Thousands of publicly-traded companies.
Multiple asset classes.
Social media algorithms screaming at you to look at this and that.
It can be hard to narrow things down and focus on the best and most sustainable long-term investment path.
This is why, in my view, dividend growth investing is as useful and valuable as ever.
It’s a long-term investment strategy that funnels investors into world-class businesses paying out steadily rising cash dividends.
And those steadily rising cash dividends are usually funded by – you guessed it – steadily rising profits.
You can find hundreds of examples of such businesses by pulling up the Dividend Champions, Contenders, and Challengers list – a compilation of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
In my experience, dividend growth investing quiets the noise, strips away the unnecessary, and points toward financial freedom.
I say this as someone who has used the strategy for 15+ years, allowing it to guide and inform me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio generating enough five-figure passive dividend income for me to live off of.
This has been enough for me to live off of ever since I quit my job and retired in my early 30s.
Now, dividend growth investing does involve more than simply investing in great businesses.
It also involves investing at great valuations.
Price is what you pay, but value is what 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.
Using the dividend growth investing strategy to focus on undervalued high-quality dividend growth stocks is a nearly foolproof way to build wealth, passive income, and freedom over time.
Of course, knowing whether or not something is undervalued first means there’s a basic understanding of valuation already in place.
If that’s not where you’re at, be sure to give Lesson 11: Valuation a read.
Written by fellow contributor Dave Van Knapp, it does a great job of breaking down valuation into easy-to-understand chunks and even provides a simple-to-use template.
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…
Lennox International, Inc. (LII)
Lennox International, Inc. (LII) is an American multinational provider of HVAC products.
Founded in 1895, Lennox is now a $14.5 billion (by market cap) HVAC leader employing more than 5,000 people.
The company reports results across two segments differentiating between residential and commercial applications: Home Comfort Solutions, 64% of FY 2025 sales; and Building Climate Solutions, 36%.
Approximately two-thirds of revenue is derived from replacements, whereas the remaining 25% comes from new construction.
More than 90% of revenue is generated from the US.
This business model is almost the epitome of “right place, right time”.
First, regardless of how it’s caused, empirical evidence suggests the world is warming, which gives rise to demand for this company’s products.
Second, demographic trends show that households in the US are migrating from north to south, reinforcing the need for HVAC systems.
Third, data centers, which are being built all over the world, require massive, specialized cooling systems, which Lennox has started to cater to.
Lennox almost can’t lose over the long run.
It simply has too many secular growth drivers already in place and strengthening.
This is why it’s almost a lock to continue growing its revenue, profit, and dividend for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Lennox has increased its dividend for 17 consecutive years.
Lennox has been a consistent dividend grower for nearly two decades already, which is impressive.
Its 10-year dividend growth rate of 14% is very strong, although more recent dividend raises have landed in the high-single-digit area.
The trade-off for the consistency and higher rate of dividend growth is the stock’s lowish yield of just 1.2%.
Still, that’s 20 basis points higher than its own five-year average, so the trade-off right now isn’t as bad as it usually is.
And with a payout ratio of only 24.6%, Lennox has plenty of headroom to continue aggressively growing the dividend.
These dividend metrics fit the pattern of a high-quality compounder: steady growth, low payout ratio, high dividend growth rate, and low starting yield.
If one has the time to let the compounding process play out as Lennox goes to work for them, this is a really nice setup.
Revenue and Earnings Growth
As nice as it may be, though, it’s mostly based on the past.
However, investors must always be concerned with the future, as the capital of today gets put on the line and risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be of use during 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.
And I’ll then reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this way should provide us with the capability to judge where the business could be going from here.
Lennox moved its revenue from $3.6 billion in FY 2016 to $5.2 billion in FY 2025.
That’s a compound annual growth rate of 4.2%.
Respectable top-line growth for a mature HVAC company.
This is right about what I’d expect, especially considering that Lennox is not particularly acquisitive.
Meantime, earnings per share rose from $6.32 to $22.79 over this period, which is a CAGR of 15.3%.
Excellent.
Excess bottom-line growth was driven by a combination of buybacks and margin expansion.
Regarding the former, the outstanding share count was reduced by more than 20% over this 10-year stretch.
Looking forward, CFRA is calling for Lennox to compound its EPS at an annual rate of 8% over the next three years.
While this is well off of what Lennox delivered over the prior decade, more recent results out of the business have been far less spectacular.
For its part, Lennox is guiding for $23.50 in EPS at the midpoint for FY 2026.
That would represent very little YOY growth.
Due to a variety of circumstances (such as labor shortages and regulatory hurdles), construction across the US, especially in terms of residential homes, is suboptimal and below potential.
This can affect Lennox more directly than competitors because of its greater reliance on residential business, although Lennox’s mix which overwhelmingly leans into replacement does bode well for the firm – regardless of trends around new starts.
Speaking of replacements, what’s great about that is the fact that air conditioning in large parts of the US is basically a non-discretionary need, so replacements are a consumer priority when old units fail.
Pulling it all together, I think CFRA’s forecast is reasonable.
That would create room for at least high-single-digit dividend growth over the coming years, by virtue of where the payout ratio is at.
It’s not the mid-teens dividend growth long-term shareholders have become accustomed to, but layering that new paradigm on top of the starting yield can get one to a low-double-digit type of annualized total return.
That’s not bad at all.
Financial Position
Moving over to the balance sheet, Lennox has a very good financial position.
Its long-term debt/equity ratio is 1, while the interest coverage ratio is over 22.
The former number is actually artificially high, as common shareholders’ equity is very low for a company of this size (because of the buybacks creating a treasury stock balance).
Moreover, Lennox commands investment-grade credit ratings of Baa1 from Moody’s and BBB from S&P.
Notably, Lennox’s balance sheet has not degraded over the last decade, despite the heavy repurchases.
Profitability is outstanding.
Although ROE is N/A due to the situation regarding shareholders’ equity, net margin has averaged 12.8% over the last five years.
ROIC is routinely north of 30%.
Lennox is a high-margin business generating high returns on capital.
Although the very near term looks a bit subpar, the long-term picture for this terrific enterprise is very bright.
And with economies of scale, brand recognition, pricing power, a large installed base, IP, R&D, and technological know-how, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Competition is very fierce in this specific industry, although only a handful of major players combine to control almost all market share.
Regulation hits Lennox both directly and indirectly (via the end markets it relies on).
Residential new starts remain challenged, reducing Lennox’s ability to sell new construction units.
The company has some exposure to geopolitics and exchange rates.
Input costs can be volatile, and the supply chain can add complexity.
Overall, the quality of the business would seem to make the risks worth the stretch.
And with the stock in the midst of a fresh 20%+ drawdown, the valuation makes it that much more worth it…
Valuation
The P/E ratio has recently dropped to 19.7.
That compares favorably to its own five-year average of 23.
The P/CF ratio of 15.8 is also meaningfully lower than its own five-year average of 19.5.
And the yield, as noted earlier, is 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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 12%, and a long-term dividend growth rate of 8%.
I’m assuming a more permanent slowdown in dividend growth relative to where things landed over the last decade, stepping things down gradually first into a low-double-digit range and then thereafter into a high-single-digit range.
Based on where the near-term EPS forecast is at, and based on the payout ratio flexibility, Lennox should be capable of delivering low-double-digit dividend growth over the short term.
After that, I’d assume a growth rate that is befitting of a mature HVAC company.
I view this as a very reasonable take on where Lennox is at and where it may be going.
The DDM analysis gives me a fair value of $411.91.
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.
My take is that this stock, which has historically been too expensive for my tastes, has entered a range of reasonableness after its recent 20%+ drawdown.
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 LII as a 4-star stock, with a fair value estimate of $560.00.
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 LII as a 3-star “HOLD”, with a 12-month target price of $470.00.
I came out low, despite a reasonable take on the prospects. Averaging the three numbers out gives us a final valuation of $480.64, which would indicate the stock is possibly 7% undervalued.
Bottom line: Lennox International, Inc. (LII) is a terrific HVAC business in the right place at the right time, with demographics, gradual warming, and compute cooling needs all playing right into its hands. With a market-like yield, double-digit dividend growth, a low payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 7% undervalued, the recent drawdown presents what looks like a rare opportunity for long-term dividend growth investors to get their hands on this name.
-Jason Fieber
Note from D&I:How safe is LII‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 90. 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, LII’s dividend appears Very Safe with a very likely 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 have no position in LII.
