Is the Aviva share price set to crash?

Businessman looking at a red arrow crashing through the floor
Businessman looking at a red arrow crashing through the floor

Since my last article on insurance giant Aviva (LSE: AV)in October, which was bearish, the share price is down around 13%. But I’m more or less alone in my bear cave with this one because most other articles published since mine have been positive and bullish on Aviva.

At first glance, I can see the attraction. The shares change hands on an earnings multiple of just over six and the dividend yield is more than eight. On top of that, City analysts following the firm expect earnings to grow by a robust double-digit percentage this year and by a few percent more in 2019. Good trading from the company and cracking value for investors, right? I’m not so sure.

I see red flags

Having the dividend yield higher than the price-to-earnings ratio is a red flag, to me. And having the dividend yield above 7% is another red flag. The title of this article asks if the Aviva share price is about to crash and I think that, collectively, the stock market thinks that the Aviva share price MIGHT crash and that is why it is assigning the company such a miserly valuation.

To me, the bear case is that Aviva is a firm with cyclical operations and earnings have been on the rise. Earnings have recovered so much, in fact, that the chief executive brought in to oversee the firm’s recovery from the last cyclical low has moved on because he thought the recovery was complete. A complete recovery means we must be somewhere near to peak earnings for the cycle, or so the market seems to believe. And the reason I think the stock market might believe that is because it has been compressing the firm’s valuation by degrees as profits have been rising every year.

That valuation-compression thing is likely to end up looking like a vain attempt by the market to discount the next cyclical plunge in earnings, the dividend and the share price. It probably won’t work, because out-and-out cyclical shares like this can plunge as much as 50% to 95% in a real economic slump, even when the valuation is ridiculously low leading into one, such as Aviva’s valuation is now.

But here’s the bull case

The bull case, of course, is that Aviva is out of favour with the market. The market is discounting an economic slump that will never come and will soon realise its mistake and mark the valuation up again, thus pushing the share price higher and delivering a big return for investors who saw the value and bought the shares.

The bull case might happen – although it’s not looking good at the moment – equally the bear case could play out, and if it does, the capital that investors will lose on the share-price decline could wipe out years’ worth of gains from the dividend.

Meanwhile, I don’t think it likely that the market will mark up the valuation until it has seen a proper economic downturn, so my view is that the risk is skewed to the downside with Aviva and I’m not prepared to risk money on the shares today.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.