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What Should We Expect Of Microsoft's Dividends Going Forward?

April 12, 2014

If you're looking to buy a partial ownership stake in a publicly-traded company, then there are a number of things that you should consider before doing so. These things include the company's business model, historical earnings growth and corporate governance. Another thing that you may want to consider is the dividend.

Dividends are very important as they can provide some cushion for investors to the downside and can also signal confidence from management in the company's future. Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. Most of them prefer to diversify into many different sectors of the economy in order to spread out their risk.

Today, let's take a look at Microsoft, a huge player in the technology sector of the economy. Let's see how the dividend of Microsoft stacks up in terms of strength and sustainability and what investors can expect going forward.

Dividend Yield

The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.

Microsoft currently yields 2.8%. This is a forward yield that is based on the most recent dividend payout of 28 cents per share. Its current yield is near its five-year high of 3.1%. Over the last five years, the dividend yield of Microsoft has ranged between 1.7% and 3.1%.

Dividend Growth

When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation as well as to show confidence from management in the company's outlook.

Microsoft has increased its dividend in each of the last four years, at an average annual rate of 21%. This comes after they held the dividend steady between 2009 and 2010. This company has paid a dividend each year, going back to 2004. While it is true that dividend growth on the order of 20% or more probably won't go on forever, Microsoft is trouncing inflation at this point in time.

Free Cash Flow Payout Ratio

While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better as they leave more room available for future dividend increases or other uses of the capital.

Free cash flow is the cash flow a company generates in its operations minus capital expenditures.

Microsoft paid out just 36% of its free cash flow over the last 12 months in dividends. This payout ratio should rise modestly, given that Microsoft just increased its dividend last fall. While the current free cash flow payout ratio of Microsoft is higher than the 23.5% of free cash flow that was paid out on average over the last four years, Microsoft's dividend is currently very safe.

From looking at the company's free cash flow payout ratio, it can be concluded that the dividend is in no danger at this point in time.

Interest Coverage Ratio

One of the ways in which we can determine whether or not a company will have trouble paying its dividend in the future is by looking at how much interest it has to pay every year. More money spent on interest means less money that is left for dividends. To determine the effect that debt has on a company's ability to pay its dividends and fund other activities, I calculate the interest coverage ratio. This ratio is calculated by dividing the company's earnings before interest and taxes by its interest payments over the year. You generally like to see this ratio at or above 2. If it's below this figure, then that may signal trouble ahead for the company in question.

Fortunately, this is not a problem at all for Microsoft, as the company had no net interest expense over the last 12 months. This is because the interest expense that they had was more than offset by interest and dividends that the company received from its investments. At this point, debt is not having an effect at all on the company's ability to pay its dividends.

Earnings Per Share Growth Forecasts

While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth. This year, analysts expect Microsoft to increase its earnings per share by 2.2%, followed by an 8.2% increase in 2015. Over the next five years, the company is expected to increase its earnings at an average annual rate of 8.5%. It should be mentioned that these projections are all based on non-GAAP earnings.

Conclusion

The current dividend of Microsoft is well-covered by its free cash flow. With a low free cash flow payout ratio and mid to high single-digit earnings per share growth on the horizon, double-digit dividend increases from Microsoft should continue in the near term, depending on how much the company wants to expand its payout ratio.

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WallStreetBeerMoney.com

"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"

dave@wallstreetbeermoney.com