.
The model is inspired by the teachings of Benjamin Graham and considers numerous metrics intended to help the investor reduce risk levels. The first part of the analysis is to determine whether the company is suitable for the very conservative Defensive Investor or the less conservative Enterprising Investor, who is willing to spend a greater amount of time conducting further research.
In addition, Graham strongly suggested that investors avoid speculation in order to remove the subjective elements of emotion. This is best achieved by utilizing a systematic approach to analysis that will provide investors with a sense of how a specific company compares to another. By using theModernGraham method, one can review a company’s historical accomplishments and determine an intrinsic value that can be compared across industries.
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Defensive Investor – Must pass all 6 of the following tests: Score = 3/6
- Adequate Size of Enterprise – Market capitalization of at least $2 billion – PASS
- Earnings Stability – Positive earnings per share for at least 10 straight years – PASS
- Dividend Record – Has paid a dividend for at least 10 straight years – FAIL
- Earnings Growth – Earnings per share has increased by at least 1/3rd over the last 10 years, using 3-year averages at the beginning and end of the period – PASS
- Moderate PEmg (price over normalized earnings) Ratio – PEmg is less than 20 – FAIL
- Moderate Price-to-Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – FAIL
Enterprising Investor – Must pass all 3 of the following tests or be suitable for a Defensive Investor: Score = 3/3
- Earnings Stability – Positive earnings per share for at least 5 years – PASS
- Dividend Record – Currently pays a dividend – PASS
- Earnings Growth – EPSmg greater than that 5 years ago – PASS
|Value Based on 3% Growth||$110.86|
|Value Based on 0% Growth||$64.99|
|Market Implied Growth Rate||7.73%|
Balance Sheet – March 2015
Earnings Per Share
Earnings Per Share – ModernGraham
Humana passes the initial requirements of the Enterprising Investor but not the Defensive Investor. In fact, the company passes every requirement of the Enterprising Investor types, but the Defensive Investor is concerned by the short dividend history as well as the high PEmg and PB ratios. As a result, all Enterprising Investors should feel very comfortable proceeding to the next part of the analysis, which is a determination of the company’s intrinsic value.
When it comes to that valuation, it is critical to consider the company’s earnings history. In this case, it has grown its EPSmg (normalized earnings) from $6.61 in 2011 to an estimated $7.65 for 2015. This is a fairly strong level of demonstrated growth, but it does not support the market’s implied estimate for annual earnings growth of only 7.73% over the next 7-10 years.
In recent years, the company’s actual growth in EPSmg has averaged around 3.1% annually, and since the ModernGraham valuation model reduces the actual growth to a more conservative figure when making an estimate, the model returns an estimate of intrinsic value well below the current price, indicating that Humana is overvalued at the present time. Clearly, Aetna must be expecting great synergies to occur by merging the companies, as they seem to be overpaying.
Disclaimer: Â The author did not hold aÂ position in any company mentioned in this articleÂ at the time of publication and had no intention of changing that position within the next 72 hours. Â Logo taken from Wikipedia for the sole purpose of identifying the company; this article is not affiliated with the company in any manner.