Great-West Lifeco (TSE:GWO), one of the three big Canadian life insurance firms, has been rallying consistently since before the beginning of the year. Year-to-date, it’s up over 17%, which is remarkable for such a stable firm. However, this has pushed the stock into overvalued and overbought territory, in our opinion. Therefore, we are neutral on the stock.
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Why GWO Stock is Overvalued
To show that Great-West Lifeco stock is overvalued, we will use the excess returns model, which is more appropriate for financial companies because they tend to have volatile free cash flows.
As a result, trying to create forecasts for them doesn’t work well. The excess returns model allows us to use historical numbers instead, which are tangible. There are a few steps to follow for this valuation method.
First, you calculate a company’s excess return, meaning the spread between its return on equity (ROE) and its cost of equity; a higher ROE than the cost of equity is a good thing. Next, you calculate its terminal value. Add them up, and you get your valuation. Here’s the formula:
- Excess Return = (Average ROE – Cost of Equity) x Book Value Per Share
- Terminal Value = Excess Return / (Cost of Equity – Growth Rate)
- Fair Value = Book Value Per Share + Terminal Value
We will use the following assumptions for our calculations:
Average return on equity (ROE): 13.2% (five-year average)
Cost of equity: 11.8%
Book value per share: C$28.21
Growth rate: 3.19% (used 30-year Government of Canada bond yield as a proxy for long-term growth expectations)
Now that we have our assumptions, we’ll plug them into the formula highlighted above. The figures are in Canadian dollars:
- $0.395 = (0.132 – 0.118) x $28.21
- $4.59 = $0.395 / (0.118 – 0.0319)
- $32.80 = $28.21 + $4.59
Therefore, GWO stock is currently worth C$32.80 per this valuation method. Its current share price is near C$36.50, making it slightly overvalued.
GWO is a Good Dividend Stock, Nonetheless
Besides GWO stock being slightly overvalued, in our view, it’s still a good dividend stock to consider due to its juicy yield and the company’s stability. GWO’s forward dividend yield comes in at 5.7%, and its distribution has grown at a 6% compound annual growth rate (CAGR) over the past seven years, which is respectable. Also, with a payout ratio of about 58%, the dividend is very well-covered, meaning future dividend hikes can be expected. In fact, just one month ago, GWO raised its dividend by 6%.
Still, looking at the graph below, you can see that GWO’s current yield is a bit lower than what it used to be, especially in 2018 and 2019.
The Takeaway
GWO is a solid insurance stock that has seen significant strength recently. However, the stock seems to have gotten ahead of itself, and it may pull back soon. Nonetheless, over the long term, GWO is still a good dividend stock, providing a mix of modest dividend growth and juicy yield.
