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Scrolling through the articles available on Microsoft (NASDAQ:MSFT), one is amazed at the amount of analysis available on Seeking Alpha. Microsoft has a huge array of products and services and there are several articles focusing on those items, comparing them to competitor's products or making a historical comparison. What I found missing among them was an article focusing purely on the financial valuation of the business.

The fact of the matter is that Microsoft still has a significant hold on a number of franchises, and a competitor cannot affect its revenue streams over the medium term by more than a few percentage points. Hence, it might make sense to apply a valuation model like discounted cash flow (DCF) to Microsoft.

For curious investors, I shall outline briefly the mechanics of the DCF method that we are going to apply. While explaining his investment strategy, Warren Buffett has always mentioned free cash flows, and that is what we are going to use here. The steps for a two-stage DCF model are as follows:

  1. Forecast the free cash flow for a certain number of years.
  2. Calculate a continuing value from that point on to perpetuity.
  3. Discount all the cash flows to the present using an appropriate discount rate.
  4. Subtract the current value of debt that the company has.
  5. This gives us the value of the equity. Divide it by the number of shares outstanding, which gives us the per-share value of equity.

The estimates necessary to apply the model to Microsoft are as follows:

Required rate of return of 12%. This is a little on the high side, but that is what Buffett calls "margin of safety." So if we err, we err on the upside, not on the downside.

Growth rate for the next three years. This is the rate at which the cash flow will grow for the next three years. For a reasonable estimate, I calculate the average FCF growth rate for the past 10 years, which is 10%. So, here we are going to build two scenarios:

  1. Assume the growth rate for the next three years is 10%.
  2. For investors who want more margin of safety, we assume that the cash flow for the next three years is 5%.

Perpetual growth rate. This is the rate at which the cash flow grows into perpetuity after the three years. Again, I will build three scenarios:

  1. Assuming the growth rate is 3% (for optimistic investors).
  2. Assuming the growth rate is 1.5% (for medium-risk investors).
  3. Assuming the growth rate is 0.1% (for cautious investors).

Running the calculations in a spreadsheet, we get six different scenarios and six different prices for the stock. Investors can make a call depending on their risk profile.

Estimated price when the three-year growth rate is 10% and

  1. The perpetual growth is 3% is : 46.8
  2. The perpetual growth is 1.5% is : 40.9
  3. The perpetual growth is 0.1% is : 36.7

Estimated price when the three year growth rate is 5% and

  1. The perpetual growth is 3% is : 40
  2. The perpetual growth is 1.5% is : 35.8
  3. The perpetual growth is 0.1% is : 32

Scenarios one and two are ideal for investors who feel highly optimistic about Microsoft and are willing to take a larger risk, while scenarios three and four are ideal for medium-risk investors. In scenarios five and six, we have built an ample amount of margin of safety into our calculations and this is suitable for low-risk investors. On the basis of this analysis, we believe that Microsoft is a lucrative buy at the current price of 26.4.

Source: Discounted Cash Flow Analysis: Microsoft Is A Buy In All Scenarios