Microsoft Represents Value Below $20 a Share

Microsoft (MSFT) continues to trade under US$20 a share. We have previously looked at $MSFT and felt it was undervalued in the US$20-25 range. We decided it was time to revisit our valuation.

Valuecruncher valuation model of $MSFT with interactive assumptions

Valuecruncher produces a valuation of US$25.34 for $MSFT. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 33.6% above the current share price of US$18.96.

Assumptions

• Revenue: Reuters aggregates 30 analysts covering $MSFT and the mean estimate of 2009 revenues is US$67.3 billion. For our analysis we have used US$64.0 billion in 2009, US$68.5 billion in 2010 and US$72.5 billion in 2011. Between 2004 and 2008 $MSFT grew revenues at a compound annual growth rate of 13.2% - revenues of US$36.8 billion in 2004 to US$60.4 billion in 2008.
• Profitability: We have used an EBITDA margin of 40.0% to 2011. Reuters has $MSFT‘s EBITD margin at 39.25% last year and an average of 37.0% over the last five-years.
• Capital Expenditure: We have assumed capital expenditures of US$3.75 billion per annum moving forward.
• Discount Rate: 11.0%.
• Terminal Growth Rate: 3.0%. In our assumptions we have 2010/11 revenue growth at 5.8% - we have assumed that growth eventually slows to a 3.0% long-term stable growth rate. We have used 3.0% as our terminal growth rate.

Our analysis incorporates the cash on the $MSFT balance sheet – Valuecruncher calculates a net debt number.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $MSFT we looked at four peer companies - IBM (IBM), Apple (AAPL), HP (HPQ) and Google (GOOG). We calculated enterprise values - market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $MSFT and the peer set.

We have used the last financial year (LFY) as the base set of metrics. $MSFT is currently priced at the bottom of the peer group for the EV/EBITDA and EV/EBIT metrics and in the middle for the EV/FCF metric. The market is currently valuing the profits (EBIT and EBITDA) and free cash flow produced by $MSFT at less than half that of the comparable numbers for $GOOG. This reflects the perceived different future growth prospects of the two businesses. The comparator numbers show $MSFT is comparably priced against the peer group - even with the strengths of its business model (39.8% EBITDA margins vs 18.9% for $IBM and 11.7% for $HPQ). $MSFT’s growth is slowing - but it is still a very good business. Should $MSFT’s profits (at the EBITDA and EBIT levels) really be valued less than $IBM and $HPQ?

Play with our assumptions – what does your analysis say? We think that $MSFT looks undervalued. Our model is interactive - you can change any of our assumptions.

Disclosure: None.

Comments

[Ishortyou:]

MS business model is broken the constant churning of products despite customer requests are making the market angry, just take a look of how Windows Vista made so many customers angry, specially when they are trying to find drivers for their hardware for Vista, so they dump Vista and stick with XP because it works, you are not going to sell me and stick up to my a.....s products that will force me to buy a whole set of hardware just because you are MS, I'd prefer even Linux for that purpose, at least they work on drivers for the old products and keep their customer support up to date.

2008 Dec 30 07:37 AM

[purduefan:]

It is true that Vista has a lot of issues. That's one of the reasons (not the only one) that Apple is gaining market share in operating systems. But from everything I have read, Windows 7 is really slick, and Microsoft will ship it later this year. Windows 7 is what Vista should have been. So that will keep Microsoft in the game and satisfy most of their users going forward. And whether you're an Apple or Linux fan, competition is always a good thing. It makes everyone else work harder to innovate, which is a win win for the consumer.

2008 Dec 30 09:16 AM

[mollytjm:]

speculating on Windows 7 should be done with caution...it's not out yet, it's not tried yet. the buzz on Vista was that it was terrific...then delayed over and over again. then a mess. MS will not get the newest Mac users back but they better get it right this time. Big business has a lot invested in MS products...if it disappoints again, it could be a problem for MS.

2008 Dec 30 10:53 AM

[Tom Armistead:]

It's about growth and margins - MSFT has a fine 5 year history on both counts but given disenchantment with Vista and competition in the form of alternatives to Office and Vista I question the sustainability of the trends that got MSFT where it is today.

My guess is that they can get away with it for a few more years and the stock could go to 30 somewhere in there.

2008 Dec 30 11:12 AM