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After visiting PC World, I can see why consumers think Microsoft (MSFT) should trade like HP (HPQ) and Dell. The fad or trendy gadgets are now smartphones and tablets, as hardly anyone walked by the PC and laptop stalls. What you buy someone as a gift nowadays is a tablet or a smartphone. Laptops are no longer wanted by many people, other than to replace a broken one.

As a result of this observation, we went back to check some figures on our investment in Microsoft and here we share some of that analysis: the potential upside and downside using a simplified dividend growth model. The upside is Windows 8 tablet demand, smartphones, Bing and Xbox, and the downside is Linux in servers along with diminishing PC demand. The question we asked was how much is an investment in Microsoft worth today given the recent growth and potential growth?

First, let us explain the methodology for this public article. We use a simplified dividend growth model by defining a hypothetical dividend of 70% of EPS (D1). Microsoft currently pays out only 50% of its earnings per share as dividends but we think it could easily afford to pay out 70%, given it generates large amounts of free cash flow and keeps large cash equivalent positions on its books.

For the rest of the required parameters, we derive the potential growth by looking at historical data and forecasts. The return on equity is derived using a CAPM model. The CAPM allows us to get the cost of equity and the related WACC given Microsoft has $20 billion in debt/liabilities. Finally we plug in the derived values for r and g in the perpetual dividend growth model:

P = \frac{D_1}{r-g}

Where P is price per share. This is a simple model but like all models, it is the parameter initialization that is of most importance. So here we use the 70% EPS as the dividend (D1).

Assumptions:

D1 = potential current dividend (70% of EPS)

r = CAPM / WACC derived expected return (function of market return and g)

g = expected average growth per annum of dividend based on revenue

Key figures we used to calibrate the model:

Enterprise Value (13 Mar 2013)3:179.57b
Market Cap (intraday):233.82B

Dividend Growth (Gordon) Model for Microsoft

(click to enlarge)Last year's quarterly growth rate

For the market portfolio we took the DJIA index. As Microsoft is well correlated to the market we integrated that fact into the relationship between r and g. Thus r is a function CAPM (DJIA, g). This is since the Dow will grow faster as Microsoft grows faster.

The result was surprising to us. Microsoft is slightly overvalued based on last year's growth, but significantly undervalued if any of the growth scenarios from tablets to mobile to Bing materialize (See 1, and 2).

In Summary

Based on these assumptions (and a beta of 1.14) at 4.8% growth Microsoft should trade at $30. However, at 6.5% growth we could expect a market price of $32-$40. The 6.5% growth is based on tablet sales and Windows 8, which we extrapolated from the Forrester data in the last article. At the unlikely top end of the spectrum we could see $100+ shares if Ballmer pulls an Apple (AAPL) and achieves 10% headline growth for several years, but this is unlikely. Finally, it is worth mentioning that if there is inflation, Microsoft will benefit as it could increase prices and headline revenue growth will increase. For the average case we see a -$8/share loss risk, with a mean +$12 / share gain over the next 24 months. Thus, for now, we are keeping our position. Please note that in the average case, Microsoft has a slightly higher risk than the Dow index. Consistently high growth values are unlikely unless clever moves are made in the data center and consumer market to achieve high growth. Therefore, we expect Microsoft to provide a return consistent with the general market albeit at a slightly higher return.

Source: Microsoft: What's The Upside?