We’re confronted with a multitude of choices every single day of our lives.

What to eat for breakfast. Which route to take to work. How to respond to our boss’s crazy requests. Whether or not to hit the gym later.

Such is life.

But to invest or not to invest isn’t really so much a choice as it is a necessity and personal responsibility.

After all, there’s going to be a day when we won’t want to or no longer can work.

And we’ll have to generate income somehow.

As such, this income will have to be passive.

While Social Security (and perhaps a pension, if you’re fortunate) will certainly help, this income isn’t supposed to be relied on to cover all of one’s expenses down the road.

Moreover, if you have any designs on retiring before you’re old and gray, you’ll need even more passive income… and you’ll need it sooner rather than later.

Indeed, I knew at a young age that there was no way I wanted to work until I was in my 60s. Doing the 9-5 till 65 was out of the question for me, especially considering my 9-5 was more like 7-6 (plus Saturdays).

There was really no choice, other than to choose me and my happiness.

And so I started aggressively saving my money and investing the savings into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

These are truly some of the best businesses in the world.

And they take care of their customers – selling products and/or services the world demands – and their shareholders – delivering growing dividends year after year, funded by growing profit – which tends to make them great long-term investments.

Indeed, dividend growth investing is my investment strategy of choice because it allows me to generate passive income (growing dividend income) without any ongoing work/concern on my part.

And that wholehearted belief in the strategy helped me build a six-figure dividend growth stock portfolio that now delivers five-figure passive dividend income into my bank account.

It’s that passive income that bought me my freedom from the 9-5 (7-6), rendering me financially independent in my early 30s.

The good news is that you have access to the same choices (or non-choices) I’ve made.

That’s what today’s article is all about, as I’m going to discuss a high-quality dividend growth stock that appears to be undervalued right now.

The high-quality part is important.

You want to invest not just in any dividend growth stock, but one that represents equity in a great business with strong fundamentals and durable competitive advantages.

And the valuation is part is just as important, if not more so.

You want to make sure you buy a high-quality dividend growth stock when the valuation is appropriate: you want to pay less than it’s worth, meaning it’s undervalued.

That’s because a dividend growth stock that’s undervalued will likely offer a higher yield, greater long-term total return potential, and less risk.

This is relative to what the same stock might offer if it were fairly valued (price and value are equal) or overvalued (price is higher than value).

Price and yield are inversely correlated, meaning, all else equal, the latter is higher when the former is lower.

That lower price and higher yield results in more current and ongoing income, but it also results in greater long-term total return.

That’s because income (via dividends/distributions) is one of two components to total return.

But capital gain, which is the other component, is also given a potential boost via the upside that exists between the lower price paid and the higher intrinsic value of a stock.

The gap between price and value (when a stock is undervalued) exists as favorable upside that, if realized by the market, produces capital gain that’s on top of whatever organic capital gain is possible as the business becomes more profitable and more valuable.

Of course, this also reduces one’s risk, as more upside naturally means less downside.

Paying far less than the fair value of a stock builds in a margin of safety, which acts as a buffer to protect an investor against unnecessary losses just in case an investment thesis is wrong or an unexpected event causes a company’s value to drop.

The greater the favorable gap between price and value, the greater the margin of safety.

These are great benefits that any long-term investor should seek out, and the wonderful thing is that it’s not that difficult to estimate just about any dividend growth stock’s value.

In fact, fellow contributor Dave Van Knapp put together a guide to valuation that streamlines the process.

But I won’t leave you readers there.

To perhaps simplify the daily barrage of choices you’ll face today, I’m going to narrow down your search a bit by focusing on one high-quality dividend growth stock that appears to be undervalued.

Let’s take a look…

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.

The insurance business has long been one of my favorite business models.

That’s because there are two very powerful cash machines – cash machines that are complementary and inextricably linked – working in favor of an insurance company.

On one hand, you’ve got the premiums, which are fees that an insurance company collects up front in exchange for insurance products.

Since most people lack the financial resources necessary to assume catastrophic risk, many insurance products are legally mandated. So you have a necessary product that almost ensures profit, when an insurance company is properly managing its risk.

Better yet, since these premiums are collected upfront (until an insurance company needs to pay out on claims), this capital can be conservatively and profitably invested by an insurance company.

This results in what’s called a “float”, which is a (often large) source of low-cost (or no-cost) capital that can actually end up being the primary profit source for an insurance company.

The insurance float famously helped Warren Buffett build Berkshire Hathaway Inc. (BRK.B) into what it is today.

And while none of us are Warren Buffett, there’s nothing stopping us from making the choice to invest in strong insurance companies, meaning we, too, can operate with some of the advantage that having a float confers.

Travelers is such a company.

And their giant float – the investment portfolio has a carrying value just north of $70 billion – helps Travelers continue to pump out increasing dividends.

The company has paid an increasing dividend for 13 consecutive years, dating back to a merger in 2004 that resulted in the company we know today.

And over the last decade, Travelers has increased its dividend at an annual rate of 10%.

That’s certainly well in excess of inflation, meaning shareholders are seeing their purchasing power increase with every dividend increase.

And that’s a very attractive growth rate when considering the stock yields 2.38% right now.

So we’re talking double-digit long-term dividend growth on top of a yield that exceeds the broader market.

With a payout ratio of just 28.7%, Travelers still has plenty of room where that dividend growth came from.

In fact, the company’s payout ratio hasn’t expanded that much over the last decade, unlike a lot of other dividend growth stocks I follow, invest in, and write about.

Travelers had a very low payout ratio a decade ago. And they still have a very low payout ratio.

That flexibility means that some of the dividend growth over the foreseeable future could be fueled via modest expansion of the payout ratio, allowing for that even if the underlying near-term EPS growth of the company isn’t up to par.

But in order to really build that expectation moving forward, we need to look at the company’s top-line and bottom-line growth over the last decade.

This will tell us what kind of overall growth Travelers is generating.

We’ll then compare that to a near-term forecast for EPS growth.

Combining and blending these numbers should help us extrapolate out future growth, helping build a base case for modeling out the stock’s value.

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%.

This is disappointing, in my view.

However, Travelers isn’t alone in this; many insurance companies have had trouble growing their top line over the last decade as price competition has been very stiff over that period.

In addition, this is total revenue we’re looking at. Premium revenue growth over the same period has actually grown at a compound annual rate of 1.49%, which is slightly better.

But the bottom-line has fared much better, with Travelers buying back a significant amount of its stock over the last decade. The company’s outstanding share count is down by ~57% over the last 10 years.

I feel this is prudent, since it doesn’t look like the stock was notably overvalued while they were buying back stock.

The company’s earnings per share advanced from $6.86 to $10.28 over this stretch, which is a CAGR of 4.60%.

The results over the last couple years caused a big deceleration here. Looking at these numbers just a couple years ago would have showed us a much brighter picture.

As noted earlier, Travelers earns a significant portion of its profit from the investment income that its float provides.

For perspective, the difference between total premiums and total claims and expenses came out to only $962 million for FY 2016. However, net investment income for FY 2016 came out to $2.302 billion.

While premiums have climbed over the last decade, there are two things working against Travelers right now.

First, that investment income, which we can see is the bigger part of the profit picture, is down quite a bit compared to where it was a decade ago, as low interest rates have harmed the company’s ability to earn a conservative but attractive yield.

Since Travelers mostly invests in fixed-income assets that are investment grade, it’s somewhat at the mercy of interest rates.

In addition, the company’s combined ratio – the number derived by dividing the sum of incurred losses and expenses by net written premiums – was up to 92.0% in FY 2017. That compares unfavorably to the 87.4% Travelers registered for FY 2007.

A combined ratio above 100% generally indicates an underwriting loss; a combined ratio below 100% generally indicates an underwriting profit.

Travelers is typically very good at generating a strong underwriting profit.

I like to see a combined ratio below 90% for a P&C insurance company. And Travelers often comes in below that number. It’s just that FY 2017 sported a higher-than-usual combined ratio.

Looking forward, CFRA believes that Travelers will compound its EPS at an annual rate of 1% over the next three years.

That would be a substantial deceleration from what the company was able to log over the last decade.
Catastrophic losses from Hurricane Harvey and Hurricane Irma won’t help the company’s case; the company recently estimated losses from Hurricane Harvey at between $245 million to $490 million after-tax. This isn’t a massive number, but it will hurt the combined ratio in the near term.

The suspension of stock buybacks while they assess the damages further limits the bottom-line growth over the near term (especially as I think the stock is attractively valued right now).

But I think they have two catalysts working in their favor over the long term.

Interest rates are sure to rise at some point, meaning that massive investment portfolio (which provides Travelers with the majority of its profit) will be even more powerful.

And these near-term issues with the combined ratio will surely pass, too, as recent losses have been unusual.

As such, I think an acceleration, rather than a deceleration, is more likely for the company’s bottom-line growth when looking out over the long term. But the near term may very well be a bit bumpy.

If they’ve been able to manage 5% EPS growth in an environment that’s been disadvantageous, I would think they can do even better when the environment turns toward their favor. And that bodes well for the dividend growth.

The company’s remaining fundamentals are solid.

The long-term debt/equity ratio is 0.27, while the interest coverage ratio is just over 12.

No problems here whatsoever.

Profitability is also robust, with the company averaging net margin of 12.10% and return on equity of 13.20% over the last five years.

As Travelers points out in the most recent annual report, its ROE is significantly in excess of what US P&C insurers average.

Overall, I think this is a really strong business.

Recent troubles with the combined ratio and low interest rates notwithstanding, the long-term picture looks really bright for the company.

The massive hurricanes that hit the mainland US in late 2017 will cause losses for Travelers (and other P&C insurers), but these losses are more than manageable.

Meanwhile, there are some massive long-term tailwinds that should work in favor of Travelers.

But I don’t think the current valuation totally reflects that…

The stock is trading hands for a P/E ratio of 12.03, which is approximately half of what the broader market is going for. While insurance stocks almost always trade for a big discount, this does seem rather excessive to me. Many of the stock’s current valuation metrics are more or less in line with recent historical averages, but I believe the stock has been undervalued and remains undervalued. That’s especially true in light of the broader market being at all-time highs.

If it’s cheap, what might be a good estimate of its intrinsic value? What’s a fair price to pay?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

That DGR is near the top end of what I allow for, but the company’s demonstrated long-term dividend growth, modest payout ratio, and long-term tailwinds are being accounted for.

However, that DGR is also just slightly lower than what I modeled for in the last time I looked at Travelers, as near-term concerns with catastrophes and a lower combined ratio are also being accounted for.

The DDM analysis gives me a fair value of $123.84.

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 perspective is that the stock is just slightly undervalued – and that’s even after peeling back my expectations a bit. But I always like to compare my valuation with that of what select professional stock analysis firms come up with. This adds depth and perspective.

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 4-star stock, with a fair value estimate of $137.00.

CFRA 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.

CFRA rates TRV as a 4-star “BUY”, with a 12-month target price (in lieu of non-existent FV calculation) $135.00.

I came in a bit light this time, but averaging the three numbers out gives us a final valuation of $131.95. That would indicate the stock is potentially 9% undervalued right now.

Bottom line: Travelers Companies Inc. (TRV) is a high-quality company that is as good as, or better than, any P&C insurer I’m aware of. They have a commitment to growing their dividend at a very attractive rate, as well as the wherewithal to continue doing so. Recent troubles notwithstanding, this is a company positioned very well for the long haul. With the possibility of 9% upside on top of market-beating yield and dividend growth, this is a fantastic dividend growth stock to consider as a long-term investment.

— Jason Fieber