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Is Direct Line Insurance Group PLC Still A Buy After The 2013 FTSE Bull Run?

2013 has been the year in which even the most hardened stock market bears have admitted that we’re in a five-year bull market — and it’s not over yet.

Although the FTSE 100 has slipped back from the five-year high of 6,875 it reached in May, it is still up 8% this year, and is 52% higher than it was five years ago. As Christmas approaches, I’ve been asking whether popular stocks like Direct Line Insurance Group (LSE: DLG) still offer good value, after five years of market gains.

Back to basics

Billionaire investor Warren Buffett says that one of the most important lessons he learned from value investing pioneer Ben Graham, is that “price is what you pay, value is what you get”.

Direct Line’s share price has kept pace with the FTSE 100 this year, gaining 8%. The firm’s shares have risen by around 25% since its flotation in October 2012, and it’s now one of the top five companies by market capitalisation in the FTSE 250.

The insurer’s shares looked good value when they first floated — just over a year later, is this still true?

Ratio Value
Trailing twelve month P/E 9.3
Trailing dividend yield 5.2%
Net asset value per share 187.9p
Combined operating ratio (YTD) 95.4%

Direct Line’s current valuation looks attractive, and the improvement in its combined operation ratio this year (2012: 99.7%) is encouraging; an insurer’s combined operating ratio is the proportion of its premium income that it pays out in claims and operating costs, so lower is better.

Overall, no red flags here — I’d be a buyer based on this information.

Rough seas ahead?

The Competition Commission recently announced their provisional findings on the UK’s £11bn motor insurance market. Alasdair Smith, who chaired the investigation, said that the commission had found that “many drivers … are footing the bill for unnecessary costs incurred during the claims process”.

Regulatory changes to enforce price transparency and cut claims costs would be good for motorists, but not necessarily for investors in Direct Line and other UK motor insurers, so I’d suggest some caution until the full scale of any changes becomes apparent.

Direct Line has tried to put a positive spin on these developments, and says that recent legal reforms, and its own efficiencies, have enabled it to cut average motor insurance prices by 5% so far this year.

However, analysts’ latest consensus forecasts are fairly cautious on earnings growth, suggesting that they share my view:

2014 Forecasts Value
Price to earnings (P/E) 10.1
Dividend yield 5.8%
Earnings per share growth 2.5%

Ultimately, it's your decision, but if you are planning to hold Direct Line shares as a long-term income investment, I would strongly suggest you take a look at this brand new Motley Fool special report, "How To Create Dividends For Life".

The report provides five golden rules to use when selecting dividend stocks -- and Direct Line's vulnerability to regulatory changes makes me concerned that it may not pass all of these tests.

To decide for yourself, simply click here for instant access to your free copy of this important report.

> Roland does not own shares in Direct Line Insurance Group.