Go Big, Microsoft

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Microsoft (NAS: MSFT) is expected to raise its dividend soon, maybe this week. Its current payout of $0.16 per share per quarter is expected to be bumped up to $0.19, according to Bloomberg estimates.

That's not enough. The company can, and should, raise its dividend dramatically higher.

Microsoft's returns over the past decade could be fodder for a book on the frustration of investing. Shares have flatlined for 10 years, yet its earnings grew at an annual rate of more than 21% during that period. That wasn't an anomaly based on cherry-picking the calendar. Over the past five years, shares have barely budged, yet earnings have grown 13% a year. Over the past three years, shares are flat, yet earnings have grown nearly 20% a year. Earnings have increased 28% over the past year. Google's (NAS: GOOG) have grown 6%. If one is to judge Microsoft by earnings power, growth, and consistency -- not stock performance -- it has been one of the great successes of American business over the past decade.

Yet you know its reputation: Microsoft is becoming irrelevant. It's running in place. It's falling behind. That's what you hear. The company faces real threats. No doubt about that. But its internal results seem disconnected from investors' perceptions.

Why? A lot of Microsoft pessimism is probably fueled by its dismal shareholder returns, which give off the aura of failure even against solid results.

Most of its poor performance over the past decade is rooted in the fact that it was obnoxiously overvalued 10 years ago. At 60 times earnings in 2000, the company was practically guaranteed to disappoint. And so it did.

But there's more to it than that. Microsoft currently trades at just over 8 times forward earnings. That's a full 50% discount from the broader market average and nowhere indicative of the performance that even the most bearish analysts forecast.

Notably, that disconnect isn't unique to Mr. Softy. Apple (NAS: AAPL) and Google -- two of the most admired companies in the world -- trade at lower price-to-earnings multiples than Consolidated Edison (NYS: ED) , one of the most dreary companies in the world. The tech industry in general has some of the strongest companies in the market yet trades at one of the lowest valuations.

There are several theories on why this is. Low dividends among tech companies is one of them. With interest rates on fixed-income products at historic lows, the attraction to dividend yields on stocks has taken on a new level of fanaticism. Investors still pay up for growth, but they really pay up for yield.

That may be the key to turning around Microsoft's low valuation. The company already has high-quality earnings and well above-average growth. Its dividend policy, however, draws yawns.

Microsoft currently pays out about 20% of its free cash flow as dividends. At current share prices, that generates a 2.5% yield.

If the company bumped that payout ratio up to 40%, 60%, or 75%, the potential yields become hard to ignore:

Dividends as % of Free Cash Flow

Potential Dividend Yield

20% (current)2.5%
40%5%
60%7.5%
75%9.3%

If Microsoft paid out 60% of its free cash flow as dividends, the odds that its stock would remain priced for a 7.5% yield are near zero. Investors would pounce on that kind of yield, sending shares higher. I'll make a prediction (though I hate making those): At a 60% payout ratio, shares would rise enough to make the yield closer to 5% than 7.5%. That would mean a share price of around $33, up from $26 today.

What are the arguments against raising the dividend? There are a few.

First, higher dividends might mean lower share repurchases. And since share repurchases aren't subject to taxes, they might be a better deal for shareholders.

But the key word there is "might." If the market is willing to pay a higher premium for yield than earnings growth, dividends might create more value. Tellingly, dividends have historically created more value than anything else management choses to do with cash, including buybacks -- corporate managers just aren't good investors. Case in point: Microsoft spent tens of billions of dollars on buybacks a decade ago, when shares were blatantly overvalued.

Second, some say higher dividends mean less cash to spend on growing the company. Don't buy it. Microsoft already has more cash than it knows what to do with, and when it finds something to do, it often entails making a questionable and overpriced acquisition, like the recent deal to purchase Skype. 

Third, much of Microsoft's earnings are made overseas, so bringing cash back to the U.S. to pay dividends could mean repatriation taxes.

This is actually a decent argument, but not quite good enough. Microsoft still earns enough cash in the United States to pay a higher dividend without excessive repatriation. And even though I'm a firm supporter of ending the repatriation tax for good, a company should sit on its hands and wait for that day to come only up to a certain point. If the repatriation tax is never repealed, will multinational companies refuse to ever use overseas profits to reward shareholders? Never? Ever?

Microsoft should go big this week. It should dramatically raise its dividend.

Disagree? Tell us why below.                              

At the time this article was published Fool contributorMorgan Houselowns shares of Microsoft and Edison. Follow him on Twitter, where he goes by@TMFHousel.The Motley Fool owns shares of Microsoft and Google. Motley Fool newsletter services have recommended buying shares of Google and Microsoft and creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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