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Overview

Microsoft (NASDAQ:MSFT) shares have been mostly range bound for the past three years, oscillating between $24 and $33. At the current price of about $27, shares have fallen precipitously from their March high of $32.95, a decline of greater than 17%. What has caused this decline? What catalysts exist that will get shares back on track? What is Microsoft actually worth? This article will attempt to use qualitative and quantitative evidence to answer these questions and assign a current value to Microsoft shares, given the outlook for future growth. Taking a look at the daily chart below from StockCharts.com, we see that MSFT may be trying to form a base around the $26.50 level, about where it trades now.

(click to enlarge)

Catalysts

We'll start by taking a look at some potential catalysts for Microsoft shares to move up (or down) in the near to medium term. The most obvious catalyst for Microsoft is their 90%+ market share in operating system software with its Windows products. Windows sales have been a bit sluggish lately due to the decreased demand for PCs we have seen across the entire industry and indeed, the PC supply chain as well. Intel (NASDAQ:INTC), AMD (NYSE:AMD), Dell (NASDAQ:DELL) and other hardware manufacturers have been pummeled in the last two quarters on fears that the PC is a dying product. I do not believe this is the case, as no product exists that can take the place of the PC in terms of computing power. Tablets may get there one day but as of now, I don't know anyone that could replace their work PC with a tablet and still function. While I believe this is a rough patch for PC, and thus, software sales, I don't think this will threaten Microsoft's dominant position in operating system software. This is a terrific business to be in as it provides annuity-type revenue streams, has great margins, and provides significant operating leverage. This operating leverage is definitely a negative when things are rough but when the turnaround in demand occurs, Microsoft stands to reap the benefits. Apparently, the Department of Defense is onboard.

The next major product category I'd like to examine for Microsoft is the Xbox gaming console. This is an area where Microsoft has been quite successful and rumors are surfacing that the third generation Xbox could hit store shelves this year. This new console could potentially generate billions of dollars in sales for Microsoft over the next 7-10 years as the Xbox 360 console is abandoned and the third generation model is adopted. Speculation abounds as to pricing and features, but assuming Microsoft can execute as well as they have with the Xbox 360, it should be a huge success.

Lastly, the most glaring defeat, in my opinion, Microsoft has suffered has been its foray into the mobile device markets. Microsoft's Surface tablet is a great product but is receiving a tepid reception in the marketplace. I'm not a tablet expert but my guess is Microsoft's lackluster sales of Surface tablets is due, at least in part, to the fact that Microsoft doesn't have a "coolness" factor with consumers the way Apple (NASDAQ:AAPL) or Samsung do. I think Microsoft's best chance with the Surface is to continue to try and market it to enterprise customers as it is a fantastic piece of technology for business people on the go, such as salespeople who need a light, mobile computing device. Surface has a major advantage for business customers; it can run Excel, PowerPoint, Word, etc. This is a great feature for a business but worthless to most consumers. Surface may not end up being a huge success, but it shows Microsoft management knows they are behind in the mobile space and are willing to do something about it.

Stock Valuation

What does all of this mean for the value of the company? To start, we need to establish the inputs for the discounted cash flow model I use. First, 2012 and 2013 earnings estimates, as well as the earnings growth rates are pulled from Yahoo! Finance analyst compilations. Second, dividend growth is assumed to be a constant 8% per year (my number). Third, I'm using a 12% discount rate in order to show what the market is pricing in at current levels, around $27 per share. Fourth, the perpetual growth rate is assumed to be 3% (also my number). Lastly, buybacks are ignored as it is impossible to forecast how many shares will be purchased and when. You may disagree with some or all of my assumptions, but all DCF analyses are subject to opinion and conjecture.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$1.85

$2.88

$3.14

$3.42

$3.72

$4.05

x(1+Forecasted earnings growth)

55.68%

8.90%

8.90%

8.90%

8.90%

8.90%

=Forecasted earnings per share

$2.88

$3.14

$3.42

$3.72

$4.05

$4.41

Equity Book Value Forecasts

Equity book value at beginning of year

$8.17

$10.06

$12.12

$14.38

$16.84

$19.54

Earnings per share

$2.88

$3.14

$3.42

$3.72

$4.05

$4.41

-Dividends per share

$0.92

$0.99

$1.07

$1.16

$1.25

$1.35

$1.46

=Equity book value at end of year

$8.17

$10.06

$12.12

$14.38

$16.84

$19.54

$22.49

Abnormal earnings

Equity book value at begin of year

$8.17

$10.06

$12.12

$14.38

$16.84

$19.54

x Equity cost of capital

12.00%

12.00%

12.00%

12.00%

12.00%

12.00%

12.00%

=Normal earnings

$0.98

$1.21

$1.45

$1.73

$2.02

$2.35

Forecasted EPS

$2.88

$3.14

$3.42

$3.72

$4.05

$4.41

-Normal earnings

$0.98

$1.21

$1.45

$1.73

$2.02

$2.35

=Abnormal earnings

$1.90

$1.93

$1.96

$1.99

$2.03

$2.07

Valuation

Future abnormal earnings

$1.90

$1.93

$1.96

$1.99

$2.03

$2.07

x discount factor (0.12)

0.893

0.797

0.712

0.636

0.567

0.507

=Abnormal earnings disc to present

$1.70

$1.54

$1.40

$1.27

$1.15

$1.05

Abnormal earnings in year +6

$2.07

Assumed long-term growth rate

3.00%

Value of terminal year

$22.95

Estimated share price

Sum of discounted AE over horizon

$7.05

+PV of terminal year AE

$11.63

=PV of all AE

$18.68

+Current equity book value

$8.17

=Estimated current share price

$26.85

As you can see, given the parameters described above, Microsoft shares are a buy at current levels, even with what I consider to be an astronomical discount rate. For a technology giant that is very stable and pays a nice dividend, I would typically use a discount rate of about 8% as there is far less uncertainty and risk associated with this type of company over a Cirrus Logic (NASDAQ:CRUS), as an example. Entering a discount rate of even 10% into the model gives Microsoft a current fair value of about $36, or roughly 33% higher than it trades now. The implication of this is that the market is pricing in some serious downside risk to Microsoft's earnings potential over the next few years. As I don't see this risk coming to fruition without some enormous, exogenous shock, Microsoft shares appear to be quite a good value at present.

I am fully aware that risks exists, such as declining PC sales and slow adoption of Windows 8, just as examples. However, Microsoft has shown over long periods of time that they can adapt and produce great software that businesses and consumers want to buy. I don't believe this will change with Windows 8 as it is a great product that just takes a bit of time to get used to. In addition, if Microsoft can shock the world and execute in the mobile phone and tablet spaces, it means significant upside to its potential earnings.

Source: Microsoft Is Priced For PC Armageddon