Freedom has always been important.
It was at the core of the founding of the US itself.
But it might be more important today than ever before.
Why?
AI is coming.
It’s coming for everything, including people’s livelihoods.
Locking in financial freedom before AI comes to do what you do for a living is critical.
In that vein, dividend growth investing comes to the forefront.
This long-term investment strategy involves buying and holding shares in high-quality businesses sending shareholders reliable, rising cash dividends.
You can find hundreds of examples of such businesses over at the Dividend Champions, Contenders, and Challengers list.
This list has invaluable information on those US-listed stocks which have raised dividends each year for at least the last five consecutive years.
As you might surmise, it takes a certain amount of specialness in order to drive the ever-growing profits necessary to deliver ever-larger cash dividend payouts to shareholders, meaning this strategy tends to funnel investors right into terrific investments.
It’s certainly worked out that way for me.
By employing this strategy for the past 15+ years, I’ve been able to build the FIRE Fund.
That’s my real-money portfolio generating enough five-figure passive dividend income for me to live off of.
It’s at the heart of my own financial freedom, and it even allowed me to retire in my early 30s.
Investing in terrific businesses is a great start, but there’s also the very important matter of valuation at the time of making any investment.
See, price is only what you pay, but it’s value that you actually get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Right now is the time to lock in on financial freedom, and doing so by steadily acquiring undervalued high-quality dividend growth stocks might just be the very best way to accomplish that.
Of course, being able to spot undervaluation first requires one to already have a thorough understanding of how valuation works.
That’s precisely where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp, it explains what valuation is and how it works using simple terminology.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Watsco, Inc. (WSO)
Watsco, Inc. (WSO) is an American distributor of air conditioning, heating, and refrigeration equipment, as well as related parts and supplies.
Founded in 1956, Watsco is now a $13 billion (by market cap) major distributor employing approximately 7,000 people.
Operating out of nearly 700 locations across 40+ states, Canada, Mexico, and Puerto Rico, Watsco sells HVAC/R equipment to contractors and dealers that serve the new construction and replacement markets.
That’s the basic business model, and it’s a pretty good one.
Plus, this company has unrivaled scale: Watsco is the largest distributor of HVAC/R equipment in the US.
In addition, via joint ventures with Carrier Global Corp. (CARR), Watsco has exclusive distribution rights for equipment from the US’s largest OEM.
That kind of scale and exclusivity is a powerful one-two punch, insulting it somewhat as it goes to work and pulls two powerful growth levers for shareholders.
The first lever is organic growth, stemming from both new construction and replacements.
Regarding the former, the US is short millions of homes; as supply comes online in order to meet demand, those new homes will need what Watsco provides.
Regarding the latter, if something is not working, it will be repaired or replaced in short order; no reasonable person is going to live without modern-day heating and cooling.
The second lever is M&A.
Watsco employs the serial acquirer model to slowly consolidate a fragmented industry.
Watsco has spent the last 40 years adding bolt-on businesses, expanding capabilities, improving scale, taking out competition, and strengthening its hold on the industry it now leads.
The company has acquired around 70 businesses since 1989, creating a unified constellation of US distribution.
With too many ways to win, Watsco almost can’t help but to grow its revenue, profit, and dividend over the coming years.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Watsco has increased its dividend for 13 consecutive years.
Its 10-year dividend growth rate of 15.4% is impressive.
Better yet, Watsco has been able to maintain double-digit dividend growth in a very consistent manner, with even the most recent dividend raise clocking in at 10%.
What’s especially incredible in this case is that this double-digit dividend growth comes on top of the stock’s market-smashing 4.4% yield.
I almost never see a 4%+ yield and 10%+ dividend growth paired together.
This current yield, by the way, is 170 basis points higher than its five-year average, indicating a favorable time to consider jumping in.
The one issue with Watsco’s dividend profile is the payout ratio.
The dividend is currently sucking up more than 100% of TTM EPS, and it’s currently just barely covered by FCF.
Ordinarily, I’d be very concerned about the dividend.
However, Watsco has some idiosyncratic factors supporting this policy, which I’ll discuss later.
It’s worth noting that Watsco has had this aggressive dividend policy for many years now, so it’s not new or suddenly unsustainable, but those who demand more safety will likely need to look elsewhere.
Other than the payout ratio, the dividend profile is fantastic.
Revenue and Earnings Growth
As fantastic as it may be, though, it’s anchored in the past.
However, investors must always be anticipating the future, as the capital of today is risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be incorporated in the valuation process.
I’ll first show you what the business has done over the last ten years in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this way should allow us to judge where the business could be going from here.
Watsco moved its revenue from $4.2 billion in FY 2016 to $7.2 billion in FY 2025.
That’s a compound annual growth rate of 6.2%.
Solid top-line growth here, especially when considering Watsco’s size in absolute terms, but the company’s acquisitive nature means this isn’t totally organic.
Meantime, earnings per share grew from $5.15 to $12.25 over this period, which is a CAGR of 10.1%.
That’s strong and provides evidence that Watsco’s roll-up strategy is working and resulting in accretive bottom-line growth for the business.
To that point, margins are up handsomely over the last decade.
And it’s clear to see that double-digit EPS growth is what’s been fueling double-digit dividend growth; again, Watsco has been passing along essentially all growth directly to the shareholders.
A cautious point here, though, is that EPS recently topped out in 2022.
Watsco is still digesting a post-pandemic hangover after an abnormal explosion in demand led to sales getting pulled forward, which has led to the company being unable to grow EPS for three years.
However, the long-term structural positioning of the firm remains strong, even if temporary cyclical pressures are present.
The US is extremely short on housing, and a catch-up in supply to meet demand over the coming years will put Watsco in the right place at the right time.
As the largest distributor of HVAC/R equipment, it stands to capture a disproportionate amount of business from a recovery that is almost inevitable at this point.
Looking forward, CFRA believes that Watsco will deliver flattish EPS growth over the near term.
CFRA’s forecast for 2027 operating EPS of $13.07 would only be a modest jump off of the $12.25 for 2025.
Watsco is being bogged down by elevated interest rates and below-trend new starts.
On the other hand, CFRA notes that more than 90 million installed HVAC systems across the US have been in service for more than 10 years and are nearing the end of their useful lives.
When you have that alongside the pent-up and growing issues in core US housing, it looks like Watsco could have two coiled springs ready to viciously uncoil in its favor over the coming years.
Throughout this challenging period, shareholders should be comforted by the fact that the business has a steady hand in the form of Albert H. Nahmad, who founded the company in its current iteration and has run the company as CEO since 1972.
Circling back around to that point I made earlier about the idiosyncratic nature of the high payout ratio, Nahmad has significant personal economic ownership and voting power through nearly 77% ownership of the company’s Class B shares.
Nobody could be more interested in cash returns than Nahmad himself.
This is an owner-operated firm with lots of shareholder alignment and management “skin in the game”, which is something I always look for and love to see.
Financial Position
Moving over to the balance sheet, Watsco has a stellar balance sheet.
The company has no long-term debt.
Moreover, it ended last fiscal year with nearly $800 million in cash.
Watsco has ~6% of its market cap in net cash, which provides awesome flexibility.
Also, Watsco has been able to more than 10x its cash over the last decade – all while maintaining that high payout ratio straight through.
Again, this is why I have such an unusually sanguine attitude toward the payout ratio.
Profitability is fantastic.
Return on equity has averaged 23.5% over the last five years, while net margin has averaged 6.4%.
ROIC is typically around 20%.
Generating such high returns on capital without leverage, during a tough period, is highly impressive.
We can only imagine what an unconstrained Watsco could do.
Also, the margins here are fat for a distributor.
Watsco was doing net margin closer to 4% a decade ago, so there’s been plenty of expansion as Watsco has scaled up and taken out competition.
Overall, Watsco is a world-class business that has positioned itself incredibly well for an eventual recovery in housing and HVAC/R.
And with unrivaled economies of scale, exclusive distribution rights, its ongoing consolidation of a fragmented industry, and proprietary technology across its vast network, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The business is highly exposed to interest rates and economic cycles, both of which feed through into housing demand and large-scale purchases, but HVAC/R generally has inelastic demand characteristics in terms of replacements.
Housing stock in the US remains well short of what’s needed to meet market demand, which limits Watsco’s ability to realize its full potential.
The industry has low barriers to entry, although exclusive contracts with OEMs puts Watsco one step ahead of would-be competitors.
Although Watsco is mostly a domestic operation, some international business exposes the company to currency exchange rates and geopolitics.
The succession plan is currently unknown, but Watsco’s decentralized model is set up to thrive through that process.
I see some risks present, but many of these are temporary and situational.
However, the valuation has already compressed heavily after a ~40% drawdown and doesn’t seem to account for a recovery…
Valuation
The P/E ratio is now at 25.5.
While that seems high at first glance, it’s based on depressed earnings.
A Watsco at full flight earns much more, which would result in a higher E (which would also almost certainly get rewarded with a higher P).
Furthermore, this is below its own five-year average P/E ratio of 27.6.
The cash flow multiple of 18.4 is quite reasonable, especially considering the near-term lid on the business, and that’s also below its own five-year average of 19.4.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
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%.
I’m coming in at half of what Watsco has delivered over the last decade, and this is also far lower than more recent proven dividend growth out of the business.
What gives?
It’s not the growth rate, quality, or durability of the business that makes me cautious; rather, it’s the extremely high payout ratio, which restricts dividend growth beyond what the business itself puts out.
Granted, Watsco has a healthy amount of cash, and it can burn some off in pursuit of generous dividend raises, but the acquisitive nature of the firm competes for that capital.
I think Watsco can easily grow at a high-single-digit rate over the coming years, but I’d actually like to see a lower dividend growth rate in order to compress that payout ratio and create a healthier dividend profile.
That’s where the buffer comes in.
With the yield already being as high as it is, this kind of dividend growth would provide a satisfying total package anyway.
The DDM analysis gives me a fair value of $470.80.
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.
Watsco is a former darling in the midst of a ~40% drawdown, which I think has created an attractive valuation.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 WSO as a 5-star stock, with a fair value estimate of $441.00.
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 WSO as a 3-star “HOLD”, with a 12-month target price of $340.00.
I’m close to where Morningstar is at on this one. Averaging the three numbers out gives us a final valuation of $417.27, which would indicate the stock is possibly 30% undervalued.
Bottom line: Watsco, Inc. (WSO) is a high-quality, founder-led HVAC leader employing the serial acquirer playbook to great effect. Its industry is in the doldrums right now, but it’s positioned to disproportionately benefit from a recovery on the other side. With a market-smashing yield, double-digit dividend growth, an elevated but explainable payout ratio, nearly 15 consecutive years of dividend increases, and the potential that shares are 30% undervalued, this could be a great opportunity for long-term dividend growth investors to snag a former darling after a massive drawdown.
-Jason Fieber
Note from D&I: How safe is WSO‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, WSO’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Disclosure: I’m long WSO.
