Microsoft: Increasing Dividend With Some Margin Of Safety

| About: Microsoft Corporation (MSFT)
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Microsoft (NASDAQ:MSFT) is a global technology firm that develops, licenses, and supports a wide range of software products and services. It also designs and sells hardware, and delivers online advertising to a global customer audience.

Microsoft has been a steady source of dividends for investors seeking income. Since issuing its first dividend in 2003, the company has increased its dividend every year except one, and the dividend as typically grown at a double-digit pace.

Below are Microsoft's historical dividends and growth rates for the past nine years:

Year Dividend Growth Rate
2003 $0.08 --
2004 $0.16 100%
2005 $0.32 100%
2006 $0.34 6%
2007 $0.40 18%
2008 $0.44 10%
2009 $0.52 18%
2010 $0.52 0%
2011 $0.64 23%

In addition, Microsoft has been able to grow its free cash flow (NYSE:FCF) per share at an impressive rate over the same time period. In fact, the company was able to increase FCF per share every year except one and was profitable throughout the entire past decade, even during the Great Recession.

This steadily rising FCF per share has been a key driver to its ability to have a rising dividend, as evidenced by the relatively low payout ratio Microsoft has maintained.

Year FCF/Share Growth Rate Payout Ratio (Div vs. FCF/Share)
2003 $1.12 -- 7%
2004 $1.15 3% 14%
2005 $1.27 10% 25%
2006 $1.34 6% 25%
2007 $1.65 23% 24%
2008 $2.16 31% 20%
2009 $1.92 -11% 27%
2010 $2.47 29% 21%
2011 $3.09 25% 21%

Considering the consistency of Microsoft's dividend and FCF growth, and the attractiveness that the stock may hold for income-oriented investors, a dividend discount model is one potentially helpful way to value the company.

Dividend Discount Model

In performing this valuation, I made several assumptions. First, I used 9% as my discount rate, based on the long-term average return of the stock market. Second, I used Microsoft's 25% dividend increase to set the dividend growth rate for 2012. I used a constant growth rate of 15% for years 2013-17, and a 7.5% growth rate for 2018-22. Finally, I assumed a 5% perpetuity rate after 2021.

Based on these assumptions, I calculated that Microsoft's intrinsic value is $35.34 per share. At the current price, the stock is ~17% below its intrinsic value and provides some margin of safety. Therefore, long-term, income-oriented investors may want to give Microsoft a closer look to see if it should be included in their portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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