Progressive Corporation Is a Great Business at a Lousy Price

PGR stock - Progressive Corporation Is a Great Business at a Lousy Price

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Progressive Corporation (NYSE:PGR) has been having an exciting couple of years. Usually insurance stocks don’t make for high-fliers. But PGR stock has bucked the trend. Progressive’s shares have doubled since 2016.

Some of that is for industry-wide reasons. Namely, with interest rates heading upward, insurance companies should enjoy rising profits. The corporate tax cuts also provide a large tailwind for earnings.

However, Progressive has benefited from a more specific catalyst. The company is on an impressive growth streak. Its move into homeowner policies has led to an impressive bundling effect with its long-established auto insurance line of business. Its policies-in-force figure is up more than 15% on the year, which is simply amazing for a national insurance company.

That said, there are limits to how far an insurance stock can run. And Progressive is coming up against that boundary. As good as things appear at the moment, it seems unlikely that Progressive will be able to continue its upward climb for much longer. Here’s why this is good time to consider locking in some profits on PGR stock.

Insurance Companies Should Trade Around Book Value

The fundamental problem for PGR stock is that it simply trades a gigantic premium-to-book value. Insurance companies tend to gravitate to a stock price based on a figure in relation to their book value. A general rule of thumb is that a company should trade at one-tenth price-to-book value of its return on equity. Thus, if an insurer earns an industry-standard 10% return on equity, it trades at 1.0x book value.

A high-quality insurer with great underwriting and management might earn a 15% ROE. In that case, you’d expect the market to pay something like 1.5x book value for the stock, given its above-average profitmaking capacity off its assets. However, there are generally strong limits to how far an insurer can trade away from its book value.

At the end of the day, an insurer’s value is still closely linked to its assets and liabilities. An insurer takes in premiums from customers, invest them, and earns a profit on the float. The value of the overall enterprise is closely tied to how many assets it has, and what rate of return it is earning on said assets.

How Much Premium Is Progressive Worth?

Here’s where the problem comes in for PGR stock. The company has just $16.89 per share in book value. That means that with Progressive stock at $60, investors are paying more than $3 for every dollar of assets that Progressive has to work with. Over the long haul, it will be exceedingly difficult for Progressive to produce ongoing strong returns for shareholders given that fact.

Progressive’s major competitors trade at far lower valuation ratios. Within the property and casualty insurance space, for example, we find Allstate (NYSE:ALL), Travelers (NYSE:TRV), and Hartford Financial Services (NYSE:HIG) all bunched between 1.4x and 1.6x book value. That means that when an investor puts capital into those firms, it has far more ability to compound and multiply, compared with Progressive which trades at 3.5x book value.

As great as management may be at Progressive, this is simply an almost unsurmountable obstacle in the long run. Progressive would need to earn a far higher return on equity — probably an unachievable one within its industry — to justify such a huge premium to book value. Given Progressive’s 17% ROE, it’s hard to justify more than 2.0x book value for the stock, which would put PGR at $34 per share. Even a stretch valuation of 2.5x book value — a fat premium to direct peers — would leave PGR stock around $41, representing substantial downside from today’s price.

Beware Interest Rate Enthusiasm

A price target of $34-$41 for PGR stock may seem crazy, given that it is trading at $58 now. But between 2013 and 2016, PGR stock consistently traded between $25 and $35 per share. It was much more in line with its book value and return on equity back then. I’d argue that this was a more correct price for the company, and that the recent run is largely misplaced.

What’s caused the big surge? Interest rates. Since Trump’s election, numerous financial stocks have taken off. This has been on the basis that Trump’s economic policies would lead to higher inflation and thus a series of Fed rate hikes. As we saw with the recent GDP number, top-line economic growth is indeed quite strong now.

However, investors may have overplayed just how meaningful this development would be for financial stocks. It’s true that insurers such as Progressive make more money when interest rates are higher. Their liabilities are generally stable, whereas investing income swings considerably with interest rates. Insurers own a lot of bonds, and thus a higher interest rate generates more profit off of their assets.

Again though, given the massive premium investors are paying for PGR stock, you’d need a big improvement in earnings to justify the stock price. Squeezing out a little more juice on the company’s $17 per share of assets just won’t get you the upside needed to maintain a $60 per stock price. If anything, competitors with lower profitability have more benefit coming from higher interest rates, as their lower valuations and price-to-book values would cause more of the rise in interest rates to trickle through into earnings-per-share.

PGR Stock Verdict

Progressive’s management team has done a great job. Between an acquisition, new business lines such as home insurance, and successful bundling, the overall business is surging. And Progressive has done well investing the proceeds of its increasing insurance premiums.

Ultimately though, there are limits to growth. PGR stock is simply trading at too big of a premium. It’d take nearly perfect execution over the next few years for PGR stock to be worth more than $60 per share. Book value drives most of the value of an insurance company, and at $17, there just isn’t enough of it to hold up Progressive’s stock price. If you want to buy PGR, wait for a correction first.

At the time of this writing, the author held no positions in any of the aforementioned securities.

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