Is This Health Care Company 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 or not 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 next is health care provider Aetna (NYSE: AET  ) .

Who are they?
Though much smaller than sector leader UnitedHealth Group, Aetna is still the third-largest health insurer in the United States, insuring over 18 million people at the end of its last quarter. In an effort to swell its membership further, Aetna agreed to acquire Coventry Health Care (NYSE: CVH  ) for $7.3 billion dollars. Not only will the acquisition boost Aetna's customer base by more than 5 million members, it will further expand its presence in Medicare and Medicaid and push its government business to over 30 percent of total revenue.

What's it worth?
All the insurers below are currently trading well below their Graham number valuation, with WellPoint (NYSE: WLP  ) leading the way, currently trading for a 33% discount relative its Graham number:

Company

EPS (ttm)

Book Value per Share (mrq)

Graham Number

Recent Price

Upside

Aetna $5.14 $30.69 $59.58 $39.12 52.3%
CIGNA Corporation (NYSE: CI  ) $4.51 $31.30 $56.36 $44.87 25.6%
Humana (NYSE: HUM  ) $7.53 $52.28 $94.11 $70.73 33.1%
WellPoint $7.30 $72.71 $109.28 $61.80 76.8%

Source: Yahoo! Finance and author's calculations; ttm = trailing 12 months; mrq = most recent quarter.

Aetna is not alone in the acquisition game over the past year. WellPoint agreed to purchase Amerigroup for almost $5 billion back in July, a deal that shouldn't be derailed by the recent resignation of its CEO. This followed CIGNA's acquisition of HealthSpring in January and Humana's March purchase of Arcadian Management Services, purchases that helped both insurers increase their presence in government-backed insurance.

Accountability time
With the ultimate fate of the Affordable Care Act up in the air until after the November election, it is hard to estimate the true effect the new regulations could have on the industry. That said, Aetna has room to grow into its valuation, so I will be placing a "thumbs-up" over on my CAPS page in order to track this call and keep myself accountable.

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Fool contributor Robert Eberhard 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 WellPoint. Motley Fool newsletter services have recommended buying shares of AMERIGROUP, UnitedHealth Group, WellPoint, and Coventry Health Care. Motley Fool newsletter services have recommended creating a diagonal call position in UnitedHealth Group. 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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