In his seminal work, The Intelligent Investor, legendary investor, Ben Graham, compared the stock market to a bi-polar neighbor that he referred to as “Mr. Market”.
In this analogy, this crazy neighbor will come to your door everyday looking to sell you stocks.
Some days, he’s euphoric. On these days, the stocks he’s selling are all priced quite high, reflecting his own enthusiasm.
[ad#Google Adsense 336×280-IA]Other days, he’s depressed.
On these days, his inventory is selling for a discount, likewise reflecting his poor outlook for the future.
This is a pretty accurate reflection of the stock market, though the oscillation between fear and greed takes a bit longer to play out in real life.
Nonetheless, this is an important analogy to remember.
Although prices change daily, the actual intrinsic value of stocks change much less often.
As such, it’s important not to get wrapped up in Mr. Market’s antics, instead only using his mood changes to your advantage: Buy when he’s depressed and don’t when he’s feeling euphoric.
How do you know the difference?
Well, you have to be able to determine the difference between price and value.
Price only tells you what something is being sold for. When you know the price of something, you know how many dollars you need to exchange for that item. Almost everything in this world has a price.
But value tells you so much more. Value tells you what you should be paying. Value tells you what something is actually worth.
Now, sometimes value is really just what people are willing to pay.
But when it comes to buying stocks, you can actually develop a system to reasonably estimate a business’s value. And once you know the value, you know whether or not you should be buying. You then know exactly what kind of mood Mr. Market is in.
There are a lot of systems out there, but Dave Van Knapp has published a handy lesson on stock valuation, published right here on the site, which can assist you with developing or honing your own system.
My own system relies on the heavy use of the dividend discount model analysis, which I’ll describe a bit more below.
Now, what I’m always interested in are high-quality dividend growth stocks selling for less than they’re worth. I’ve spent the last five years buying great dividend growth stocks on sale, which has helped me build a six-figure portfolio in the process.
And the best resource for finding and researching these high-quality dividend growth stocks is David Fish’s Dividend Champions, Contenders, and Challengers list.
It looks like we have a stock on that list that appears to not only be high quality, but also potentially priced below its intrinsic value.
Travelers Companies Inc. (TRV) is a holding company that, through its subsidiaries, provides commercial and personal property and casualty insurance products to individuals, businesses, government units, and associations.
Insurance is one of my all-time favorite industries. It’s also an industry I remain woefully underexposed to, which is something I hope to change soon.
But what’s really wonderful about the insurance industry is what’s called the “float”. The float is basically a huge source of capital that’s accumulated by insurance companies through the very business model.
Insurance companies charge premiums up front, which generates a huge source of incoming capital. They hold this capital until claims come in and they have to pay out. But the interim allows insurance companies to generate an attractive rate of return on a very low-cost source of capital.
However, the float has to be invested very conservatively. So that largely means fixed income, with US debt being one of the most secure out there. But interest rates remain stubbornly low, constraining the returns for the investment portfolios that insurance companies manage.
Even with this headwind, though, TRV has increased its dividend for the past 11 consecutive years.
And with a 10-year dividend growth rate of 9.5%, the dividend is increasing at a pretty attractive rate.
But we don’t just care how much a dividend has grown. We want to know if the dividend will be able to grow in the future, right? Well, a payout ratio of just 23.7% means TRV is paying out less than 24 cents of every $1 in profit. So there’s plenty of room for future growth there.
In addition, the stock actually offers some pretty solid current income. Yielding 2.35%, that’s about 40 basis points higher than the broader market. Couple that with high-single-digit dividend growth and you have a recipe for appealing long-term total returns.
So the dividend metrics are great. Let’s next take a look at what kind of growth the company has managed over the last decade. This will tell us where the company’s been, which will also give us some indication as to where they might be going. And that’ll help us value the business.
From fiscal years 2005 to 2014, TRV has grown revenue from $24.365 billion to $27.162 billion. That’s a compound annual growth rate of just 1.21%.
Meanwhile, earnings per share increased from $2.33 to $10.70 over this stretch, which is a CAGR of 18.46%.
The bottom line has grown much faster, which is in large part due to an aggressive share repurchasing plan – TRV has reduced its outstanding share count by about 50% over the last decade. That’s quite significant.
S&P Capital IQ sees 6% compound annual growth for EPS over the next three years, citing continued challenges in a low-rate environment.
TRV, like most insurance companies, maintains a very conservative balance sheet. The long-term debt/equity ratio is 0.26, while an interest coverage ratio of 14.7 indicates on issues with interest expenses or debt.
Their profitability is at or near the top of the industry. They’ve posted net margin that’s averaged 11.13% and return on equity that’s averaged 11.41% over the last five years. Both of these numbers are pretty good on their own, but TRV’s recent results have been even better.
So we can see the quality here. But is this stock a good deal right now?
The stock trades hands for a price-to-earnings ratio of 10.06. That’s about half the broader market. It’s also lower than TRV’s own five-year average P/E ratio of 10.6.
So we might have a deal on our hands. But what is TRV actually worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. That rate is at the upper end of what I normally use, but I think TRV warrants it considering the historical growth across profit and the dividend, as well as the low payout ratio. The DDM analysis gives me a fair value of $131.76.
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.
This stock is worth far more than it’s being sold for from where I’m standing. But my opinion isn’t the only one around. Let’s see what some of the professional analysts that follow this stock value it at.
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 TRV as a 3-star stock, with a fair value estimate of $108.00.
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 TRV as a 4-star “buy”, with a fair value calculation of $119.40.
I came in on the high side this time, but the opinions are all in harmony – the stock appears to be worth more than it’s selling for. Averaging out these three fair value opinions gives us a final figure of $119.72. That would indicate this stock is potentially 15% undervalued.
Bottom line: Travelers Companies Inc. (TRV) is a great company operating in one of the oldest and best business models around: insurance. The float has allowed them to build a $73 billion investment portfolio, and any rise in interest rates could serve as a huge tailwind. Meanwhile, the stock offers an attractive yield, great fundamentals, and the potential for 15% upside here. I’d strongly consider TRV right now.
— Jason Fieber, Dividend Mantra