Many people want to make investing more complicated than it needs to be.

That’s in spite of investing greats like Peter Lynch and Warren Buffett constantly distilling things down into simplistic terms.

One of Lynch’s best pieces of advice is to invest in what you use and know.

And Buffett constantly espouses the importance of owning slices of wonderful businesses.

Well, what if you could combine these two pieces of advice?

That’s what I routinely do.

And I do it through the implementation of the dividend growth investing strategy.

This strategy is all about buying and holding shares in wonderful businesses that pay safe, growing dividends to their shareholders.

You can find hundreds of examples by perusing the Dividend Champions, Contenders, and Challengers list.

This list has complied invaluable data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioBy sticking with wonderful businesses, we’re abiding by Buffett’s advice.

And since many of us are using the products and/or services that these businesses are providing, we’re also abiding by Lynch’s advice.

I’ve been diligently using this strategy for more than a decade now, building out my FIRE Fund in the process.

That’s my real-money portfolio.

It’s chock-full of high-quality dividend growth stocks, and its produces enough five-figure passive dividend income for me to live off of.

Indeed, I’m blessed to say that I’m able to live off of dividends at a young age.

In fact, I retired in my early 30s.

My Early Retirement Blueprint spills the beans on how I was able to accomplish that.

Investing in the right businesses has been key to my success.

But so has valuation at the time of investment.

That’s because while price is what you pay, it’s value that you ultimately end up getting.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying high-quality dividend growth stocks when they’re undervalued can allow you to heed the advice of Warren Buffett and Peter Lynch, which can lead to considerable wealth and passive income over time.

Of course, finding undervaluation does first require a basic understanding of valuation as a whole.

But this isn’t as difficult or complex as you might think.

My colleague Dave Van Knapp has made it far easier with the introduction of his Lesson 11: Valuation.

Part and parcel of an overarching series of “lessons” on dividend growth investing, it endeavors to teach the basics of how to go about valuing almost any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Microsoft Corporation (MSFT)

Microsoft Corporation (MSFT) is a global technology company that provides a range of hardware and software products and services.

Founded in 1975, Microsoft is now a $1.8 trillion (by market cap) technology gargantuan that employs 220,000 people.

FY 2022 revenue can be broken down across the following three business segments: Intelligent Cloud, 38%; Productivity and Business Processes, 32%; and More Personal Computing, 30%.

Some of the company’s primary products and services include Windows operating software, Azure intelligent cloud, Office software, the Xbox gaming system, LinkedIn, and Surface computers and tablets.

I like to invest in “sure things”.

And I can think of fewer things that are more sure than our future society becoming increasingly reliant on technology.

Conversely, I find it impossible to imagine a future in which human beings are using less technology.

As one of the world’s largest technology companies, Microsoft is set to capture a lion’s share of this.

But it’s not just scale that sets Microsoft apart.

It’s also breadth.

Whereas Microsoft was once mostly focused on software through their massively popular Windows OS, the company has transformed itself by broadening out into areas like enterprise solutions, networking, cloud computing, gaming, and even entire computer systems.

But wait.

There’s more.

Microsoft’s breadth is increasing.

Microsoft acquired ZeniMax Media, which is the parent company of game publisher Bethesda Softworks, for $7.5 billion.

And the company is following that up with a planned acquisition of Activision Blizzard Inc. (ATVI), the maker of several major games (such as the extremely popular Call of Duty series), for $68.7 billion.

Microsoft is beefing up its content production power in an industry that has a very bright future – the gaming industry is now bigger than Hollywood.

In addition, Microsoft has been turning itself into a serious player in the defense space.

For example, Microsoft was recently awarded a share of a $9 billion cloud computing contract from the US Pentagon.

Microsoft has incredible scale and breadth across areas of technology that are growing and becoming ever-more important.

This is why the company is almost a lock for higher revenue and profit, and a growing dividend, over the years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Microsoft has increased its dividend for 20 consecutive years.

The 10-year dividend growth rate of 12% is impressive.

What might be even more impressive is the consistency of dividend growth.

Microsoft has been pretty relentless over this period, with the dividend being raised at a 10% or higher clip in just about every year.

On the other hand, what you sacrifice here is yield.

The stock yields only 1.2%.

Investors can take some solace in the fact that this stock has, at times, yielded less than 1%.

This yield is now back to its own five-year average.

Still, this is really more of a long-term compounder than a current income producer.

And with the payout ratio at just 29.3%, the dividend is positioned for more of that relentless double-digit growth.

If you’re a younger dividend growth investor who has time to let the compounding process play out, these metrics are very compelling.

Revenue and Earnings Growth

As compelling as these metrics may be, they’re largely looking backward.

However, investors are risking today’s capital for tomorrow’s rewards.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be of great use when it’s time to estimate intrinsic value.

I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.

And I’ll then reveal a professional prognostication for near-term profit growth.

Blending the proven past with a future forecast should give us what we need in order to develop a picture of what this business’s growth path might look like from here.

Microsoft has raised its revenue from $77.8 billion in FY 2013 to $198.3 billion in FY 2022.

That’s a compound annual growth rate of 11%.

I typically look for a mid-single-digit top-line growth rate from a mature business such as this.

With a market cap of nearly $2 trillion, it’s quite fair to say that this is a mature business.

Despite that size, Microsoft has grown its top line at a brisk pace.

That’s extremely impressive.

Meanwhile, earnings per share grew from $2.58 to $9.65 over this period, which is a CAGR of 15.8%.

Just terrific.

A combination of steady margin expansion and buybacks conspired to fuel excess bottom-line growth.

For perspective on the latter point, the company’s outstanding share count has been reduced by approximately 11% over the last decade.

Looking forward, CFRA is projecting that Microsoft will compound its EPS at an annual rate of 16% over the next three years.

Basically, CFRA is assuming a continuation of the status quo.

I see no reason to quibble with this.

After all, Microsoft is, in some ways, actually becoming better as it gets bigger.

That’s a difficult and rare feat.

There’s the new defense deals, acquisitive growth in gaming, as well as the potential in AR/VR.

CFRA highlights that last point: “We note tremendous upside potential in AR/VR, both for gaming and a growing number of industrial use cases well-suited to MSFT’s Hololens goggles and development platform.”

Meantime, the main “cash cow” of the company – cloud – remains a rock, showing 24% YOY revenue growth in the most recent quarterly report.

The company’s biggest segment is also its fastest-growing segment, which is incredible.

Microsoft’s Azure platform is estimated to have a solid #2 share of the lucrative global cloud market, and this market is only getting bigger.

Importantly, cloud isn’t just a third-party enterprise thing.

Its applications have moved internally, as CFRA notes: “Revenue from cloud-based businesses also includes LinkedIn, Bing, and Xbox-Live and is now ~65% of total.”

I’m willing to accept CFRA’s forecast as the base case here, which easily supports the expectation for low-double-digit dividend growth over the foreseeable future.

Simply put, it’s a compounding machine that should keep compounding at a high rate.

For growth-oriented dividend growth investors, this is about as good as it gets.

Financial Position

Moving over to the balance sheet, Microsoft has a phenomenal financial position.

The long-term debt/equity ratio is 0.3, while the interest coverage ratio is over 40.

Furthermore, Microsoft has more than $100 billion in total cash – enough to pay off all long-term debt twice over.

It’s a fortress balance sheet.

Indeed, Microsoft is one of only two US companies with a AAA credit rating from Standard & Poor’s – higher than the US government, which can literally print money.

Profitability is extremely robust.

Over the last five years, the firm has averaged annual net margin of 29.7% and annual return on equity of 38.9%.

Fundamentally speaking, this is one of the best businesses I’ve ever seen.

And with global scale, switching costs, patents, R&D, and IP, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

Their very business model is a risk, as ever-changing technology introduces the risk of obsolescence.

As broad as Microsoft is, the company missed the transition to mobile and now lacks a meaningful presence there.

With a market cap of $1.8 trillion, Microsoft is staring down the law of large numbers.

The planned acquisition of Activision Blizzard leads to risks around cost and execution.

Saturation, especially in regard to Windows OS, is a downside risk to growth.

Considering the immense quality of the enterprise, I see these risks as very acceptable.

And with the stock down 30% from its 52-week high, the valuation makes the business especially appealing right now…

Stock Price Valuation

The P/E ratio is sitting at 25.3.

I think that’s a perfectly reasonable earnings multiple for this growth profile, which puts the PEG ratio well below 2.

Consider that the stock’s own five-year average P/E ratio is 36.9.

We aren’t even close to that.

This is a stock that often looks expensive, but it doesn’t right now.

There’s a similar disconnect in the sales multiple, with the current P/S ratio of 8.7 being much lower than its own five-year average of 9.9.

And the yield, as noted earlier, is right in line with its own five-year average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a two-stage dividend discount model analysis.

I factored in a 10% discount rate, a 15-year dividend growth rate of 12%, and a long-term dividend growth rate of 8%.

The business is still in a state of high growth, despite its massive market cap.

I’m using a two-stage valuation model to account for this.

Microsoft has been relentlessly consistent with low-double-digit dividend growth.

And CFRA is expecting the 15%+ CAGR for EPS to continue for the foreseeable future.

With the low payout ratio and fortress balance sheet, I’m not sure why one wouldn’t expect Microsoft to continue handing out ~12% dividend increases (averaged out) for the next decade or so.

Now, that’s a very high rate of growth to extrapolate out indefinitely.

However, I do see this business as quite capable of high-single-digit dividend growth over the long term.

The DDM analysis gives me a fair value of $239.73.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I think the valuation is at least fair, which is enough for such a high-quality business that often looks expensive.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates MSFT as a 4-star stock, with a fair value estimate of $320.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates MSFT as a 5-star “STRONG BUY”, with a 12-month target price of $330.00.

I came out rather low, which is surprising. Perhaps I was too prudent. Averaging the three numbers out gives us a final valuation of $296.58, which would indicate the stock is possibly 26% undervalued.

Bottom line: Microsoft Corporation (MSFT) is one of the best businesses I’ve ever seen, with quality radiating from every angle. As it’s gotten bigger, it’s actually gotten better. With double-digit dividend growth, 20 consecutive years of dividend increases, a very low payout ratio, and the potential that shares are 26% undervalued, long-term dividend growth investors looking for a world-class compounder would be wise to strongly consider buying shares in this very high-quality business.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from D&I: How safe is MSFT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MSFT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends & Income