Good news for Microsoft (Nasdaq: MSFT ) shareholders. I'm confident your stock could double.
This isn't about new products. It's not about beating Apple. It's not even about growing the company. It's a simple tweak to capital allocation.
One of the dilemmas Microsoft shareholders face is the fact that the company is enormously profitable, yet the market has trouble realizing or accepting it. Earnings per share have grown 14% per year for the past five years, and, critically, are expected to grow 12% per year for the next five. The competitive threats Microsoft faces slow its growth, but it's still growing. Yet shares now trade at nine times forward earnings -- a pathetic level implying near irrelevancy.
When a market won't acknowledge that kind of value, it's time to rub it in its face. Here's how Microsoft can do that.
Microsoft generated $23 billion of free cash flow last year. It currently pays about 20% of this cash out as a dividend. Most of the remainder goes toward share repurchases. If it simply stopped repurchasing shares and paid all its free cash flow out as a dividend, the dividend yield at current share prices would be nearly 12%.
That would wake the market up like smelling salts. There's absolutely no way investors would allow Microsoft to trade with a 11% yield. They'd bid shares up considerably -- and quickly -- until the yield fell to a more sensible level. The market might not be willing to pay up for Microsoft's earnings, but it will for its dividends. The response would be rabid. Shares would surge.
Now, paying out 100% of free cash flow is unreasonable. Earnings fluctuate, and companies need cash for other investments. Fair enough. But a more reasonable 70% payout ratio would still generate a dividend yield of roughly 8% at today's share price. That too, simply wouldn't be ignored by the market. Investors would bid shares high enough to make the yield competitive with other investments -- probably in the neighborhood of 4%.
That, folks, is how Microsoft could double.
What's crazy about all this is that Microsoft isn't doing a bad job allocating capital already. Where it lacks in dividends it more than makes up for in share buybacks. The company has repurchased a net $78 billion of its stock since 2006, shrinking shares outstanding by almost one-fifth. This is probably a more efficient way than dividends to return cash, since shareholders are avoiding dividend taxes. That, I think, makes this story more compelling: Microsoft could probably double if it tweaked its capital allocation strategy, but its current strategy is probably still superior.
I don't expect Microsoft to increase its payout ratio to 70%. This is merely a valuation exercise. But it's an important one, and shows deep value potential. A company is worth the amount of free cash it spins off over time, discounted to the present value. On rare occasions, markets lose their bearings to the value of those cash flows, blinded by what's popular over what's profitable. When I look at Microsoft's dividend potential, I can't help but think that's the case today. Value investor Bill Miller has used the same analysis to show how Hewlett-Packard (NYSE: HPQ ) and Intel (NYSE: INTC ) look cheap as well. Cash is king -- once the market gets its hands on it.
It takes patience, sometimes years of it, but markets eventually realize the potential of mispriced companies. Microsoft will get there soon enough.
Interested in Microsoft? Consider adding it to My Watchlist.