American Financial Group Inc (NYSE: AFG), a financial firm with a market capitalization of $9.9 billion, currently trades at a P/E multiple of 21.1x which is above the sector’s median multiple of 19.9x. Although this makes AFG look unattractive, investors may change their mind after reviewing the assumptions behind the P/E ratio. In the post below, I explain how to apply P/E multiples and what to watch out for.
How To Utilize American Financial Group’s PE Multiples
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare American Financial Group’s P/E ratio to its peer group that includes W.R. Berkley Corporation (NYSE: WRB), The Hanover Insurance Group, Inc. (NYSE: THG), The Travelers Companies, Inc. (NYSE: TRV) and Old Republic International Corporation (NYSE: ORI).
Since American Financial Group’s P/E ratio of 21.1x is higher than the median of its peers (16.3x), it means that investors are paying more than they should for each dollar of AFG’s earnings. As such, our analysis shows that AFG represents an overvalued stock. Furthermore, finbox.io’s P/E Ratio Model calculates a fair value of approximately $97.50 per share which implies roughly 12.5% downside.
I selected a fair multiple of 18.5x in my analysis by averaging American Financial Group’s current P/E ratio with its peer group.
The P/E Ratio’s Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to American Financial Group. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare American Financial Group with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
On the other hand, if the second assumption does not hold true, American Financial Group’s higher multiple may be because our selected comparable companies are being undervalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to AFG. But keep in mind the P/E ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on American Financial Group by taking a look at the following:
Valuation Metrics: how much upside do shares of American Financial Group have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is American Financial Group’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: how much free cash flow does American Financial Group generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.