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 met this ideal situation. Currently, there are 71 companies in the index that meet these criteria. I will be making a CAPScall on these companies after comparing them with competitors and their current value in relation to their Graham numbers. Up next is insurer American International Group (NYSE: AIG  ) .

What is it?
American International Group, perhaps better known as AIG, is in our collective minds because of the havoc it caused back in 2008. A government bailout, necessitated in part by massive losses from credit default swaps, earned AIG a place as "America's most hated company." The government is still owed about $45 billion of the initial bailout, representing ownership in about 70% of the company's common stock.

Things have turned around of late for the insurer, however, and it shouldn't be long before its obligation to the government is paid in full. It is currently trading at a steep discount, fetching a 43% markdown to its book value. Its derivatives business, the unwieldy beast that helped accelerate its near demise four years ago, has been widely unwound, with only 5% remaining and on the way out. This should help strengthen the insurer going forward, unlocking some untapped value in this former pariah.

What's it worth?
Even after eliminating a large portion of earnings that were primarily based on a tax gain during the year, AIG still has the third-highest upside of similarly sized insurers.

Company

EPS (TTM)

Book Value Per Share (MRQ)

Graham Number

Recent Price

Upside

AIG $1.67* $60.58 $47.71 $34.56 38.1%
Allstate (NYSE: ALL  ) $4.10 $40.07 $60.80 $37.40 62.6%
Travelers (NYSE: TRV  ) $5.56 $64.89 $90.10 $64.64 39.4%
ACE (NYSE: ACE  ) $5.97 $75.98 $101.02 $74.59 35.4%
Loews (NYSE: L  ) $2.15 $49.31 $48.84 $40.79 19.7%

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

Allstate, currently second place among car insurers, crushed earnings last month but could feel an impact from damages caused by Hurricane Isaac. Travelers was the first Dow company to miss on earnings expectations this quarter, but it was still an improvement over last year, though it might experience a squeeze going forward if interest rates remain low.

ACE may boast the highest book value per share among the others on the list, but the ongoing drought affecting most of the U.S. could lead to a higher amount of crop-insurance claims. Finally, some have described Loews as a cheaper version of Berkshire Hathaway. 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 United States.

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 for AIG to grow into its Graham number valuation, I will be placing a "thumbs up" over on my CAPS page to track this call and keep myself accountable. I will also be adding American International Group to My Watchlist to stay up to date on anything that may cause me to change my opinion of the company.

If you're 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. 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 check out 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. We Fools don't 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. The Motley Fool has a disclosure policy.


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