Microsoft Corporation ($MSFT) is my largest position in my dividend growth portfolio due to it’s recent 2-year stock price appreciation. It wasn’t by design, but I don’t look a gift horse in the mouth either. Having said that, today I will share with you my quick analysis about Microsoft valuation and assess whether I find it attractively valued at its current share price.

Background

Microsoft was founded in 1975 by Bill Gates (20-Years old) and Paul Allen in Albuquerque, New Mexico. The story is well known by many of you and it is also pretty well covered as it’s one of the biggest entrepreneurial success stories in recent American history.

If you are interested in their history and if you have 18 minutes of time on hands, then I recommend watching the following video.

Fast forward to 4 February 2014, Satya Nadella was named CEO of Microsoft. In my opinion this was a turning point in the history of Microsoft. Until then, Microsoft has been struggling and muddling along under the leadership of Steve Ballmer. 

This is visible in the stock price, because it literally went nowhere in the era of Steve Balmer:

I guess that the acquisition of Nokia in September 2013 says it all. It will go in the history books as one of the worst acquisitions for a giant like Microsoft. It got already written off by 7.6 Billion USD in July 2015. Almost a full impairment after 2 years!

Anyway, that was then and times have really changed since then. The appointment of Satya Nadella has in hindsight been an excellent decision. Until then, Satya was pretty unknown to the outside world, but he was leading Microsoft’s cloud and enterprise group. His main responsibility was to build and run the company’s computing platforms.

It was not just his knowledge that brought a stunning turnaround to the company. I would say even more his leadership style. He’s the example of a servant and agile leader who has also written a very nice book back in 2018: “Hit Refresh”. 

In this book he describes the journey of Microsoft’s transformation while it’s still happening. It gives a very unique insight in his thought process and how he looks at leadership. Usually we get these books written after a successful transformation happened (or not but still claim it as a success: Jeff Immelt), hence why it makes this book so interesting.

Anyway, you get it, I became a big fan of Satya Nadella. I would even consider a poster above my bed, but unfortunately I’m not a teenager anymore 😉

Microsoft as a Business in 2020

How does Microsoft earn their money?

Let’s look into their most recent annual and quarterly reports for that. Microsoft categorizes their business into the following segments:

1️⃣ Productivity and Business Processes

This segment consists of Office commercial products, Office consumer products, LinkedIn and Microsoft Dynamics. In case you are wondering, this is the segment where your purchases of Word, Excel, PowerPoint and OneDrive are reported. 

2️⃣ Intelligent Cloud

This segment consists of service products and cloud services and Enterprise services. It doesn’t say a lot right? Well, this is for instance the section where the very hot Azure sales are reported. Besides that also products like Visual Studio, SQL Server and GitHub.

3️⃣ More Personal Computing 

This segment consists of Windows, Surface, xBox and Bing Search. I consider this a real consumer business unit, because it focuses on products that we’re literally using in our living rooms.

Clearly, this is not your parent’s Microsoft anymore from the late 90’s and early 2000’s. Windows and Office as products are still huge, but they don’t make up anymore 90% of their total sales.

So how do they financially perform?

ioCharts has some great charts for that to start of with. Just look at their stellar revenue growth in just the last 5 years.

As you can see, it’s revenue growth is very strong and at the same time its net income doubled in just the last 3 years.

It doesn’t really tell us yet where the catalyst resides. For that we have to zoom in a bit into the individual business segments to understand where this growth is really coming from.

Luckily Microsoft is shareholder friendly enough, because it has done already most of the work for us:

As you can see, Intelligent Cloud is really on fire. It grew its latest Q4 sales with a whopping 17.4% and it catapulted itself instantly into the biggest segment by revenue. The same can be told about its net income, because it grew with 18.7% year-over-year.

While Microsoft is not fully transparent about the absolute numbers, it is clear though that Azure is the main contributor to these stellar growth figures. Azure grew sales with 47% just in Q4 fiscal year 2020 alone. 

Overall the company grew its sales in fiscal 2020 with 13.6% and its net income with 23.3%. At the same time it’s currently a nice diversified business as can be seen in the below chart.

Competition

Microsoft is having its bets in multiple markets, so it’s hard to name a single competitor. If you would really like to get an extensive view on it, then I would recommend their latest annual report as they list all their main competitors per segment.

Generally speaking you could almost list all Tech stocks in there. Just look at the below example which I am listing straight from my mind:

• Amazon Web Services vs Azure
• Google Docs vs Microsoft Office
• Salesforce vs Microsoft Dynamics
• Sony PlayStation vs Xbox
• Google Search vs Microsoft Bing

This is one of the reasons why Microsoft is so interesting to my as an investor, because it is among the top 3 players in all of those markets (although one could argue that Microsoft Bing is far inferior from Google Search).

I could actually still write lot’s of pages about Microsoft’s business, but let’s stay in the mindset of a quick analysis ;-). So to sum it up:

• Azure and the growth in cloud is their main catalyst
• A well diversified product portfolio with market leading positions
• Strong overall growth in both sales and income

Microsoft’s Dividend Safety

Is their dividend safe? That’s the main question that I want to answer as a dividend growth investor when considering buying Microsoft shares. I can hear you thinking already: duh, of course their dividend is safe! 

Well, you might be right, but wouldn’t you want to spend a few minutes analyzing the answer to this question first before hitting the purchase button?

Let me therefore explore several determining factors first so that we get insight in the right facts instead of just assuming it.We want to be intelligent investors, not speculators.

Microsoft Dividend history

Microsoft has been paying a dividend since 2003, hence its dividend history is still rather short. Since then it was neither a continuous dividend growth, because the company froze its dividend back in 2010 in the aftermath of the great financial recession.

I also found their average 10 year growth rate quite impressive even though the company was struggling during Steve Balmer’s years regarding product innovation. It didn’t stop them from growing their dividend while maintaining a healthy pay-out ratio. The average dividend growth ratio was 14.56% which is far above my desired average growth of 6% which I seek for my portfolio.

Please note though that the dividend growth was rather hovering between 7.5% and 10% over the last 5 years. This was needed, because the dividend growth was outperforming the actual earnings and free cash flow growth in the preceding years.

To me this means a pretty good dividend growth history since its inception back in 2003.

Earnings / Cash Flow

Their earnings / cash flow was pretty flat until 2016, but from there it started to show a rapid growth onwards. This is really the result of the cloud business picking up and the implementation of Satya’s strategy. I find it really fascinating to see what a difference a CEO makes.

Just to clarify when looking at the below graph. Microsoft’s earnings were heavily impacted by the tax cut from Trump’s administration back in 2017 (Fiscal Year 2018). See the below note from the annual report in 2018:

(a) Includes a $13.7 billion net charge related to the Tax Cuts and Jobs Act, which decreased net income and diluted earnings per share (“EPS”) by $13.7 billion and $1.75, respectively. Refer to Note 13 – Income Taxes of the Notes to Financial Statements.
Source: https://www.microsoft.com/en-us/annualreports/ar2018/annualreport

This is also the reason why you can see that the Free Cash Flow wasn’t impacted that year, because it was an accounting impact, not a cash impact.

Both the EPS and FCF payout ratios are very healthy, because they are currently hovering around 35%. This is way below my max threshold payout ratio of 60%. 

These EPS and FCF per share numbers are a little bit influenced by share buybacks, because the company has purchased back approximately 9% or their total share count during the last decade.

Optimism for next year by the analysts is also pretty high regarding their earnings. It is again expected to grow significantly (13%) over the next 2 years as per the below overview from Yahoo Finance. No wonder, because covid-19 has really accelerated digital transformation initiatives which has the potential to really push the cloud momentum forward.

Long Term debt & Cash

Now this is where it gets interesting. Microsoft always gets appraised by it’s balance sheet and mostly it’s cash position. Most of us know Microsoft as well as a company that hardly has any debt compared to others. 

Well, it has been taking a different approach to leverage over the last few years as can be seen in the below chart:

The sudden increase in debt between 2015 and 2017 can be explained due to the LinkedIn acquisition and the low-interest environment. This is what Microsoft writes in the 2017 annual report about their large increase in debt:

We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. See Note 12 – Debt of the Notes to Financial Statements for further discussion.

The good thing is that Microsoft started to pay down their debt again from 2018 onwards and this makes sense. It had so much additional cash flow pouring in that even though it is a low interest environment, it still makes sense to use that overflow of cash to lower the debt. Remember: until 2017 the Free Cash Flow was rather flat.

Regarding their cash position: it’s simply insane. 136 billion is currently parked on their balance sheet. This is a 45% of their balance sheet. 

The debt/equity ratio currently stands at 57% and I find this a very healthy level. I expect it to further decrease if the trend in the last few years can be considered an indicator.

My conclusion: their balance sheet is one of the best I’ve ever seen and it rightly deserves a AAA credit rating.

So, is their dividend safe?

Well, it might come as no surprise, but I believe that Microsoft has one of the safest dividends of the entire market at this moment in time.

A payout ratio of ~35%, a rapidly growing business supported by a strong catalyst and a super strong balance sheet gives me no doubt that their dividend has the potential to grow in double digits numbers over the upcoming decade.

We have now done our due diligence regarding their business model and financial strength. But is Microsoft also an interesting stock to purchase at the current price?

Microsoft Valuation – Fair Value Estimates

Look, most Dividend Growth Investors use a valuation approach to investing, often inspired by Warren Buffett.

Myself included.

Hence, by just looking at the price and some basic metrics (i.e. Price / Earnings, Dividend Yield, Chowder Rule) the stock gets easily excluded from our screeners. It just feels pricy!

But we’re better than that, hence why we do regularly a proper assessment for our biggest portfolio positions.

So let’s get started!

Dividend Discount Model – Microsoft valuation

I like the dividend discount model (DDM), because it provides me a quick and quantitative check to predict the fair value of a stock. The theory assumes that the sum of all its future dividends discounted back to a present value does just that.

For this analysis, I’m assuming a 8.5% discount rate. I realise that we’re in a low rate environment, but the shareholders will have high expectations regarding their required rate of return due their growth story.

Using this number and an expected moderate dividend growth of 7% (on the low end) gives us a fair value of $136 USD.

Microsoft seems very overvalued at today’s share price of $217 when using the Dividend Discount Model.

Discounted Cash Flow – Microsoft valuation

While I like the Dividend Discount Model, I do think that a Discounted Cash Flow analysis fits better to a company like Microsoft. It allows us to better plot in their growth numbers and derive a more accurate net present value from there.

As you can see, my fair value estimation of $194.54 is much higher using the DCF approach compared to the DDM approach.

I am assuming though that this fair value estimate is much more accurate.

Having said that and for the financial wizkids under us: let me clarify few important assumptions behind this calculation:

• I didn’t use the weighted average cost of capital (WACC) as a discount rate. The WACC is currently approximately 11.3% using the CAPM model, but I believe that this isn’t the right model to use as discount rate. The flaw with using WACC for a company like Microsoft is that the CAPM model includes the Beta based on past price performance. This therefore blows up the WACC for MSFT which in my opinion is unfair. MSFT has a very strong balance sheet, with relatively low debt. Hence why I corrected the WACC downwards to reflect the low interest environment and the quality of the balance sheet. If you do want to use the WACC, then the fair value would be reduced to $109 when all else considered equal.
• Recent Free Cash Flow growth was on average in the high teens over the last few years. I have used a more conservative number of 9.6%. I truly believe in the cloud story and I would be surprised if FCF stays growing with 15% in the upcoming 5 years. I am a bit more conservative by nature, hence why I have brought it down.
• The DCF assumes 5 year of strong FCF growth, after that a terminal growth rate of 5%. This is on the high-end for what I typically use, but I believe that Microsoft will still grow quite steadily in the years after.

Time it takes to grow to 10% Yield On Cost

The time it takes to get to a 10% yield on cost is not something that I often mention in my blog post. But I find this also a pretty important litmus test, because I know that the compounding effect really gets on steroids once it hits such 10% yield on cost.

So let’s have a look at Microsoft’s prospects 👇

As you can see, the fact that we are having a very low starting yield of 0.94% at current prices ($217) means that it will take a very long time to reach this 10% goal.

• a 10% CAGR would take 25 years
• a 12% CAGR would take 21 years
• a 15% CAGR would take 17 years
• a 20% CAGR would take 13 years

CAGR = Compounded Annual Growth Rate.

Needless to say, this takes a very long time compared to some other higher yielding stocks. I.e. it would take British American Tobacco “just” 5 years to reach a 10% yield on cost at a CAGR of 4%. Off course, that’s a totally different stock with a different story, but it does matter when trying to gain the benefits as a dividend growth investor.

Conclusion on Microsoft valuation

I have given you three different perspectives regarding the value of Microsoft shares, so I leave it up to you to chose the one that fits you best as part of your own Microsoft valuation 😉.

Personally I will use the fair value estimate of the DCF calculation. However, I do see Microsoft currently as a growth stock which means that the dividend yield might stay low for quite some time.

Having said that, usually dividends follow earnings / cash flow growth and therefore I wouldn’t be surprised if we see an accelerating dividend growth rate in the upcoming years. Actually, the first indication we will see anytime soon, because usually Microsoft announces their dividend hike around this time of the year (mid-september).

Now that I know the fair value, what will I do next?

Well, I don’t intend to sell my shares in Microsoft. It is my largest portfolio position and it will probably stay like that for quite some time. I also believe that this is a company that you should try to buy at a fair price, because otherwise you’ll keep on chasing it. Hence why I’m only using a 10% margin-of-safety.

This means that I consider adding to my position at a share price of:

$175.09

This also means that the stock price would still need to drop ~20% from today’s price action.

Final Thoughts and Conclusion on Microsoft Valuation

I don’t often analyse high-growth stocks, but it was very interesting to do it this time. It’s my largest position so I feel that I need to know my “sh*t” regarding what I own.

I’m also aware that most of the stocks that I added lately to my portfolio were lacking momentum. Usually there was something “wrong” with them which suppressed their share price. This is not the case with Microsoft and therefore I’m very happy with this position.

It gives me the diversification in my portfolio. It mixes high-growth with slow-growth, high-yield with low-yield, Tech with Consumer Defensive, etc.

Therefore I would like to finish this post with the following consideration:

If you find the dividend yield too low at a fair value price of $194.00, then why not purchase it together with some stock of Danone or British American Tobacco?

I.e.: instead of 1000 Euro only to British American Tobacco, just buy 500 Euro of it. Invest the other 500 Euro in Microsoft. It would probably give you an average yield of around 4.5% on the 1000 Euro invested.

Just sharing my thoughts on Microsoft’s valuation 🙏

What do you think about Microsoft? Do you own it or are you considering to buy it?

Let me know what you think about it in the comment section below 👇

Yours Truly

European Dividend Growth Investor

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