How Microsoft Could Double

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.

Fool contributor Morgan Housel owns shares of Microsoft. Intel and Microsoft are Motley Fool Inside Value recommendations. Apple is a Motley Fool Stock Advisor pick. The Fool has written puts on Apple. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended a bull call spread position on Apple. Motley Fool Options has recommended a diagonal call position on Intel. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (39)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 16, 2011, at 8:28 PM, jimmy4040 wrote:

    Several thoughts come to mind.

    First, isn't a substantial portion of the cash in Europe and wouldn't they have to pay taxes to repatriate it?

    Second

    "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"

    Since the shares consistently lose value over time, there is no advantage over the tax paid on a dividend. At best it's a wash. In fact, were it not for share buybacks, the stock would probably trade in the low 20's. It does however trap MSFT shareholders into holding long term. Since they are losing share value over any given time frame, they HAVE to believe in a someday when this will all turn around.

    Third, Gates, Allen and Ballmer, don't WANT the cash personally, so they're not about to do what's best for the rest of the shareholders. They are after all the company!

    My own personal disclosure. I was a holder of MSFT for about 4 years. After losing money comparatively speaking, I sold about 5 years ago. I do buy call options anytime a rumor comes around that Ballmer is leaving. They always expire worthless so far, but it's a LOT less expensive than actually buying the stock! LOL

    On last thought, to the extent that anyone cares at all what I think, I'll be deluged with revenue numbers and ROI figures. Frankly, I don't work for the company, so all that matters to me is share price appreciation + dividend.

  • Report this Comment On March 16, 2011, at 8:33 PM, jimmy4040 wrote:

    BTW, some of what I wrote was tongue in cheek, as is anybody writing that MSFT could double. So if you want to call me a fool, do it with a smile!

  • Report this Comment On March 16, 2011, at 8:38 PM, TMFHousel wrote:

    ^ Re: repatriation: yes, but msft is already using the rest of fcf for buybacks ... they do repatriate already, and use US-earned funds to return money to shareholders. this isn't going from idle cash to dividends; it's going from buybacks to dividends.

    Re: gates et al, agreed. I don't expect msft to do this. it just shows you what the company could possibly be worth.

  • Report this Comment On March 16, 2011, at 8:47 PM, topsecret10 wrote:

    Taking bets ?

  • Report this Comment On March 16, 2011, at 10:16 PM, WeeWillieKeeler wrote:

    Good article Morgan. I just recently bought into MSFT. Too cheap to ignore at these levels. Let the bears temporarily drag it down.

    As the Chief Investment Strategist of Grantham Mayo Van Otterloo (GMO) stated: "although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition."

  • Report this Comment On March 16, 2011, at 10:31 PM, techy46 wrote:

    Microsoft has been repurchasing shares to offset the 50-100million that are sold each year by Bill Gates. He's has 600 million left. Maybe up the dividend to 3-4% and lessen shares purchases equally.

  • Report this Comment On March 17, 2011, at 8:57 AM, pondee619 wrote:

    " I'm confident your stock could double"

    It's good to see fool writers hedging their bets, rather than waiting for another fool to do so. CONFIDENT your stock COULD double? Not so confident. .

    A confident fool would say that the stock will double..

    I'm cofident that your stock will double; or

    I (believe, think, hope, feel) that your stock could double.

  • Report this Comment On March 17, 2011, at 10:32 AM, jimmy4040 wrote:

    Seriously though, how can anybody remain a MSFT investor at this time? Right now there are fortunes being made all over this market, by shorting Japan, or going long Japan, scooping up GE if you think it has been oversold, going long rare earth if you believe that story.

    How can anybody stay in this old woman stock and watch the world pass them by?

  • Report this Comment On March 17, 2011, at 11:01 AM, FoolTheRest wrote:

    Jimmy,

    The reason I invested recently in MSFT is best summarized by Morgan's points. Sure, Its best days are behind it and it is sleepy. Meanwhile, while no longer an innovator, its core products still dominate the market. These products quietly give MSFT ridiculously high margins and ROE, contributing to an equally ridiculous hoard of cash. The thesis Morgan opined shows a way to juice the stock price using that cash. He then states that he believes the current course is a better one.

    Regarding your other idea, it is more about psychology than "how can" or "why." If you are the kind of investor who can have a conviction about something and jump into it, then by all means, go for it. It is your personality. Most people do not have this kind of fortitude, which is good, because very few people make money speculating in such a way. I could easily say, "how can anyone not pick up shares of their favorite boring, sleepy companies (AFL, MCD, DEO, etc) during this recent pullback?" but I would be mistaken. I see it as an opportunity while others may see it differently. You see a speculation play in the making, others see a time to sell, and others will simply be too afraid to do anything. None of these are wrong.

  • Report this Comment On March 17, 2011, at 11:23 AM, jimmy4040 wrote:

    jsi:

    Thanks for the reply. Obviously I exaggerate for effect, but all portfolios should have room for speculative money, as well as investment money. GE is really not spec money after all either. It's just buying a stock that has been oversold on headlines, and which has a better dividend that MSFT.

    I come from the investing school that says the largest amount of money is made in the shortest intervals of time. Miss those points, and you may as well be in a Treasury.

    For instance I'm no investing genius ( I used to own MSFT after all) but I just made 5% on a sale today of a long Japan etf. That's in two days. That's more profit than MSFT investors will see all this year (unless Ballmer leaves) Could it have gone the other way? Of course, that's why I took my profit and walked away from the table.

    You don't have to invest the whole kit and kaboodle but 10-15% of your capital should enable anybody to juice returns without risking serious money.

    It is a big investing world!

  • Report this Comment On March 17, 2011, at 12:15 PM, FoolTheRest wrote:

    Indeed, Jimmy, the possibilities are endless. Congratulations on EWJ. I thought about it and then decided to put capital to work elsewhere. Happy hunting!

  • Report this Comment On March 17, 2011, at 1:56 PM, jimmy4040 wrote:

    I really think there is a longer term play in Japanese etf's but things are crazy right now. My current threshold is 5-7% up I sell, 10% down I buy.

    It's an exhilirating time for investors!

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