Insurance giant Aviva (LSE: AV.) has been catching the eye of value investors lately. With the shares up nearly 32% over the past year, handily outpacing the FTSE 100’s 8.3% return, I think it’s worth taking a closer look. Is there more growth to come for Aviva, or is the share price due a breather?
Solid numbers
At first glance, valuation metrics look pretty tempting. Trading at a price-to-earnings (P/E) ratio of just 10.1 times, the company appears significantly undervalued against competitors in the insurance sector, with an average of around 15 times. Furthermore, the price-to-sales (P/S) ratio of 0.6 times suggests the market isn’t fully reflecting likely future revenue growth.
For many, the most alluring feature is the company’s generous dividend yield, currently sitting at a juicy 6.75%. This kind of income potential is hard to ignore. However, I think income investors should proceed with caution. While the 73% payout ratio isn’t alarming on its face, the dividend isn’t well covered by free cash flows. This could spell trouble if the economic winds shift unfavourably, or if profits take a hit from an unknown event.
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But for value investors, here’s where it gets interesting: the shares are potentially trading at a 46.3% discount to a discounted cash flow (DCF) estimate of fair value. Of course, a large gap doesn’t mean it’s a no-brainer investment, the market could well be reflecting the plentiful risk and uncertainty in the insurance sector.
I’d be most concerned about the impact from climate change here. For insurers, the increased frequency and severity of natural disasters, and resulting claims, makes for a highly uncertain future. Companies in the sector are having to play a dangerous game of accurately determining the right balance to strike between staying competitive and exposing themselves to such risks. A business with the track record and resources of Aviva should be well positioned to succeed, but nothing is guaranteed.
Future growth
Recent performance has been encouraging. The company reported first-half operating profits of £875m, handily beating analysts’ expectations of £830m. Earnings per share (EPS) jumped to 23p, up from 14p in the same period last year.
Looking ahead, analysts forecast annual earnings growth of 4.38% for the next five years. While not explosive, this steady growth could provide a solid foundation for long-term investors.
Under the leadership of CEO Amanda Blanc, the firm has been streamlining its operations, focusing on core markets in the UK, Ireland, and Canada. The recent sale of its Singapore Life Division demonstrates this commitment to simplification. However, this narrowed focus could be a double-edged sword. While it may improve operational efficiency, it also increases exposure to any economic difficulties in its primary markets.
One to watch
With an attractive valuation and robust dividend yield, the firm is undeniably tempting. Recent financial performance and strategic focus also inspires confidence that growth can continue if the economy holds up.
However, the dividend’s sustainability, a narrowing geographical focus, and challenging macroeconomic environment all warrant careful consideration. I suspect that the shares will continue to grow steadily over the next year. Of course, things could easily change, but I suspect if the shares can climb and remain above the 500p mark, investors could see decent returns over the next year. I’ll be adding it to my watchlist.
