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About thirteen years ago, in December 1999, Microsoft Corporation (NASDAQ:MSFT) stock traded at $58. If you invested in Microsoft stock in December 1999, by now you would have lost 54% of your money. That is almost 6% compounded annual losses. This is because way back then, Mr. Market was awarding Microsoft and almost all of the tech companies with sky high valuations. Microsoft in December 1999 was trading at 75 times its earnings.

Mr. Market once again seems to be mispricing Microsoft, whose stock closed at $26.70 on January 9, 2013. This time the stock is trading at insanely low valuation. Let's see why.

Microsoft is trading at Price to Earnings ratio of 9, based on FY 2013 expected earnings, and at a P/E ratio of 8 based upon next year's expected earnings.

The main reason for this is the threat of mobile devices on Microsoft's Windows operating system, which at present powers most of the personal computers in the world and which has ruled the world of personal computers laptops, netbooks and desktops during the last two decades. There is no doubt that the wider adoption of the smartphones, tablets, e-readers, portable game consoles and internet connected TVs is pressuring Microsoft's business and is expected to pressure its enviable margins. In our opinion though, Microsoft is neither facing an existential threat nor is its business in a terminal decline. It may not and most likely will not grow its per share earnings, revenue or free cash flow at the double digit rate which it has done for more than ten years. As a matter of fact it does not have to, in order for its shareholders to make money from this point onwards.

VALUATION: However we tried to value Microsoft, it turned out to be a screaming buy. Let's look at the simplest of them all, a back of the envelope type of DCF calculation, where we calculate Microsoft's intrinsic value by estimating its future free cash flows.

Assumptions: We are going to make some very pessimistic (read ridiculous) assumptions for this exercise. Here they are.

Growth Rates: Microsoft has grown its per share revenue at a compounded annual growth rate (OTCPK:CAGR) of 13% in the last 11 years. We are going to assume a declining revenue growth rate for the next 6 years, which then settles at a 2% annual rate.

Revenue growth rate estimates for 10 years and beyond:

2013E

2014E

2015E

2016E

2017E

2018E

2019E onwards

-10%

-8%

-6%

-4%

-2%

0%

2%

As a reference, sell side analysts expect Microsoft to grow its EPS at a positive 9% CAGR in the next 5 years.

Free Cash Flow Margins: Average Free cash flow margins for Microsoft during the last 11 years, last 3 years and latest financial year are 37%, 37% and 40% respectively. In the spirit of being conservative, we'll not use the higher number i.e. 40% from FY 2012; we'll instead use the lower long-term average number, i.e. 37%. In fact we'll start with 37% FCF margin and then drop it by a couple of points in each of the next 10 years. Yes, each of the next 10 years. As the following table shows, the FCF margin reaches at 17% in the year 10 and then remains at that level.

FCF margin estimates for 10 years and beyond:

2013E

2014E

2015E

2016E

2017E

2018E

2019E

2020E

2021E

2022E

2022E+

35%

33%

31%

29%

27%

25%

23%

21%

19%

17%

17%

Discount Rate: We'll use a discount rate of 10%, widely believed annual return of the broad market.

Let's look at how Microsoft's FCF looks like, using the above assumptions.

DCF calculation for Microsoft:

Year

Revenue Growth Rate

Revenue/share

FCF Margin

FCF/share discounted @ 10% rate

2012

6%

$8.67

40%

$3.491

2013E

-10%

$7.8

35%

$2.22

2014E

-8%

$7.18

33%

$1.97

2015E

-6%

$6.75

31%

$1.77

2016E

-4%

$6.48

29%

$1.63

2017E

-2%

$6.35

27%

$1.51

2018E

0

$6.35

25%

$1.43

2019E

2%

$6.47

23%

$1.37

2020E

2%

$6.60

21%

$1.27

2021E

2%

$6.73

19%

$1.17

2022E

2%

$6.87

17%

$1.07

Year 11

onwards

2%

$33.11

17%

$8.30

Intrinsic Value

$23.72

1: FY 2012 FCF not discounted.

As you can see, the sum of the future free cash flows, discounted at 10%, comes to $23.72.

And one more thing; Microsoft has a book value of $8.20 which should be added to $23.72. But, we are actually not going to add all of the book value to our intrinsic value. Instead we'll use only the cash Microsoft has. As per the latest quarterly filings,

  • Microsoft has $66.64 billion in cash and equivalents which comes to $7.94/share.

  • $58 billion of Microsoft's cash is held overseas. If Microsoft decides to bring it back to the U.S.A., it will have to pay a high repatriation tax (~ at a rate which is the difference of taxes it already paid in overseas jurisdictions and taxes it's supposed to pay in the U.S.A.). Yes, that hurts and that's why any company which has a massive cash pile overseas does not like to bring it back to U.S.A. Unless, of course, if Congress awards them a tax holiday.

  • Anyway, to remain conservative in our assumptions, let's assume that Microsoft management loses its brain and decides to bite the bullet by paying Uncle Sam the repatriation tax at a corporate tax rate of 35%. By doing this cash transfer from overseas, it now has $37.7 billion in the U.S.A. which comes to $4.49/share.

  • Cash it already had in U.S.A. = $66.64 - $58 = $8.64 billion i.e. $1.03/share

  • Total cash/share in U.S.A. (post repatriation tax) = $1.03 + $4.49 = $5.52

  • Intrinsic Value = sum of discounted FCF/share and tax adjusted cash/share = $23.72 + $5.52 = $29.24.

Microsoft stock closed at $26.70 on January 9, 2013 and as you can see that even after using our ridiculous assumptions, the intrinsic value for Microsoft comes to $29.24. Microsoft is not undervalued or deeply undervalued. It's insanely undervalued. We went long recently and remain a buyer at these levels.

Source: Microsoft Is Ridiculously Undervalued