Is This Insurer Cheap According to Graham?

Earlier this year, I spent some time dissecting Benjamin Graham's The Intelligent Investor, the seminal book on value investing. Along the way, I talked about the Graham number as a means of valuation when it comes to stocks. The formula is pretty straightforward: Multiply earnings per share by book value per share, then multiply that by 22.5, and finally take the square root. The result, in dollars, is the Graham number.

However, a quick check can help determine whether a company might be worthy of a look using the teachings of Graham. He said that in an ideal situation, the P/E ratio and P/B ratio multiplied together should not exceed 22.5, with a maximum P/E ratio of 15 and P/B of 1.5. With that in mind, I looked at the stocks of the S&P 500 that exceeded a P/B of 1.5 but still met the ideal situation mentioned above. Currently, there are 68 companies in the index that meet these criteria. I will be making a CAPScall on these companies after comparing them to competitors and their current value in relation to their Graham numbers. Up first is insurer ACE Ltd. (NYSE: ACE  ) .

Who are they?
ACE Ltd. is one of the world's largest multiline insurers. Among the products it offers are commercial property and casualty insurance, personal accident and supplemental health insurance, reinsurance, and life insurance. It has operations in 53 countries through its various subsidiaries, and it employs more than 16,000 people worldwide.

From an investment standpoint, they may see some rough seas ahead as more claims are filed as a result of the ongoing drought through most of America. Fortunately for them, but not so much for the U.S. taxpayer, the Department of Agriculture subsidizes the crop insurance industry, which will help limit the direct impact of higher claims. For its most recent quarter, earnings and revenues were higher than expectations, and the company recently increased its dividend by 34%.

What's it worth?:
When compared with insurers of about the same size, ACE Ltd., despite having the highest book value per share of the group, is not the "cheapest" on the list:

Company

EPS (TTM)

Book Value Per Share (MRQ)

Graham Number

Recent Price

Upside

ACE Ltd. $5.97 $75.98 $101.02 $73.46 27.3%
American International Group (NYSE: AIG  ) $1.67* $60.58 $47.71 $34.80 27.1%
Travelers Cos. (NYSE: TRV  ) $5.56 $64.89 $90.10 $24.97 27.7%
Loews (NYSE: L  ) $2.15 $49.31 $48.84 $40.48 17.1%
Allstate (NYSE: ALL  ) $4.10 $40.07 $60.80 $37.86 37.7%

Source: Yahoo! Finance and author's calculations; *Adjusted due to a large tax benefit during Q4 2011.

Allstate continues to maintain second place among car insurers, helping it to crush its earnings for the most recent quarter. Nevertheless, it has the most room to grow into its Graham valuation among the insurers on the list. AIG is still recovering from the blow dealt to it by credit default swaps at the height of the financial crisis. However, it continues to recover from the damage caused by the government bailout, recently crushing its quarterly earnings.

Travelers reported earnings Thursday, becoming the first Dow company to miss expectations this quarter. The quarter, though, was still better than what the company experienced last year. Loews, not to be confused with the home improvement store, has been described by some as a cheaper version of Berkshire Hathaway, and it is easy to see why. The company holds a variety of assets and makes the insurance list because of its holding of CNA Financial, one of the largest commercial property-casualty insurance companies in the U.S.

Accountability time
A stock's valuation, regardless of the method used, is but one thing to look at when evaluating a potential investment. With room to grow into its Graham number valuation, I will be placing a thumbs-up over on my CAPS page in order to track this call and keep myself accountable. I will also be adding ACE Ltd. to My Watchlist to stay up to date on anything that may cause me to change my opinion of the company.

If you are looking to find other companies to add to your retirement portfolio, be sure to pick up a copy of our free special report "3 Stocks That Will Help You Retire Rich" featuring a company mentioned in this article. Click here to get your copy while it's still available.

Fool contributor Robert Eberhard owns shares of Berkshire Hathaway, but holds no position in any other company mentioned. Follow him on Twitter, or click here to see his holdings and a short bio. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of American International Group and Berkshire Hathaway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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