Capitalism is really amazing.

I mean, we live in a country where you can invest capital and earn an attractive return on that capital over a long period of time, such that the effect of compounding usually turns your ending capital into much more than that which you started with.

Best of all, this isn’t a system that’s only accessible to the rich and connected.

Anyone can take part in this process.

I remember when I first started investing, the whole idea of it seemed kind of scary.

After all, our education system will teach you about the periodic table and how to dissect a frog, yet we pretty much never talk about how to balance a budget or open a brokerage account.

[ad#Google Adsense 336×280-IA]So I was left to my own devices.

But what I realized after a short period of time is that capitalism isn’t very scary at all. Capitalism is actually incredibly exciting.

Indeed, I figured out that compounding might just become my best friend, as it would allow my money to work for me.

Seeing as how money can work 24/7 without getting sick or tired, I figured it’d probably be a better worker than me.

And that’s pretty much exactly what’s happened.

By living below my means and investing in high-quality stocks that pay growing dividends, I’ve been able to build a six-figure portfolio that spits out more than $11,000 in dividend income for me.

This income is completely passive, and it’s allowed me to retire decades before most people.

I used to wait tables in high school and college. And I can tell you it took many long days and nights of running ragged to earn $11,000. Yet my money earns this for me without breaking a sweat.

Better yet, this income will highly likely grow organically, faster than inflation, all by itself.

It’s like getting a pay raise without doing anything to earn it!

That’s because I invest in high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

These are stocks that represent underlying equity in businesses that pay increasing dividends to shareholders.

I stick to high-quality dividend growth stocks because, in my view, it’s the only logical way to invest.

After all, I become a part-owner in a company when I buy its stock. Shareholders are, collectively, the owners of any publicly traded company.

Well, as the owner of a business, I expect my rightful share of its profit.

And if profit is growing (as it should be), so should my income.

But as great as dividend growth investing can be, one shouldn’t just buy any stock at any price.

There are hundreds of great dividend growth stocks out there to choose from.

However, that doesn’t mean that all of them are appealing investments all of the time.

One must first determine whether or not a stock is high quality, which requires a full quantitative and qualitative analysis.

So we’re talking about looking at top-line growth, bottom-line growth, debt, profitability, and competitive advantages.

One must then determine whether or not the price being asked for the stock is appropriate, which requires one to estimate the intrinsic value of the stock.

Price is simply how much something costs.

Value, though, is what that something is actually worth.

Value gives context to price. Without knowing value, it’s impossible to know whether or not the price is appropriate.

And that’s where the process of actually valuing a dividend growth stock factors in.

Fortunately, just like capitalism, resources designed to facilitate valuation are plentiful and, often, free.

For instance, fellow contributor Dave Van Knapp put together a series of lessons on dividend growth investing. And one of those lessons specifically focuses on valuing dividend growth stocks.

When you know the value of a dividend growth stock, you’re in control.

And the benefits available to investors when they buy dividend growth stocks when they’re priced below their intrinsic value are numerous and substantial.

Buying a stock when it’s priced below its value is also known as buying an undervalued stock.

An undervalued dividend growth stock will generally offer a higher yield, greater long-term total return prospects, and less risk.

This is all relative to what the same stock might offer if it were fairly valued (priced roughly equivalent to fair value) or overvalued (priced above fair value).

All else equal, a lower price will result in a higher yield. That’s because price and yield are inversely correlated.

So when you buy a stock when it’s cheaper, the yield will almost always be higher. That means more current and ongoing income on your investment.

This increased income has a positive impact on total return, as yield is a major component of total return.

The other component, capital gain, is also positively impacted by virtue of the upside that exists between the lower price paid and the higher value of the stock.

If you pay $50 for a stock conceivably worth $70, you have roughly $20 worth of upside that is likely to be recognized over time, as price and value tend to converge over the long haul.

Paying much less than fair value also reduces risk, as paying $50 for a stock worth $70 (using the same example as above) means you have a large buffer.

If something goes wrong with the business, you have a margin of safety. That means even if the stock becomes worth less due to some adverse change in the company’s dynamics, you have a cushion before the stock becomes worth less than you paid.

As always, you want the least amount of risk and the most possible amount of reward. A margin of safety means the relationship between risk and reward is advantageous.

With all of this in mind, you can see why I’m always on the hunt for high-quality dividend growth stocks that are undervalued.

Well, I believe we have one on our hands right now…

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.

I really love investing in insurance. It’s one of the oldest business models around. And it’s just a great way to make money.

Insurance is often required, such as when you have a lien on a house, car, or boat. So there’s built-in demand. Moreover, most people can’t afford the risk of self-insuring their assets, which further bolsters demand.

But insurance is really wonderful in the sense that you’re able to charge premiums up front and then invest that pool of capital, earning an attractive and low-risk return on what’s essentially very low-cost capital.

The pool of capital that an insurance company is able to accumulate and invest is called a “float”. And this is one of the major sources of profit for insurance companies.

Meanwhile, there should be a sizable difference between the premiums charged and the claims paid, which is underwriting profit. That’s the other way insurance companies make money.

Combined, these two sources of profit provide for an enviable and defensible business model.

Travelers has been very proficient at growing its profit over a long period of time.

Likewise, the dividend continues to grow, too.

The company has increased its dividend for 12 consecutive years.

And the dividend has grown at a compound annual rate of 10% over the last 10 years.

On top of that really solid dividend growth, the stock yields 2.20%.

CaptureOf course, we want to have some assurance that Travelers can continue growing its dividend.

Well, the stock’s payout ratio is just 26%, which is extremely conservative.

There’s plenty of room for future dividend raises, even if EPS were to somehow stop growing, or even shrink.

But along with that payout ratio, we should also be able to estimate what kind of future profit growth to expect, which will go a long way toward whatever future dividend growth Travelers is able to realize.

So we’ll first look at the last decade in terms of revenue and profit growth. And we’ll then compare that to a near-term forecast for EPS growth. Combined, this should give us an idea as to what kind of underlying profit growth Travelers should be able to generate moving forward.

Travelers has increased its revenue from $26.017 billion to $27.625 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 0.67%.

So revenue is basically flat over the last decade. Not very impressive, overall.

However, Travelers has reduced its outstanding share count by over 50% over the last decade, which has allowed for EPS growth even in the face of static revenue.

Earnings per share for the company grew from $6.85 to $10.28 over this 10-year stretch, which is a CAGR of 4.61%.

Looking out over the next three years, S&P Capital IQ believes Travelers will compound its EPS at an annual rate of 1%.

That would be a fairly significant deceleration from what Travelers has been able to produce over the last decade, but the disappointing top-line growth combined with what’s still a low-rate environment limits the company’s earnings power.

That said, interest rates are slowly rising, and this should be a long-term tailwind for Travelers, providing a catalyst for growth acceleration, rather than deceleration. If the company has been able to generate ~5% growth in an environment that was working against them, I would suspect that they should be able to do even better with higher interest rates, which helps their float.

Insurance companies are usually run very conservatively, and Travelers is no exception here.

The balance sheet is evidence of that, and it’s also evidence of the high-quality nature of the firm.

Travelers has a long-term debt/equity ratio of 0.28 and an interest coverage ratio of roughly 12 .

Profitability is robust, up there with some of the best companies in the industry.

Over the last five years, Travelers has averaged net margin of 12.10% and return on equity of 13.20%.

All in all, Travelers offers a lot to like.

You’ve got an appealing yield, double-digit dividend growth over a decade, a very low payout ratio, and a great business model.

However, growth has been a bit tough to come by over the last decade, no doubt in part due to low interest rates.

But the dividend is in a great position to continue growing, the company is buying back lots of stock, and rates are rising.

I think the company is positioned pretty well.

Yet the valuation doesn’t really give them the benefit of the doubt…

The stock is trading hands for a P/E ratio of 11.80 right now, which is less than half of what the broader market is trading for. In a market that is sitting near its all-time high, you don’t see stocks trading for P/E ratios this low very often.

What might the stock be worth? Do we have a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate.

[ad#Google Adsense 336×280-IA]And I assumed a long-term dividend growth rate of 8%.

I think the 8% number is pretty reasonable when considering the company’s 10-year dividend growth rate, modest payout ratio, and potential for EPS acceleration.

The DDM analysis gives me a fair value of $144.72.

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.

So my analysis shows that the stock is quite cheap here. But I also acknowledge that my viewpoint is but one of many. That’s why I like to compare my valuation to that of what professional analysts have come up with.

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 $117.00.

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 $128.40.

I came in the highest, but I really believe that Travelers has the wherewithal to grow their dividend in the high single digits for many years to come. Nonetheless, averaging out these three figures gives us a final valuation of $130.04, which would indicate the stock is potentially 7% undervalued right now.

TRV_chartBottom line: Travelers Companies Inc. (TRV) is a high-quality company operating an age-old business model with built-in demand. With both underwriting and the float, they have two wonderful sources of income. And the latter should benefit from higher interest rates, which could be a long-term tailwind. With the potential for 7% upside on top of a dividend that’s experiencing double-digit growth, this is a stock that’s definitely worth a look here.

— Jason Fieber