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Summary

  • Microsoft currently offers a 2.8% yield that is covered nearly three times by its free cash flow.
  • Microsoft's dividend has increased each year over the last four years at an average annual rate of 21%.
  • With a 36% free cash flow payout ratio, and high single-digit earnings per share growth forecasts, Microsoft should be able to maintain double-digit dividend increases in the near term.

Dividends can be a very important component of an investor's total return. Heck, dividends accounted for 42% of the stock market's return from 1930 to 2012. Dividends can provide downside protection and may even create a price floor for some stocks.

Many investors prefer dividend-paying stocks that increase their dividends every year at a rate above inflation in order to create a nice income stream that they can draw upon in later years. These investors will typically spread their risk out among a variety of different sectors.

Today, let's consider a dividend opportunity in the technology sector by looking at the dividends from Microsoft (NASDAQ:MSFT). Let's see how the dividend of Microsoft stacks up in terms of strength, sustainability, and potential for growth going forward. While many seasoned investors may consider such an analysis as determining the obvious, this analysis does provide a framework by which the dividends of any stock can be evaluated.

Dividend Yield

The dividend yield is usually the first metric that investors think of when it comes to evaluating the health of a company's dividend. After all, it represents the percentage of your investment that you will receive back over the next 12 months.

Microsoft currently yields 2.8%. This is a forward yield that is based on its most recent quarterly payout of $0.28 per share. Its current yield is near its 5-year high of 3.1%. Over the last 5 years, the company's dividend yield has ranged between 1.7% and 3.1%.

Dividend Growth

While it's nice to see a strong dividend yield, you want to make sure that the dividend will rise over time in order to protect your income stream from inflation. This is one of the main reasons why dividend growth stocks are very popular. Dividend growth can also serve as a signal from management that it is confident in the company's prospects.

Microsoft has increased its dividend in each of the last four years, at an average annual rate of 21%. This was after the company kept the dividend steady between 2009 and 2010. Microsoft has paid a dividend each year, going back to 2004. While dividend increases on the order of 20% or more can't be expected to go on forever, it is safe to say that dividends from Microsoft are trouncing inflation at the moment.

Free Cash Flow Payout Ratio

High dividend yields and strong dividend growth are all well and good, but investors need to make sure that the company is generating enough free cash flow to cover their dividend payments. Otherwise, investors may see dividends either freeze or get cut, which can hurt the value of their investment. The free cash flow payout ratio shows how much of the company's free cash flow is being eaten up by dividend payments. Lower free cash flow payout ratios are better, as they leave more room for future dividend increases along with more value-creating activities.

Free cash flow is defined as the company's cash flow generated by operations minus its capital expenditures over a 12-month period.

Over the last 12 months, Microsoft has paid out just 36% of its free cash flow to shareholders in the form of dividends. Given that this payout ratio covers the last 12 months, and that Microsoft just increased its dividend last fall, I would expect this ratio to rise modestly after four quarters at the current level of payout.

The company's average free cash flow payout ratio over the last four full fiscal years is 23.5%. This shows that the company's recent dividend growth has outpaced its free cash flow growth, but at just 36% of free cash flow, Microsoft's current dividend looks very safe.

Interest Coverage Ratio

An important factor to consider is how debt might affect the company's dividend payouts in the future. More money spent on interest payments means less money left over for dividend payments. The interest coverage ratio can help you determine whether the company's debt might mess up your future income stream. It is calculated by dividing the company's earnings before interest and taxes (also known as EBIT) by the company's interest payments made over the last 12 months. If the ratio is less than 2, then that may be a problem going forward.

However, this is not a problem at all for Microsoft, as the company currently has no net interest expense. Its interest expense is more than offset by interest income and dividends from its investments. So, debt is not a factor at all when it comes to the sustainability of the dividends from Mr. Softy.

Earnings Per Share Growth Forecasts

While it can be very instructive to look at past dividend payouts and how they relate to past earnings, it's important to look ahead and see if the company can keep its profit engine humming along in order to continue supporting its dividend payments.

One way in which we can do that is by looking at analyst forecasts for earnings-per-share growth. During fiscal 2014, analysts on average currently expect Microsoft to increase its non-GAAP earnings per share by 2.2%, followed by an 8.2% increase in 2015. Over the next 5 years, the company is expected to grow earnings at an average annual rate of 8.5%.

If analyst forecasts hold true, then the company should not only be able to maintain its dividend going forward, but also increase it in the future.

Conclusion

Microsoft currently has a reasonably attractive dividend yield, and has shown a record of strong dividend increases over the last four years. With a free cash flow payout ratio of just 36%, and high single-digit earnings per share growth on the horizon, double-digit dividend increases may continue for the next few years, depending on how far management wishes to expand its free cash flow payout ratio.

Some may bring up the company's nearly $84B in cash and short-term investments, but the lion's share of this money is held by foreign subsidiaries, and is unlikely to be repatriated and paid out as dividends. However, some of this money may be used to help fund its foreign operations, allowing more of its cash flow from operations to be distributed to shareholders.

If you are an investor who is looking for a company with good dividend growth prospects in the technology sector, then Microsoft may be for you.

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.