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Microsoft Corp.
Estimating Microsoft's Value...

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By babyfrog
July 23, 2004

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Over on the Dividend Growth Investing board, we talk about companies that pay and raise their dividends. Now that Microsoft is acknowledging that it is a maturing company, is cleaning up its act, and becoming much more shareholder friendly, it is starting to look and act much more like a decent, long-run dividend growth company. As such, I would like to take this opportunity to construct my interpretation of an estimated value for Microsoft, as a Dividend Growth Investor might see it.

The stock buyback of options-created shares I view as a good thing, as it looks like a legitimate attempt to clean up the options-related excesses of the past. The continuation of the employee ownership program, where the company compensates employees with actual shares of stock, rather than options, I also view as a good thing. I am a firm believer in the power of employee ownership to help companies and employees act in the best interests of shareholders. Stock ownership programs are a cost effective way to assure that those interests are aligned.

The one time dividend is a nice feature, but it does not excite me much, as it is a one-time thing, and it really does not affect the value of the company on an ongoing basis. What excites me, however, is the company's increase in its regular dividend. The payment and sustainable growth of dividends over time is the hallmark of a dividend growth company, and I would like to believe that Microsoft's increase in its regular dividend is an indication that it is attempting to join the ranks of other blue-chip stalwart companies in becoming a dividend growth company.

I have avoided investing in Microsoft and many high-tech companies in the past, primarily because I am a dividend growth investor, but this apparent shift in dividend policy makes Microsoft, for the first time, a company on my radar screen of possible investments. The key calculation in Dividend Growth investing is a company's valuation based on the Dividend Discount Model. That model values a company as the net present value of expected future cash flows to shareholders, AKA future dividends. The long run, steady-state equation is P=D/(R-G), or Price equals Current Dividend divided by (Required rate of return minus dividend growth rate).

Microsoft's new annual dividend is $0.32, and my personal minimum Required Rate of Return is 12%. That gets me 2/3 of the way towards being able to determine what the dividend discount model would consider a fair price for Microsoft. The other third is the dividend growth rate. Microsoft does not have a long history of paying dividends, so the calculated growth rate is not a pure science - the best I can do is estimate. And I can estimate based on earnings, if I make the presumption that the company will attempt to grow dividends in line with its earnings growth over time.

One good place to look to start estimating is with the company itself. The company's press release is calling for 'diluted earnings per share' in fiscal year 2005 of $1.05 - $1.08, well above the $0.76 reported for fiscal year 2004. For fiscal year 2003, adjusting for the change in accounting standards, the company reported $0.69 per diluted share.

The move from $0.69 - $0.76 was a move of 10.14%. The move from $0.76 to $1.05 (using the low end of published company estimates) will, if met, be a move of 38.16%. That latter rate seems abnormally and unsustainably high, especially for a company going out of its way to tout its special dividend and its dividend hike. So to build a range for the company's fair value, I'll take a guess at a range between 10.25% and 10.75% sustainable earnings and dividend growth for Microsoft.

That's a slowdown from historical growth rates for the company, but not outrageous for a younger and still nimble dividend growth company, especially one just entering that maturation phase. Putting those numbers into the dividend discount model, I get a fair value for Microsoft of somewhere between $0.32/(.12-.1025)=$18.29 and $0.32/(.12-.1075)=$25.60. Now, that analysis ignores the $3.00 special dividend which must be added back in, making my fair value estimate somewhere between $21.29 and $28.60. According to the Fool's quote page, Microsoft closed at $29.00 today, putting it just above the upper end of what I could reasonably estimate as a fair price for me to consider purchasing it, should it really be turning into the dividend growth company I hope this announcement symbolizes.

For the first time, I am actually considering an investment in Microsoft. The data suggest that it may very well be transforming itself into a shareholder friendly, dividend growth company, and my fair value estimates indicate that the company may very well be near a decent ownership price.

-Chuck


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