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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Microsoft's (NASDAQ:MSFT) case, we think the firm is undervalued. Though there have been reports that Windows 8 is off to a poor start, we think the company is fairly valued at $47 per share, significantly higher than where it is currently trading.

We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for a presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Microsoft posts a VBI score of 6 on our scale, reflecting our "undervalued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. We compare Microsoft to peers Adobe Systems (NASDAQ:ADBE), F5 Networks (NASDAQ:FFIV), and Oracle (NYSE:ORCL). In the spirit of transparency, we show how our strategy has created outperformance in the portfolio of our newsletter below:

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Our Report on Microsoft

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Investment Considerations

Investment Highlights

• Microsoft's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• Microsoft's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.

• Microsoft has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 30.9% in coming years. Total debt-to-EBITDA was 0.4 last year, while debt-to-book capitalization stood at 15.3%.

• The firm's shares have underperformed the market benchmark during the past quarter. Although Microsoft's valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels. There may be a better entry point yet.

• The firm sports a very nice dividend yield of 3.5%. We expect the firm to pay out about 31% of next year's earnings to shareholders as dividends.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital ((NASDAQ:ROIC)) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Microsoft's 3-year historical return on invested capital (without goodwill) is 121.9%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Microsoft's free cash flow margin has averaged about 36.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Microsoft, cash flow from operations increased about 31% from levels registered two years ago, while capital expenditures expanded about 17% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Microsoft's shares are worth between $38.00 - $56.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $47 per share represents a price-to earnings (P/E) ratio of about 23.5 times last year's earnings and an implied EV/EBITDA multiple of about 11.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 8.1%. Our model reflects a 5-year projected average operating margin of 38.2%, which is below Microsoft's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Microsoft, we use a 10.5% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $47 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Microsoft. We think the firm is attractive below $38 per share (the green line), but quite expensive above $56 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Microsoft's fair value at this point in time to be about $47 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Microsoft's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potentially change. The expected fair value of $58 per share in Year 3 represents our existing fair value per share of $47 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Windows 8 Adoption Slow But We Still Think Microsoft Is A Steal

Additional disclosure: MSFT is included in our Dividend Growth Newsletter.