The ironic thing about get-rich-quick schemes?

They tend to do the complete opposite of what they’re advertising.

Instead of getting rich, participants usually end up worse than they were before.

And that’s not even to mention the opportunity cost taken on through participation, whereby one doesn’t take the better road and misses out on what could have been.

This is why I’m much more interested – and actively participating – in the idea of getting rich slowly but surely.

When you take your time and build something real and lasting, you end up in a much stronger position that you can enjoy and appreciate.

This is why, for the last 15 years, I’ve been using the dividend growth investing strategy – a long-term strategy involving buying and holding shares in world-class businesses showering shareholders with steadily rising cash dividends.

In order to sustain ever-larger cash dividend payouts, a business almost has to be great.

It’s awfully difficult to run a terrible business (which is probably in decline) and simultaneously afford to send out more and more cash to shareholders.

You can see what I mean by pulling up the Dividend Champions, Contenders, and Challengers list.

This list has curated information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.

As you can see, it’s the “cream of the crop”.

Like I said earlier, I’ve been using this strategy for myself for 15 years.

What’s it done for me?

Well, it’s guided me as I’ve gone about building the FIRE Fund.

That’s my real-money portfolio which generates more than enough five-figure passive dividend income for me to live off of.

It’s been so spectacularly effective for me, I was able to retire in my early 30s.

That’s something I detail in my Early Retirement Blueprint.

Now, there’s more to dividend growth investing than just investing in the right businesses.

There’s also the matter of investing at the right valuations.

See, price is only what you pay, but it’s value that you ultimately 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.

Avoiding get-rich-quick schemes (which will instead almost certainly result in becoming poor) in favor of slowly accumulating undervalued high-quality dividend growth stocks can lead to an abundance of wealth, passive dividend income, and financial freedom over time.

The preceding information on valuation does, of course, assume a basic understanding of the mechanics of valuation.

If that understanding is not yet in place, no worries.

We’ve got a great resource for you.

Lesson 11: Valuation, written by fellow contributor Dave Van Knapp, shares the ins and outs of valuation using simple terminology and even provides a template you can use on your own.

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 $17 billion (by market cap) distribution giant that employs approximately 7,000 people.

This is the largest US distributor of HVAC/R equipment, along with related parts and supplies.

Operating out of nearly 700 locations across 40+ states, Canada, Mexico, and Puerto Rico, Watsco sells to contractors and dealers that serve the new construction and replacement markets.

Watsco generates 70% of revenue from sales of equipment.

Multiple joint ventures with Carrier Global Corp. (CARR) has given Watsco exclusive distribution rights for equipment from the US’s largest OEM.

While the domestic housing market has been mostly frozen in recent years due to interest rates and other factors, limiting new construction opportunities, Watsco has multiple levers to pull over the long run to grow and produce fantastic results for investors.

There’s first the organic growth, stemming from both new construction (which must pick up in coming years in order to close the supply-demand gap) and replacements.

Regarding the former, the US is short millions of homes; as the deficit is reduced in coming years, all of 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 HVAC/R.

In addition to organic growth, 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, and strengthening its lock on the industry it now leads.

The company has acquired something like 70 businesses since 1989, creating a unified constellation of US distribution, all while maintaining a stellar balance sheet (which I’ll touch on later).

Simply put, Watsco has strong tailwinds blowing its way, setting the course for continued revenue, profit, and dividend growth over the coming years.

Dividend Growth, Growth Rate, Payout Ratio and Yield

To date, Watsco has increased its dividend for 13 consecutive years.

Its 10-year dividend growth rate is 15.4%, which is fantastic.

What’s especially great about Watsco is how relentless it’s been with double-digit dividend growth.

The dividend is increased by at least 10% in pretty much every year.

It’s a machine.

To this point, Watsco just increased its dividend by 10% only days ago.

On top of the double-digit dividend growth, the stock yields a market-beating 3.2%.

That’s a very strong yield to be had when you’re getting 10%+ dividend growth on top of it.

It’s not often that you see this kind of yield and growth combination.

This 3.2% yield, by the way, is 60 basis points higher than its own five-year average, making it a bit more juicy than it usually is.

The one thing to be aware of is that Watsco effectively pays out all of its net income to shareholders in the form of dividends, routinely pushing the payout ratio to 100%.

I think there are valid reasons for this, which I’ll touch on, but it’s something to be aware of.

Watsco has had this policy for many years now, so it’s not new or suddenly unsustainable, but those who want a bigger cushion may need to look elsewhere.

For those willing to accept the company’s decision to return all net income back to shareholders, it’s a terrific blend of income and growth that is hard to replicate elsewhere.

Revenue and Earnings Growth

As terrific as it may be, though, much of this is based on information from the past.

However, investors must always be thinking about the future, as today’s capital is risked for tomorrow’s rewards.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be utilized during the valuation process.

I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.

I’ll then reveal a professional prognostication for near-term profit growth.

Lining up the proven past with a future forecast in this way should allow us to sketch out with reasonable confidence where the business could be going from here.

Watsco grew 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%.

For the largest player in its field, this is a very strong rate of top-line growth; however, Watsco’s acquisitive nature has given a boost to this.

Meanwhile, earnings per share has increased from $5.15 to $12.25 over this period, which is a CAGR of 10.1%.

Excellent.

We can now see that double-digit EPS growth has been providing the fuel for all of that double-digit dividend growth.

We can also see excess bottom-line growth, indicating accretion when it comes to acquisitions as Watsco rolls its industry up.

The only issue here is that Watsco has been facing a tough stretch since a local topping out of EPS in 2022.

It’s still digesting a post-pandemic hangover after sales got pulled forward, which has resulted in the company unable to grow EPS for three years.

As rates come down and the US housing market unfreezes, I have no doubts that Watsco will see a normalization of its business.

The US remains in a sharp deficit of housing supply, 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 the recovery.

Looking forward, CFRA is forecasting that Watsco will compound its EPS at an annual rate of 4% over the next three years.

I’m mixed on this forecast.

On one hand, Watsco has faced three years of decline, which is extremely unusual for the business.

Watsco’s CEO called the recent environment “the most complicated in memory”.

That says a lot, and I can understand the pessimism out of CFRA.

However, I think the last few years of weakness only primes Watsco for a huge recovery over the coming years.

Indeed, CFRA notes that nearly 100 million HVAC systems in the US are over 10 years old, reaching the end of useful life.

Combining that replacement cycle with pent-up demand for US housing, generally, amidst a frozen market and supply deficit almost couldn’t set up Watsco any better over the next decade.

While the next year or so may still be slow, I see Watsco as positioned very favorably over the long run and would find it difficult to imagine anything less than a return to the status quo.

Seeing as how the status quo is double-digit EPS and dividend growth, that paints a very nice picture.

That’s a 3%+ starting yield and double-digit dividend growth, lining things up for a low-teens type of annualized total return profile.

Circling back around to that high payout ratio, I think a lot can be explained by the fact that Albert H. Nahmad, who founded the company in its current iteration, has run the company as CEO since 1972 and 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 cashflow out of Watsco than its CEO.

This is an owner-operated firm with lots of shareholder alignment and management “skin in the game”, which I love to see.

Notably, this is a rare situation where you have a high-quality compounder also offering a respectable yield.

The stock has compounded at nearly 16% annually over the last decade – and that’s with a recent drop in the stock.

If every investment I had compounded at 16%/year, I’d be a very happy camper.

Financial Position

Moving over to the balance sheet, Watsco has a stellar balance sheet.

The company has no long-term debt.

Furthermore, it ended last fiscal year with nearly $800 million in cash.

Watsco has nearly 5% of its market cap in net cash, which is just terrific.

I’d also like to point out that Watsco has been able to more than 10x its cash while maintaining that high payout ratio.

This illustrates just how strong the business is – and how well it’s being managed by its longtime CEO.

Profitability is outstanding.

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.

A peak Watsco is almost unbeatable.

Also, the margins here are pretty fat for a distributor.

Watsco was doing net margin closer to 4% a decade ago, so there’s been nice expansion here.

Overall, this is a world-class business that is perfectly positioned for a recovery in key markets over the next few years.

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.

While Watsco has risks, as every business does, this risk profile strikes me as being relatively benign.

And with the stock down more than 25% from recent highs, the valuation seems relatively benign…

Valuation

The stock is trading hands for a P/E ratio of 33.

While that’s on the higher end of what I’m typically covering, it’s actually sitting close to its own five-year average of 31.5.

That’s basically what the market has, on average, deemed to be a fair earnings multiple for Watsco, so it’s clear that this stock usually commands a very healthy premium.

I’m not the kind of investor who likes to pay premiums, but I can also understand the enthusiasm for a founder-led firm generating consistent double-digit growth and sky-high returns on capital without leverage.

That said, the sales multiple of 2.1 isn’t egregious at all, and that’s actually below its own five-year average of 2.3.

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%.

This dividend growth rate looks downright conservative when compared to Watsco’s demonstrated EPS and dividend growth over the last decade.

I mean, even the last dividend increase, announced only days ago, was 10%.

What gives?

Well, my caution is not rooted in the growth rate, quality, or durability of the business; rather, it’s the extremely high payout ratio, which restricts dividend growth beyond what the business itself does, is what makes me cautious.

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 also limits this avenue.

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.

With the yield already being where it’s at, a 7% dividend growth rate should be enough to satisfy most shareholders 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.

I think, despite some high multiples, the valuation, which is acceptable after a 25% drop, makes this stock at least worthy of consideration again after spending several years being way too expensive.

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 3-star stock, with a fair value estimate of $444.00.

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 $444.00.

Exact match from Morningstar and CFRA, which is rare, showing that both agree the stock looks slightly undervalued. Averaging the three numbers out gives us a final valuation of $452.93, which would indicate the stock is possibly 11% undervalued.

Bottom line: Watsco Inc. (WSO) is an owner-operated firm generating consistent double-digit growth and sky-high returns on capital without leverage. By employing the serial acquirer model to consolidate its fragmented industry, it’s created the largest OEM-backed distributor network out there. With a market-beating yield, double-digit dividend growth, a high but explainable payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 11% undervalued, this is a high-quality idea worthy of consideration again for long-term dividend growth investors.

-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 70. 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 Safe with an unlikely 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.