Stock Bought: MSFT

Today I bought shares of Microsoft (MSFT), the world's largest software maker. The company dominates the market for desktop operating systems (more than 90% of PCs still run Windows) and makes the popular Office productivity applications. Additional business components include server software, online advertising tools, and the Xbox video game system.

Microsoft is often derided as "dead money" because its stock price return for the past several years has been negligible. However, this ignores three important points. First, MSFT was overvalued at the turn of the century (P/E > 30), so the poor return mainly reflects the stock coming down to a more realistic valuation. Second, the focus on stock price return ignores the return from dividends that MSFT has been paying since 2003. Third, despite the lackluster stock price movement, the company's operating results have been quite good.

To elaborate on the last point (see also this article by Chuck Carnevale), Microsoft has had fairly steady revenue and earnings growth, with 10-year growth rates of 10% for revenue and 11% for earnings. The company has maintained high margins, strong operating and free cash flows, and returns on equity above 20%. Its financial position is excellent, with $66B in cash, $12B in debt, debt/capitalization of 14%, debt/equity of 18%, 59x interest coverage, and a current ratio of 2.7. Value Line gives it a safety rating of 1 and a financial strength rating of A++. It is one of just a few companies with an AAA credit rating from S&P.

For a tech company, Microsoft's recent dividend history is pretty good. The company has increased its dividend for 10 consecutive years and has a 5-year dividend growth rate of 15%, which also happens to be the size of the most recent increase, announced in September 2012. The EPS payout ratio is 50% (which is a bit misleading; see below) and the FCF payout ratio is 35%. The company also has a strong history of share buybacks, reducing the number of outstanding shares by more than 20% over the past 10 years.

I consider Microsoft to be undervalued at the current price. It appears to have a P/E of 14.2, but that reflects a large, one-time charge they took against earnings last year. Adjusting for that, Value Line reports EPS of $2.72 for 2012, which gives a P/E of 9.7. Other metrics include P/S of 3.1, P/B of 3.2, and PEG of 1.0. Using a Dividend Discount Model with a below-average dividend growth rate of 9% and an aggressive discount rate of 12%, I calculate a fair value of $33.43. Morningstar gives a fair value of $35.00 and a 4-star rating, whereas S&P gives a fair value of $36.90 and a 5-star rating. The average of those three estimates is a fair value of $35.11, which implies a 25% margin of safety at the current price. MSFT is flirting with its 52-week low and is 20% off its 52-week high. (For another informative look at its valuation, albeit from early 2012, see this article by Dividend Monk.)

I bought 55 shares of MSFT at the price of $26.30 per share, giving me a 3.48% yield on cost. At the current dividend rate, I can expect to receive quarterly dividends of $12.65, which will add a total of $50.60 to my annual dividend income. Microsoft is now the 26th stock in my portfolio and my second tech stock (the other being INTC). I continue to be wary of tech stocks in general, but I feel comfortable having MSFT in my portfolio, especially given the extent of its undervaluation and its continued innovation efforts (see this article by Catalyst Investments). However, I will likely keep the overall allocation of my portfolio to tech stocks below 10% (it is currently 8%).

It is a bit difficult to find undervalued stocks at the moment, so even though I have sufficient cash on hand to make another purchase this month, I may just sit back and watch what happens as quarterly earnings are reported. If there is a significant dip that catches my eye, then I might take advantage of it.