Shares of Microsoft Corporation (MSFT) have returned only 4.6% over the past 12 months. At $28.21 per share, the stock is trading at around the mid-point of the 52-week trading range between $24.30 and $32.95 and offers an attractive dividend yield of 3.3%. Despite the almost flat one-year share performance, MSFT has been one of my core dividend investments given the stock's cheap valuations and decent dividend yield, which provide a solid margin of safety. In this article, I will elaborate the value and dividend analysis that supports my bullish view.
From a relative valuation perspective, MSFT is priced at an attractive discount based on the company's financial performance relative to its peers (see table below). Comparing to a peer group consisting of MSFT's comparable peers (see table below), growth potential seems to be the company's primary weakness. Analysts on average forecast MSFT's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 8.3%, 8.1%, and 27.2% over the current and next fiscal years.
Although the company's EPS growth estimate is significantly above the peer average, both the revenue and EBITDA growth expectations are below the peer averages of 15.5% and 23.3%, respectively. Additionally, MSFT's EBITDA margin is predicted to compress slightly by 0.2% over the same period, compared to a much higher average expansion of 5.6% for the comparable companies.
On the profit side, except for MSFT's trailing gross margin, which is slightly below the par, all of the company's other margin and capital return metrics are above the peer averages, indicating a superior profitability. In terms of leverage and liquidity, MSFT assumes a low level of debt as reflected by the firm's below-average debt to capitalization and debt to EBITDA ratios.
MSFT has a robust free cash flow margin at 33.8%, well above the peer average of 27.5%. Due to the high profitability and the low leverage, the company was able to maintain a solid interest coverage ratio. Both MSFT's current and quick ratios are substantially above the par, and the company's cash position of $53.7B represents roughly 23% of the current market capitalization, reflecting a fortress-like balance sheet.
To summarize the financial comparisons, MSFT's relatively slower growth prospects appear to be the primary drag in the valuations. However, I believe the stock should not trade at a large discount to the peer-average valuation given the company's larger firm size, superior profitability, and robust liquidity position. Nevertheless, the current stock valuations at 2.5x forward EV/EBITDA and 9.1x forward P/E represent an average valuation discount of 48% to the peer-average trading multiples (see table above), suggesting that the stock may be somewhat undervalued.
Comparing MSFT's valuation to that of the market, the stock's forward P/E multiple is currently trading at a 36% discount to the same valuation multiple of the S&P 500 index (see chart below). In addition, MSFT's trailing EV/EBITDA multiple has also underperformed the market since 2010 and currently trades at a 23% discount (see chart below). The large valuation discount to the market further supports my view that the stock is somewhat undervalued, given that MSFT's estimated long-term earnings growth rate of 9.4% is well above the average estimate of 7.9% for the S&P 500 companies.
In September, MSFT announced that the quarterly dividend per share will be raised by 15% from $0.20 to $0.23 in the November 2012 payment period, and that has helped lift the stock's dividend yield to the current 3.3% level. MSFT has a sound dividend policy and a strong commitment to continuously improve the dividend. Since FY2007, the annual dividend per share has been raised by a 6-year CAGR of 15% from $0.40 in FY2007 to $0.92 in FY2013E (see chart below).
Additionally, the annual dividend payment historically only represented a small portion of the annual free cash, meaning that there is an ample slack to maintain the current pace of the dividend growth (see chart below). It should also be noted that the size of the stock buybacks was fairly small in recent years. With the continued growing free cash flow and the dividend only occupying a small fraction of that, I expect the profitability for the company to authorize a significantly larger buyback program to be quite high.
According to the three-year dividend yield chart shown below, there appears to be a pattern that every time after MSFT announced a dividend hike which instantly pushed up the dividend yield, the subsequent stock price appreciation drove down the yield significantly. This could be partially caused by the high demand from the yield-hungry investors, and I expect the pattern would persist at least in the near term, given that the market interest rate may continue to be low.
At the current 3.3% yield, I believe any upward yield movement would attract a significant demand from income-oriented investors, as MSFT offers one of the highest yields among the system software vendors, and thus the yield's upside is very limited. Assuming a target dividend yield at 2.9%, and supposing that the current annualized dividend per share of $0.92 would be raised by another 15% to $1.06 in September 2013, the scenario would imply a stock value of $36.50, representing 29% upside from the current market price.
In conclusion, MSFT's low valuations, fairly high dividend yield, and solid dividend growth prospect imply an attractive risk/reward investment profile. I strongly recommend buying the shares now.
Comparable analysis table is created by author, all other charts are sourced from Capital IQ, and all financial data is sourced from Morningstar and Capital IQ.