Summary
- American Financial Group is a quality company with a history of growing earnings.
- At current prices, there is modest upside.
- The company pays a dividend which helps us stay patient.
- This article will demonstrate one valuation method and a way to juice returns - without adding outsized risk.
What To Expect From This Article
Valuation always matters. Finding quality companies with a high likelihood of future earnings growth at reasonable valuations is the cornerstone of my investing.
The idea is to buy shares of quality companies at reasonable valuations. This gives the investor an opportunity to benefit from future company progress.
Otherwise, buying when prices are well above normalized valuation levels can set the stage for portfolio destruction. Why? Because buying at inflated prices can lead to years of disappointing price action as the company results catch back up to the stock price.
This article will add to the American Financial Group ( AFG ) conversation by offering a method to value company shares compared to the current company stock price, and then offer a conservative use of options to enhance returns on this quality company.
The Thesis Here
The thesis here is that American Financial Group is a quality company that is fairly priced right now. Sort of a Goldilocks situation: shares are not too expensive, nor exceedingly cheap.
The current price to value relationships sets up an opportunity to use options in a conservative approach to improve returns.
First, A Look At The Big Picture
AFG shares have held their own since the beginning of the year. Note, the stock is up 1.32% since January 1, 2022.
AFG Price YTD ( Seeking Alpha )
This performance is notable when one considers the painful overall stock market performance in that same time period.
Index Performance YTD ( Seeking Alpha )
A member of the Financial Services - Property & Casualty sector, AFG has outperformed the Financial Services sector and all but two other sectors this year.
Sector Performance YTD ( Seeking Alpha )
A Quality Company And History Of EPS Growth
For those looking for a large company with a solid credit rating and a history of growing earnings, American Financial Group fits the bill. With a market cap above $11B and S&P Credit Rating of BBB+, the company has found a way to increase fundamental metrics over the long haul.
Check out the chart below. Courtesy of my useful FAST Graphs subscription, the orange line demonstrates EPS growth over 20 years, while the black line indicates the stock price over that same period (the blue line shows the company's own normal PE ratio).
Earnings and Price History (FastGraphs)
A Look At Valuation
Others authors have done a fine job using a price-to-book valuation model.
This article utilizes a review of a company's own normal price-to-earnings ratio and applies that normal to expected earnings per share to reach a valuation.
Assuming EPS of $11.50, at today's prices the current P/E is 11.2X. The company's normal PE is 12.5X. This suggests upside over the next 12-14 months of perhaps 10%.
Using a forecasting tool in FAST Graphs, the blue line represents the normal P/E calculation, and the stock price is the black line.
Valuation Forecast (FastGraphs)
Risks To This Valuation
The valuation depends on the accuracy of the earnings per share estimates and the company reverting to normalized multiples. Marco factors or company performance may lower EPS in the short-to-medium term (or longer).
Catalysts For Future Growth
The company has a number of initiatives under way such as efficiency efforts and continued balance sheet management that will likely continue to drive growth of fundamentals. In addition, IMHO, environmental headwinds such as inflationary pressures and interest rate impacts will eventually abate or stabilize and the company will adjust, as it has done in the past and will likely continue to do so in the future.
Options Can Help Offset Risk
Options-savvy investors with accounts appropriately sized could consider selling out-of-the-money calls and simultaneously selling out-of-the-money puts to increase your return. Here's an educational example:
Step 1: Buy 100 shares of AFG for $128.49. Your cash outlay is $12,849.
Step 2: Say you sell an April '23 $140 Call and receive $5.40 per share per contract (remember that every contract requires 100 shares). This means you will receive $540 immediately for the obligation to potentially sell those shares for $140 per share up to April 21, 2023.
Step 3: Say you sell an April '23 $115 Put and receive $4.85 per share per contract. This means you receive $485 immediately, and you have the obligation to buy 100 shares of AFG at $115 per share if required by the option buyer.
Your total option premium collected immediately is $1,055. Therefore, your net cash out-the-door is $11,794.
Possible Outcomes
When the markets close April 21, 2023, there are now only 3 possible outcomes: the stock price will be above $140 per share, below $115 per share, or somewhere in the middle.
Let's describe each possibility:
If the stock price closes that day in April above $140, your 100 shares will be called away. You will receive $14,000 cash. Your initial cash out-the-door was $11,794, and you will have received estimated dividends of $112. The annualized cash-on-cash return would be 31%.
If the stock price closes that day in April below $115 per share, you will be required to buy another 100 shares at $115 each, resulting in an additional cash outlay of $11,500. You also received option premium and dividend during the contract period, so your total cash outlay for 200 shares is $23,182. The average net cost is $115.91 per share.
Lastly, if the stock price closes that day in April between $115 and $140 per share, you will simply keep the shares, keep the option premium, and collect dividends. You will have collected $1,055 + $112 on your original cash outlay.
You are now in position to do it all over again for another cycle.
Closing Thoughts
In a period of market uncertainty and relatively higher volatility, American Financial Group is a quality company priced about right. While neither outrageously priced nor a screaming deal, conservative-minded investors could consider this reasonably priced with potential for continued growth and upside. And using options could sweeten the pot for those so inclined.
Thank you for your time reading this article.
For further details see:
American Financial Group: A Way To Play This Today