Price: 438.31 GBP Date: 4 May 2016
Company profile:
Aviva Plc provides insurance, savings, and investment products to over 31 million customers around the world (Aviva, 2016). Aviva is a composite insurance that combines life insurance, general insurance, and asset management (Aviva, 2016). Aviva operates worldwide with its headquarters in London United Kingdom (Yahoo! Finance, 2016).
One-year Price chart:
Figure 1: One-Year Aviva Price Chart
Source: Bloomberg
Price performance:
Valuation (by DDM and by comparables):
Analysts’ recommendation:
Introduction 3
Price performance and news analysis 3
News 4
Valuation 5
Multi-stage DDM 5
SML analysis 6
Discussion of pros and cons of the methods used for the above valuation 7
Conclusion 10
Appendix 13
Exhbit1: Aviva returns calculcations 13
Exhibit 2: FTSE Return Calculations 14
Exhibit 3: Aviva Risk-Adjusted Return Calculations 15
Introduction
Aviva Plc provides insurance, savings, and investment products to over 31 million customers around the world (Aviva, 2016). Aviva is a composite insurance that combines life insurance, general insurance, and asset management (Aviva, 2016). Aviva was incorporated in 1990 as CGNU plc. However, in July 2002 it changed its name to Aviva Plc. Aviva share price has depreciated by 11.93% over the last twelve months.
Price performance and news analysis
The price table below compares the price performance of Aviva compared to the price performance of FTSE 100 over the last twelve months
According to Reuters (2016), Aviva has a beta of 1.40. The risk free rate is equivalent to the UK 10-year bond yield of 1.465%. The market return is equivalent to the FTSE 100 return. The risk-adjusted return on Aviva can be expressed as:
E(r) = 1.465% + 1.40 (rm – 1.465%)
News
The CAPM states that the required return on equity is dependent on the risk free rate, the systematic risk of the share as measured by its beta factor, and the equity premium that represents the difference between the market rate of return and the risk free rate of return.
E(R) = rf +β (rm – rf)
The risk free rate is equal to the UK 10-year bond yield of 1.465% (Investing, 2016).Aviva has a beta of 1.40 (Reuters, 2016). The market return is equivalent to the past three-year FTSE 100 average return of 8.4% (Yahoo! Finance, 2016). Aviva required return is 11.174%.
E (R) = 1.465% +1.40 (8.4% - 1.465%) = 11.174%
Aviva dividends are expected to grow at 15% for the next five years before reverting to a constant growth of 7.7% equivalent to its average dividend growth rate.
VO = 23.92p + 27.51p + 31.64p + 36.38p + 41.83p + 41.83(1.077)
1.11174 1.111742 1.111743 1.111744 1.111745 (0.11174 – 0.077)*1.1117455
Vo = 870.35p
The DDM valuation suggests that Aviva share is trading at approximately 50% of its intrinsic value. The surge in the intrinsic value is attributable to repayment of debt, increase in buffer capital, improved solvency, and a 15% increase in dividend. With a reduction in interest rates and a more favorable economic outlook, Aviva is likely to continue posting better results over the next five years that will enable Aviva to sustain an annual dividend increase of 15%.
P/EPS estimates the value of Aviva share to be worth 702.88p.The DSP/P estimates the value of Aviva share to be worth 800p. The Price/Book ratio estimates the value of Aviva share to be worth 806p. The average valuation using comparables estimates Aviva share to be worth 769.63p. Aviva share price would have to appreciate by 75.59% to reach the price estimated by comparables.
SML analysis
Based on the DDM the intrinsic value is 870.35p. Under CAPM it is expected to appreciate by 11.174% so a year from now the intrinsic value of Aviva share would be expected to be 967.60p (1.11174*870.35p). The expected return would be:
E(r) = (967.60 – 438.31)/438.31 *100% = 120.76%
Figure 2: SML
Discussion of pros and cons of the methods used for the above valuation
The dividend valuation model is useful in valuing shares especially for a minority investor who can neither change the dividend policy, nor influence the share price (Stowe, 2007). The model is suitable to an investor who will make the majority of their return through dividend receipts. When using the DDM, it is easy to justify the valuation because it makes use the dividends that an investor would expect to receive by holding a particular share. The multistage DDM is capable of modeling that valuation of a company that experiences different growth rates over the relevant valuation period (Stowe, 2007).
The DDM however, suffers certain drawbacks. The DDM is not suitable in valuing companies that do not pay dividends or companies that do not have a stable dividend policy (Stowe, 2007). The DDM is not a suitable model a majority shareholder who can change the dividend policy. In addition, the DDM is sensitive to the growth rates, the cost of equity, and future dividends, therefore, DDM is not suitable for companies that are operating in highly cyclical environments (Stowe, 2007).
The comparables approach is useful in calculating the value of the firm relative to its peers. The comparable approach assumes that if a company is operating in the same industry, have the same revenue, then their worth should be comparable or similar (Stowe, 2007). The comparable approach is an easy valuation model and is useful in calculating preliminary valuation of a minority stake. The comparable approach is useful in judging the market sentiment about a company i.e. finding out whether a company share is trading significantly higher or lower than the industry averages (Stowe, 2007).
The main drawback of the comparables approach is that in reality, there are no two perfect substitutes, and therefore, the multiples used may not accurately estimate the value of the company (Stowe, 2007). There is a risk of comparing apples with oranges and the valuation may not accurately reflect the intrinsic value of the company (Stowe, 2007). The multiples used may not be typical, for instance the company earnings may be untypically high or low resulting in overvaluation or undervaluation of the company.
The CAPM uses the beta factor to estimate the required return depending on the systematic risk of a security as measured by its beta factor (Stowe, 2007). CAPM makes an explicit relationship between the risk of a company’s shares relative to the market and the investors’ required return. The CAPM is useful to shareholders who generate the majority of their return from capital gains.
However, CAPM tends to overstate the required return on shares with large betas and underestimate the required return on shares with low betas (Stowe, 2007). CAPM is a single factor model and fails to take into account other variables that may influence the required rate of return (Stowe, 2007). In addition, CAPM is a single period model some of the variables such as the risk-free rate and the market rate of return change on a daily basis (Stowe, 2007). Calculating the equity premium is difficult in practice. In the short-run, the market return that combines the total dividends and the capital gains or losses may be negative when capital losses more than offset the total dividends paid (Stowe, 2007). The negative market return would imply that investors expect a negative return from holding the shares of a particular company and this would be absurd. To overcome the challenge, an average market return for a couple of years is often used. In this case, the twelve-month market return based on FTSE 100 was -10.63% and so the valuation resulted to using a three-year average FTSE 100 return of 8.4%.
Analysts’ view
Analysts expect Aviva share price to outperform with an average target price of 567p (M.4 Traders, 2016). Out of 24 analysts, 10 analysts expect the share to outperform the market, 5 analysts recommend to investors to buy the share, 5 analysts recommend to investors to hold the share, 3 analysts believe the share will underperform relative to the market return, and 1analyst recommends to investors to sell the share (M.4 Traders). Overall, 83.33% of the analysts hold a positive opinion about Aviva share.
Analysts’ recommendation:
Analysts are basing their opinion on increased profitability, reduced debt, increased solvency II ratio, and a positive macroeconomic outlook. For the 2015 fiscal year, Aviva reported a 20% increase in operating profit to £2,665. The EPS increased by 2% to 49.2p, while dividends per share increased by 15% to 20.8p. The move by ECB to cut the refinancing rate to zero gives Aviva and other firms in the financial sector bright prospects.
Conclusion
The valuation models show that Aviva share is trading at a huge discount and this gives investors an opportunity to buy the share at a bargain and experience significant capital gains in future. The DDM estimates the value of Aviva share to be 870.35p and this would provide an investor a possibility of making 102.23% capital gain. The comparables approach estimates the value of Aviva share to be worth 769.63p meaning that shareholders can make a capital gain of 77.59%.
Under the leadership of Mark Wilson Aviva is transforming into a simpler, leaner structure, focused on businesses with better returns that will generate cash and strengthen the financial position of Aviva (Hargreaves Lansdown, 2016).
Aviva increased its solvency II ratio of 180% leaving it with one of the strongest and most resilient balance sheet in the UK.A high solvency ratio sheet makes the business less susceptible to fluctuations in the interest rates. Aviva has turned its focus on building a profitable UK insurance composite that is capable of funding international expansion in the future (Hargreaves Lansdown, 2016). `
Overall, the valuation of Aviva shares shows that the share is trading at a significant discount. I would recommend investors to buy the share as it offers huge potential for capital gain. Given the favorable macroeconomic outlook, reduced debt, and increased operating profits. Shareholders will earn significant return by owning Aviva shares.
References
Aviva, (2016). About Us - Aviva. [online] Aviva.co.uk. Available at:
http://www.aviva.co.uk/about-us/ [Accessed 4 May 2016].
Bloomberg, (2016). AV/:London Stock Quote - Aviva PLC. [online] Bloomberg.com. Available
at: http://www.bloomberg.com/quote/AV/:LN [Accessed 6 May 2016].
Hargreaves Lansdown, (2016). Aviva plc share price | AV. | Share price. [online] Hargreaves
Lansdown. Available at: http://www.hl.co.uk/shares/shares-search-results/a/aviva-plc-ordinary-25p [Accessed 6 May 2016].
Investing, (2016). UK 10-Year Bond Historical Data - Investing.com. [online] investing.com.
Available at: http://www.investing.com/rates-bonds/uk-10-year-bond-yield-historical-data [Accessed 6 May 2016].
Jones, S. (2015). Aviva Says First-Half Profit Jumps, Increases Dividend. [online]
Bloomberg.com. Available at: http://www.bloomberg.com/news/articles/2015-08-06/aviva-says-first-half-profit-jumps-increases-dividend-by-15-?cmpid=yhoo [Accessed 8 May 2016].
M.4 Traders, (2016). AVIVA : analysts consensus and price target for AVIVA | Xetra: GU8 | 4-
Traders. [online] M.4-traders.com. Available at: http://m.4-traders.com/AVIVA-6063691/consensus/SHARE [Accessed 6 May 2016].
Randow, J. (2016). ECB Keeps Rates Unchanged as Draghi Weighs Risks of QE Signaling.
[online] Bloomberg.com. Available at: http://www.bloomberg.com/news/articles/2015-10-22/ecb-keeps-rates-unchanged-as-draghi-weighs-risks-of-qe-signaling [Accessed 8 May 2016].
Reuters, (2016). ${Instrument_CompanyName} ${Instrument_Ric} Quote| Reuters.com. [online]
Reuters. Available at: http://www.reuters.com/finance/stocks/overview?symbol=AV.L [Accessed 6 May 2016].
Stowe, J. (2007). Equity asset valuation. Hoboken, N.J.: John Wiley.
Yahoo! Finance, (2016). Aviva PLC. [online] Yahoo! Finance. Available at:
https://uk.finance.yahoo.com/q?s=AV.L [Accessed 4 May 2016].
Appendix
Exhbit1: Aviva returns calculcations
Exhibit 2: FTSE Return Calculations
Exhibit 3: Aviva Risk-Adjusted Return Calculations
