Shareholders of annuities provider Challenger Ltd (ASX: CGF) have experienced impressive returns over the past 12 months, with its market price rallying by more than 70%. I must admit it has been rewarding, as a shareholder myself, watching the convergence of price and value over such a short period.

Australia has an aging population which we all know is entering retirement. Consequently, there will be greater demand for certain services that cater towards the needs of retirees.

The number of Australians over the age of 65 is projected to double within the next two decades. Because of this demographic trend it is expected that the superannuation industry will quintuple over the next two decades from around $2 trillion to $10 trillion.

Obviously, demand for life-time annuities will also increase with the majority of annuity sales made to consumers who have just entered retirement. In Australia, the number of retirees with fixed income is only 9 percent, however, in other developed nations the average is approximately 52 percent. If Australia were to reach parity with other developed nations, this too would benefit Challenger.

To put this into perspective, if the number of Australian retirees with fixed income were closer to 50%, Challenger's earnings would increase by at least five-fold.

Challenger currently holds circa 70% market share in lifetime annuities and assets under management amount to more than $60 billion.

It's evident Challenger is a business with bright prospects. Its dominant position in the market would make it difficult for Challenger not to do well over the next two decades.

However, if the conventional view is such, wouldn't its potential be baked into its price already? In other words, isn't it likely that you're already paying for the potential growth Challenger is likely to experience?

Well, not quite. I still believe if you were to purchase shares in Challenger today you could still expect modest returns over the longer term. I still believe there is a discrepancy between Challenger's intrinsic value and its market price.

If the superannuation industry does indeed achieve a compounded annual growth rate (CAGR) of approximately 8% over the next two decades, then it would be reasonable to suggest that Challenger can grow its earnings at an equivalent rate.

Assuming Challenger can grow its earnings at an average CAGR of between 6-8% per annum over the next decade, and then grow its earnings perpetually at 3% per annum over its life time, I estimate Challenger's intrinsic value lies somewhere between $11.69 and $13.56 per share.

At today's price of $11.64, Challenger shares are currently trading at a discount to its intrinsic value of between 0.4 percent and 14 percent.

Whilst you could argue Challenger shares are still good value for money, since they can be purchased just below intrinsic value, I would argue that the margin of safety (discrepancy between price and value) is insufficient.

I emphasise the importance of purchasing a security only once it can be purchased at a significant discount to its intrinsic value. This is because evaluating a business's future requires making predictions and the tricky job of the analyst is in predicting. As Yogi Berra once pointed out, "It's tough to make predictions, especially about the future".

While I always take a conservative approach to forecasting, inevitable, unforeseen circumstances do arise from time-to-time. The larger the margin of safety, the greater buffer available to fall back on if my analysis is wrong.

Foolish takeaway

Whilst Challenger is certainly no bargain at its current price, a drop in share price below $10 could present an excellent buying opportunity for investors.

The post Why the Challenger Ltd share price could hit new highs in 2017 appeared first on The Motley Fool Australia.

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