Undervalued Dividend Growth Stock of the Week: Microsoft (MSFT)

We are finally starting to emerge from the global pandemic.

The US is reportedly administering upward of 4 million vaccine doses per day.

At this rate, the US should have most adults vaccinated before summertime.

With the rest of the world following suit at haste, there’s plenty of cause for optimism.

In fact, some believe we’re in store for a Roaring Twenties redux.

The original Roaring Twenties came after the Spanish flu.

History might not repeat itself exactly, but it does often rhyme.

And if we are about to rhyme, that could be great news for investors.

I think it could be particularly great news for dividend growth investors.

That’s because the dividend growth investing strategy focuses an investor on only the best businesses out there.

The Dividend Champions, Contenders, and Challengers list says it all.

That invaluable resource lists more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

As you might imagine, it takes a special kind of business to be able to pay out reliable, rising dividends for years on end.

And that’s why I’ve been taking advantage of this strategy for more than a decade, building my FIRE Fund in the process.

That’s my real-money stock portfolio.

It produces the five-figure passive dividend income I live off of.

Indeed, I was able to retire in my early 30s.

And I describe in my Early Retirement Blueprint how I used this strategy to accomplish that.

But as great as the dividend growth investing strategy is, an investor has to pay attention to what they’re buying and what they’re paying for it.

That doesn’t mean paying attention only to price, though.

Price only tells you what you’re paying. 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.

Loading up your portfolio with undervalued high-quality dividend growth stocks could position you incredibly well for the coming decade – and beyond.

Fortunately, valuation isn’t a terribly complex concept.

Fellow contributor Dave Van Knapp has greatly simplified it via his Lesson 11: Valuation.

As part of a series of “lessons” on dividend growth investing, it provides a valuation model that you can easily apply to almost any dividend growth stock out there.

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…

Microsoft Corporation (MSFT)

Microsoft Corporation (MSFT) is a global technology company that provides a range of hardware and software products and services.

Founded in 1975, Microsoft is now a $1.9 trillion (by market cap) technology leviathan that employs more than 160,000 people.

FY 2020 revenue can be broken down across the following three business segments: Intelligent Cloud, 34%; More Personal Computing, 34%; and Productivity and Business Processes, 32%.

Some of the company’s primary products and services include Windows operating software, Azure intelligent cloud, Office software, the Xbox gaming system, LinkedIn, and Surface computers and tablets.

In a world that’s quickly becoming dominated by technology, Microsoft has become one of the very biggest and best technology companies.

Once heavily reliant on software through their massively popular Windows OS, Microsoft has adeptly transformed itself into a major player in areas like enterprise solutions, networking, cloud computing, gaming, and even entire computer systems.

Moreover, its breadth is only increasing.

They’ve broadened out their gaming strategy with the recent $7.5 billion acquisition of ZeniMax Media, which is the parent company of game publisher Bethesda Softworks. This gives them more content production power in an industry that has a bright future – gaming is an industry that’s bigger than Hollywood at this point.

Adding to their suite of offerings in that area, the company is also reportedly in discussions to acquire Discord – a group-chat that’s often used for livestreaming games.

Simultaneously to this gaming buildout, Microsoft is also scooping up tech contracts with the US military.

One of the world’s biggest technology companies is also becoming a major defense contractor. That’s a gamechanger.

Microsoft recently announced that it signed a $22 billion contract with the US Army to provide HoloLens augmented reality headsets. That’s on top of the $10 billion JEDI contract Microsoft won in 2019 (which is currently being fought in court).

All of this bodes incredibly well for Microsoft to defy the gravity of its huge size and continue growing its profit and dividend at a brisk pace.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Microsoft has increased its dividend for 19 consecutive years already.

The 10-year dividend growth rate of 14.3% offers plenty to like.

And with a payout ratio of 33.3%, this dividend is extremely safe.

I see plenty of dividend growth ahead.

However, the stock’s low yield of 0.90% does leave something to be desired.

It’s not an income play. This is instead a long-term compounder, which makes it perfect for younger investors who have time to let that compounding process play out.

These dividend metrics are some of the best you’ll find. I think Microsoft has the safest dividend in the world.

Revenue and Earnings Growth

But as great as the numbers are, it’s those future dividend payments we care most about.

Investors are risking today’s capital for tomorrow’s returns.

Thus, I’ll now build out a forward-looking growth trajectory for Microsoft, which will later help us to estimate the stock’s intrinsic value.

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

Then I’ll compare that to a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this way should give us a very good idea as to what the growth path looks like.

Microsoft grew its revenue from $69.943 billion in FY 2011 to $143.015 billion in FY 2020.

That’s a compound annual growth rate of 8.27%.

Now, not all of this growth was organic. Microsoft has been acquisitive. The 2016 $26.2 billion acquisition of LinkedIn is particularly notable.

However, I still see this as a very impressive rate of top-line growth for a large business like this. To compound a revenue base of almost $70 billion at more than 8% annually is herculean.

Meanwhile, earnings per share increased from $2.69 to $5.76 over this period, which is a CAGR of 8.83%.

Share buybacks helped to propel some of this excess bottom-line growth: Microsoft reduced the float by 10.5% over the last decade.

This would be impressive EPS growth for any business. It’s particularly impressive for a business of this size.

But wait. There’s more.

Microsoft is in many ways a much better business today than it was a decade ago. And their growth is actually accelerating.

If we look at EPS growth over just the last five years, EPS compounded at an annual rate of more than 22%!

Satya Nadella took over as CEO in 2014, and he’s performed nothing short of miracles.

Looking forward, CFRA is forecasting that Microsoft will compound its EPS at an annual rate of 21% over the next three years.

That would be right in line with what Microsoft has done over the last five years.

Furthermore, their most recent quarter (Q2 FY 2021) showed an amazing 34% YOY increase in EPS. This was largely driven by Microsoft’s key cloud platform Azure, which showed 50% YOY revenue growth.

Cloud computing is a megatrend. Amazon.com, Inc. (AMZN) runs market leader AWS, but Azure is second in the marketplace and closing in.

Meanwhile, Microsoft commands an estimated 83% global market share for PC operating systems. As global computing goes, so goes Microsoft.

I view CFRA’s forecast as reasonable. Ordinarily, it’d be hard to accept this kind of growth projection from a company that’s working with such massive numbers – the law of large numbers would seemingly limit them. But Microsoft is one of those rare, exceptional businesses.

This kind of growth can easily fund double-digit dividend growth for the foreseeable future, especially in light of the payout ratio being so low.

Financial Position

Moving over to the balance sheet, the company maintains one of the cleanest financial positions I’ve ever seen.

Their long-term debt/equity ratio is 0.50, while the interest coverage ratio is over 21.

Furthermore, the company has over $135 billion in total cash on the balance sheet.

That’s larger than the market cap of many Fortune 500 companies, and it covers the long-term debt more than twice over.

This is why it’s one of only two companies in the world with a credit rating of AAA from Standard & Poor’s.

Profitability is extremely robust, as you might expect.

Over the last five years, the firm has averaged annual net margin of 23.72% and annual return on equity of 30.50%.

Microsoft is almost the perfect business. It’s practically flawless. And as difficult as it might be to believe, their best days are likely yet ahead.

Plus, the company is protected by durable competitive advantages that include global scale, switching costs, patents, R&D, and IP.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

Their very business model is in some ways a risk. Technology changes fast. And large companies can become disrupted. Microsoft must remain flexible and adaptive.

As broad as the business is, they missed the boat in several huge addressable markets. Mobile is an example.

The sheer size and maturity of the business is also a risk. At some point, it would seem that their absolute size will limit relative growth.

Overall, I’m highly optimistic about Microsoft’s long-term prospects.

That optimism is somewhat bolstered by the valuation, which isn’t as high as it arguably should be…

Stock Price Valuation

The stock’s P/E ratio of 36.92 might look high at first glance.

But one of the very best businesses on the planet deserves a high multiple.

If CFRA’s EPS growth forecast holds true, the PEG ratio is well below 2.

In addition, this P/E ratio isn’t far away from Microsoft’s own five-year average P/E ratio of 36.4.

Paying a premium compared to where it’s typically been, on average, over the last five years doesn’t strike me as imprudent.

That’s because the company is clearly firing on all cylinders and in many ways better now than it was at any point over the last five years.

I’ve been hearing investors complain about Microsoft’s valuation for years. All the stock has done is climb higher – it’s up more than 350% over the last five years – causing many to miss the boat.

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.

The two-stage analysis accounts for a current high rate of growth and the eventual slowing.

I factored in a 10% discount rate, a 15-year dividend growth rate of 15%, and a long-term dividend growth rate of 8%.

This DDM analysis assumes that the 10-year dividend growth rate repeats itself for the next 15 years.

That’s not unreasonable when looking at the recent EPS growth, near-term growth forecast, low payout ratio, and incredible balance sheet flexibility.

If Microsoft could manage near-15% dividend growth over the last decade, I see no reason why they can’t do at least that well over the next 10+ years.

The terminal dividend growth rate of 8% is at the top end of what I usually allow for. But if there’s any business that earns the benefit of the doubt, it’s this business.

The DDM analysis gives me a fair value of $284.46.

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.

The stock’s valuation doesn’t seem undemanding from where I’m sitting.

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 MSFT as a 3-star stock, with a fair value estimate of $263.00.

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 MSFT as a 5-star “STRONG BUY”, with a 12-month target price of $280.00.

I came out almost exactly where CFRA is at. Averaging the three numbers out gives us a final valuation of $275.82, which would indicate the stock is possibly 11% undervalued.

Bottom line: Microsoft Corporation (MSFT) is one of the highest-quality and most impressive businesses I’ve ever seen. Despite their sheer size, they’re growing faster than ever and getting better as they get bigger. With an extremely low payout ratio, double-digit dividend growth, 19 consecutive years of dividend raises, and the potential that shares are 11% undervalued, this dividend growth stock is perfect for investors who have time to let it magically compound their wealth and passive income for them.

-Jason Fieber

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.

Note from D&I: How safe is MSFT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, MSFT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.