They say youth is wasted on the young.
We can take that in a lot of ways.
But I think a lot of it boils down to young people not fully appreciating and taking advantage of the time they have.
I’d know firsthand, as I wasted most of my first 30 years.
However, once I finally got in gear and gained some traction, I moved with a sense of urgency.
Fortunately, before it was too late, I realized how invaluable that time was – particularly in the sense of investing and how compounding plays out when you give it some time.
What totally changed my life was finding dividend growth investing in my late 20s.
Dividend growth investing is a long-term investment strategy which advocates buying and holding shares in world-class businesses paying out safe, growing cash dividends to shareholders.
You can find hundreds of such businesses by taking a look at 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.
A key reason why this strategy works so well is that it limits investors to those businesses great enough to generate the steadily growing profit necessary to sustain steadily growing cash dividend payouts, and great businesses tend to make for great long-term investments.
Furthermore, those growing dividends can be the solid bedrock underpinning financial independence.
This is also something I’d know firsthand, as I used this strategy to achieve financial independence and retire in my early 30s.
The FIRE Fund, which is my real-money portfolio, generates enough five-figure passive dividend income for me to comfortably live off of.
If you’re curious as to how such an early retirement is possible, be sure to read my Early Retirement Blueprint (it lays it all out for you).
Now, great businesses paying you ever-larger dividends can take you far in life – especially if you start early.
However, that’s not the whole story.
There’s also the matter of valuation at the time of making any investment.
And that’s because while price is what you pay, value is what you 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.
Making sure you don’t waste your most valuable asset (time) by steadily acquiring undervalued high-quality dividend growth stocks as soon as possible is a great way to set yourself up for immense wealth, passive dividend income, and financial freedom.
Now, the preceding verbiage on valuation might come across as confusing to those who aren’t already familiar with the concept.
Well, fear not.
That’s where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp as part of a series of “lessons” designed to teach the dividend growth investing strategy, it simplifies the valuation concept and provides tools for anyone out there to use and confidently estimate the fair value of almost any dividend growth stock you’ll run across.
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 Corp. (MSFT)
Microsoft Corp. (MSFT) is an American multinational technology company.
Founded in 1975, Microsoft is now a $3.1 trillion (by market cap) tech behemoth employing approximately 230,000 people.
FY 2025 revenue can be broken down across the following three business segments: Productivity and Business Processes, 43%; Intelligent Cloud, 38%; and More Personal Computing, 19%.
Microsoft is an incredibly diversified technology machine.
It could almost be thought of as a tech ETF rolled up in a single company.
A sampling of some of its products and services are: Windows operating system, Azure intelligent cloud, Copilot, Office 365 software subscriptions, Microsoft Teams, the Xbox gaming system and its related ecosystem, LinkedIn, and Surface computers and tablets.
In addition, Microsoft owns around 1/4 of fast-growing OpenAI, giving the company a huge foothold in AI.
By the way, Microsoft has invested $13 billion into OpenAI, which is now worth north of $130 billion – a ten-bagger already for Microsoft, which is incredible and just goes to show the company’s ability to allocate capital at scale.
There are so many ways for Microsoft to win and make money here.
Starting off as primarily an operating system purveyor, Microsoft has parlayed that early success (and cashflow) into enterprise solutions, networking, cloud computing, gaming, entire computer systems, and now artificial intelligence.
It has exposure to almost every major technology theme that exists.
The breadth is stunning.
And so is the company’s ability to grow its revenue, profit, and dividend – at scale that is almost unprecedented.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Microsoft has increased its dividend for 24 consecutive years.
It’s on track to become a Dividend Aristocrat next year.
Back when I first started investing in 2010, technology companies were looked at as somewhat unreliable – particularly in terms of sustained dividend growth.
My, how times change!
The company’s 10-year dividend growth rate of 10.2% is both solid and extremely consistent.
Its five-year dividend growth rate is also 10.2%.
To say that Microsoft has been reliable around dividend payments and dividend raises is a huge understatement.
With the payout ratio sitting at 21.7%, the dividend is about as safe as it’s ever been.
In fact, the dividend hasn’t been growing as fast as the business, creating an extra cushion and room for more aggressive dividend hikes in the future.
The only drawback is the stock’s yield, which is currently sitting at a lowly 0.9%.
Still, that is 10 basis points higher than the stock’s five-year average yield.
For those who are more in need of immediate income (such as retirees), this stock doesn’t really work (nor has it ever worked), but for those who appreciate the long-term power of compounding out of a world-class business, there’s little to dislike about anything related to Microsoft’s dividend profile.
Revenue and Earnings Growth
As likable as it may be, though, this dividend profile is largely built using information from the past.
However, investors must always be anticipating future information, as today’s capital ultimately gets risked for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when the time comes later to estimate fair value.
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.
Lining up the proven past with a future forecast in this manner should allow us to reasonably gauge where the business could be going from here.
Microsoft advanced its revenue from $91.2 billion in FY 2016 to $281.7 billion in FY 2025.
That’s a compound annual growth rate of 13.4%.
To compound revenue this quickly when it’s coming off of $90+ billion base is almost unbelievable.
Now, Microsoft did have some acquisitions in this time period, including LinkedIn (for $26.2 billion) in 2016 and Activision Blizzard (for $68.7 billion) in 2023.
Still, the needle was mostly moved from internal, organic growth.
Earnings per share increased from $2.10 to $13.64 over this period, which is a CAGR of 23.1%.
Very, very impressive.
Any company being able to compound its bottom line at north of 20% per year is terrific, but doing it at this scale is a different beast.
Superlatives almost fall short.
Consistent buybacks (Microsoft reduced its share float by about 7% over the last decade) and margin expansion combined to help drive excess bottom-line growth.
Looking forward, CFRA sees Microsoft compounding its EPS at an annual rate of 22% over the next three years.
That’s roughly in line with what Microsoft did over the last decade, except Microsoft is now starting with a revenue base nearly three times higher than it was 10 years ago (making a consistent growth rate this high at this level of scale astonishing).
Balancing things out, I think CFRA’s stance is reasonable.
On one hand, it only gets more challenging to compound as the numbers get larger.
On the other hand, Microsoft has even more opportunities today than it did 10 years ago.
AI, which might be its largest opportunity right now, is something that actually requires massive scale on the investment/spending side, which behooves the likes of Microsoft.
Said another way, the opportunities have scaled with Microsoft.
CFRA notes that Microsoft has a complete AI stack, ranging from from infrastructure (e.g., cloud computing) to applications (e.g., agentic AI through Copilot), meaning Microsoft can monetize AI in every possible way on both the supply and demand side.
And I don’t see much of a threat from AI on the software side, either, meaning it’s almost a one-way street for the company.
The company’s OS is too big, complex, integrated, and supported for companies to try to code something internally on an individual basis.
The very idea of that is absurd.
Moreover, Microsoft’s enterprise OS is almost a monopoly, with very little direct competition, and the switching costs makes it very sticky once installed.
Since this software is fee-based licensing with highly visible and recurring revenue, this is a cash cow for Microsoft.
With the business growing this fast, and with the payout ratio being so low, the dividend could easily grow at a low-double-digit rate from here – even as Microsoft reinvests into the business, reinforces its offerings, and broadens its capabilities across the stack.
This is an unusual situation where mid-teens dividend growth would actually result in a low payout ratio compressing further.
It’s very unique and very appealing, especially for dividend growth investors who have the delayed gratification gene and the ability to let an investment blossom over time.
Financial Position
Moving over to the balance sheet, Microsoft has a stellar financial position.
While its long-term debt/equity ratio of 0.1 and interest coverage ratio of over 55 go a long way toward indicating extreme financial solvency and prudence, they don’t go far enough.
That’s because Microsoft actually has net cash on the balance sheet adding up to more than $50 billion (as of the end of last fiscal year).
In fact, Microsoft is one of only two publicly-traded companies to hold a coveted AAA credit rating from S&P.
The balance sheet is a fortress.
Profitability is outstanding.
Return on equity has averaged 40.7% over the last five years, while net margin has averaged 35.9%.
ROIC is also routinely in the 30% area.
To generate returns on capital this high with net cash is almost beyond words.
Put simply, summing it up, Microsoft is a world-class company with some of the best fundamentals I’ve ever seen.
And with economies of scale, a virtual monopoly in sticky enterprise OS, network effects, switching costs, a rare ability to spend/invest billions on tech, and duopoly/oligopoly economics in every key business area outside of OS, 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.
Regulation might be the biggest challenge of those three, as Microsoft (and Big Tech, in general) is constantly facing regulatory headaches globally as a visible and lucrative target.
Microsoft is investing extremely heavily into AI, which is an unproven technology with unquantifiable returns on investment.
There’s a risk, albeit currently highly unlikely, that AI is one day able to eat into Microsoft’s lucrative OS business, which would be a huge problem.
The company’s sheer size would seem to introduce the law of large numbers at some point, as its size and saturation are usually headwinds, but Microsoft has been able to navigate this beautifully.
Microsoft relies on acquisitions to drive growth, enter new markets, and set up opportunities, which means capital allocation, integration, and execution are recurring challenges.
The very business model is a risk unto itself, as technology companies must constantly innovate and stay ahead of the curve in order to not get left behind and become obsolete over time.
Microsoft has made a large investment in OpenAI, but it lacks direct control over this investment.
Being an international company, Microsoft has exposure to geopolitics and exchange rates.
There are some risks here, but many of them (other than AI) have been around for years – all while Microsoft has produced extraordinary results.
What is new, however, is how lowly the market is valuing the business…
Valuation
The P/E ratio is now sitting at 24.1.
That’s the lowest it’s been in at least a decade.
For a company generating 20%+ EPS growth and 40%+ ROE, this earnings multiple is shockingly low.
That puts the PEG ratio at right about 1 – a level usually reserved for names that do not have this much quality and visibility.
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 discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 15%, and a long-term dividend growth rate of 8%.
Now, Microsoft clearly has the wherewithal to grow the dividend at a mid-teens rate over the near term.
In fact, like I said earlier, this is a very rare situation in which 15% dividend growth would actually likely result in the compression of the payout ratio (because the business is growing even faster than 15%, and it’s forecasted to continue doing so).
While it has the wherewithal, the only question is whether or not it has the willingness.
I think a lot of that will come down to how much Microsoft decides to invest in AI, as well as how much of an ROI it’s seeing from its investments.
Factoring out the heavy CapEx cycle we’re in now (Microsoft is guiding for nearly $200 billion this year alone), I’d feel very confident in mid-teens dividend growth cranking up almost immediately, but the spending may pull this down.
Either way, I can’t imagine the dividend growth not being made good at some point, even if it’s delayed for a year or two while Microsoft cements its place in AI.
There’s too much business growth and too low of a payout ratio.
The DDM analysis gives me a fair value of $353.44.
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.
In my estimation, this stock has finally started to at least become somewhat reasonable again after its 20% drawdown since last summer.
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 5-star stock, with a fair value estimate of $600.00.
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 $480.00.
I came out super low this time. I just can’t get to where these two firms are at on this one. Averaging the three numbers out gives us a final valuation of $477.81, which would indicate the stock is possibly 15% undervalued.
Bottom line: Microsoft Corp. (MSFT) isn’t just one of the biggest companies in the world; it’s one of the best companies in the world. From AI to cloud to gaming, the company has multiple very large growth levers at its disposal. With a market-like yield, an extremely low payout ratio, double-digit dividend growth, nearly 25 consecutive years of dividend increases, and the potential that shares are 15% undervalued, this soon-to-be Dividend Aristocrat is low-hanging fruit for long-term dividend growth investors looking to increase their exposure to tech.
-Jason Fieber
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.
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 MSFT.
