Undervalued Dividend Growth Stock of the Week: ACE Limited (ACE)

It’s been said that the best place to hide is in plain sight.

Well, that seems to be the case for some high-quality stocks out there that are priced less than they’re worth.

Although it might seem like an impossible task to find great stocks that are trading for prices below intrinsic value because the broader market has run up so much over the last five or so years, I find that not to be the case.

Sure, the deals aren’t as plentiful as they were three or four years ago, but they’re not impossible to find.

How do we find these deals, though?

First, you have to be able to value stocks.

See, the price of a stock only tells you how much money you have to pull out of your pocket to exchange for shares.

Price only tells you how much you’re paying.

But it’s value that tells you so much more.

Value tells you what a stock is worth. It tells you what you’re actually getting for your money.

Imagine you just arrived to Earth today. You see prices everywhere. Prices on food. Prices on clothing. Prices on cars.

But how would you know whether or not any of these prices are sensible? How would you know if these prices are good deals or bad deals?

You wouldn’t, unless you knew how to value these things.

People value things all the time. You calculate in your own head whether or not something is a good deal. You do this when you buy groceries, or go shopping for a used car, etc.

And that kind of behavior is even more necessary when it comes to buying stocks.

Even better, there are systems out there that are designed to help streamline the process. These systems make it a lot easier to value businesses, which will help you determine whether or not you’re paying a fair price or not.

One such system is discussed here on the site. Penned by Dave Van Knapp, a prominent investor and writer in this space, his guide should provide immense help if you’re unsure as to how to go about valuing stocks.

Once you have a system in play that you’re able to work with, you’re in control.

This control should help you reasonably determine whether or not a stock is priced below its intrinsic value, and this can make a tremendous difference in terms of your investment success.

Buying even just one stock at a price 20% lower than it’s worth can lead to higher total returns over the life of the investment and a higher initial yield on your investment.

For instance, say a stock is worth $50. And let’s also assume it pays out a $1.00/year dividend. That’s a 2% yield.

If you have $1,000 to invest, you could pick up 20 shares of this stock priced at $50.

Assuming dividends reinvested, 7% share price growth and dividend growth, and a 30-year investment horizon, you’d be looking at an annualized total return of 9.14% and $13,788 at the end of three decades.

Now, if you’re able to score that same stock at $40, you’d be able to buy 25 shares at a 2.5% yield.

More shares for the same amount of money and a higher yield to start with. You can already see where this is going…

At the end of 30 years (using the same assumptions), that would lead to an annualized total return of 9.68% and a total investment worth $15,967.

You ended up with almost $2,200 more in your pocket for doing nothing other than scooping up the same stock for less than it was worth.

Easy money.

But just imagine if you repeat this process over and over again with every stock you buy. Just imagine the potential.

Buying high-quality dividend growth stocks for less than they’re actually worth is something I’ve attempted to do month in and month out as I’ve built up my own personal portfolio, which is a portfolio that should generate enough passive dividend income for me to live off of by the time I’m 40 years old.

And the stocks I buy can largely be found on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish’s list is the ultimate “shopping list”, in my opinion, especially for dividend growth investors. And that’s because it contains valuable information on more than 700 US-listed stocks, all of which have increased their dividends for at least the last five consecutive years.

I love dividends. They’re a very large part of the stock market’s total return over the last 100 years.

But I love increasing dividends even more. And these stocks – these dividend growth stocks – are generally great investments when it comes to generating increasing passive income.

What I like to do is use Mr. Fish’s list as a shopping list, looking for great stocks that appear to be trading for prices below their actual value.

And I may just have found one…

ACE Limited (ACE) is a global insurer, providing commercial and personal property and casualty insurance, personal accident and supplemental health insurance, reinsurance, and life insurance to a variety of clients across 54 countries.

Insurance has long been a favorite industry of mine.

And that’s because insurance companies are able to profit tremendously off of low-cost capital by use of float.

While insurance companies generally make (or, at least, should make) money off of the premiums they charge for their services, this isn’t necessarily the largest source of profit.

Instead, they collect those premiums up front and are able to invest that money until claims are made against those premiums. In the interim, an insurance company can build up a substantial float that can generate significant profit for the company on what is essentially very low-risk and low-cost capital.

And ACE has built up an investment portfolio worth over $60 billion, primarily invested in investment-grade fixed-income securities. This portfolio generated $2.3 billion in income for the company last fiscal year. The potential for rising interest rates could boost this number even higher.

The combination of an excellent underwriting business (the combined ratio was below 90% for P&C last year) and a large investment portfolio has allowed ACE to increase its dividend for the past 23 consecutive years.

aceOver the last decade, the company has boosted that dividend by an annual rate of 12.3%.

With a payout ratio of just 30.1%, there’s plenty of room to continue growing that dividend for years to come.

On top of that double-digit long-term dividend growth, one is getting a fairly attractive yield right now of 2.64%. That yield, by the way, is more than 50 basis points higher than the five-year average yield of 2.1% for this stock.

Underlying operations have also been fantastic over the last 10 years, which we’ll take a look at next. Without knowing how fast a company is growing, it’s difficult to know how much it might be worth.

Revenue is up from $13.088 billion to $19.171 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 4.33%.

Not bad when considering that a lot of other major insurers have had trouble growing the top line in a competitive market for pricing.

Bottom-line growth has been much more brisk; earnings per share grew from $3.31 to $8.42 over this period, which is a CAGR of 10.93%.

Improving profitability, increasing net premiums written, and a growing investment portfolio have all helped.

S&P Capital IQ believes ACE will grow EPS at a compound annual rate of 5% over the next three years, but this number could be boosted rather dramatically by the announced (and approved) acquisition of Chubb Corp. (CB), itself a high-quality insurer. ACE anticipates this deal being accretive, so we’ll see how that turns out. Either way, 5% could be on the conservative side here.

The company’s balance sheet is excellent, as expected for a company that takes on risk as a business model. A long-term debt/equity ratio of 0.11 and an interest coverage ratio over 13 both indicate very solid financial footing here.

Profitability is outstanding. Over the last five years, ACE has averaged net margin of 15.66% and return on equity of 11.25%. These numbers compare very favorably to just about any other insurer in the industry.

The potential for rising interest rates. An accretive acquisition of a high-quality competitor that makes ACE better while simultaneously reduces the size of the playing field. Global operations. Low combined ratio year after year. More than two decades of growing dividends.

A lot to like here. Which is why we might think the stock trades for a premium. But does it?

The stock trades for a P/E ratio of 11.44. That’s a bit higher than the five-year average, though EPS for FY 2014 was hurt by multiple adjustments.

Insurers are usually valued on a price-to-book ratio, and ACE trades hands for a P/B ratio of 1.1, in line with the five-year average.

However, the yield is substantially higher than the five-year average. And ACE is about to be a bigger and potentially better company.

So what’s it worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 7.5%. That dividend growth rate is quite conservative compared to the company’s long-term growth in EPS and the dividend. And a low payout ratio seems to ensure solid dividend growth even before the acquisition of Chubb is considered. The DDM analysis gives me a fair value of $115.24.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

I believe we’re looking at a high-quality dividend growth stock that’s trading for a rather large discount to its intrinsic value. But I’m not the only one around looking at ACE. Let’s compare my opinion with that of some professionals that have taken the time to value the business.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates ACE as a 4-star stock, with a fair value estimate of $116.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates ACE as a 4-star “buy”, with a fair value calculation of $104.90.

So I’m in line with Morningstar, but both firms believe it’s a buy here. Averaging out the three numbers so as to smooth out fluctuations and work with a final valuation gives us $112.05. I think that’s a reasonably accurate figure. And that would mean this stock is quite possibly 10% undervalued right now.

sc ACEBottom line: ACE Limited (ACE) is a global insurer that has operated at a high level for years. And the acquisition of Chubb could turn this company into an absolute powerhouse. Consistent dividend growth along with the dual catalysts of a high-quality acquisition and potential for rising interest rates is exciting. But the stock appears to provide for 10% upside on top of that. I recently initiated a position in this company due to the appealing long-term prospects, which is to say it’s a strong recommendation here.

— Jason Fieber, Dividend Mantra

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