In this article, I'm going to show how much Microsoft Corporation stock (MSFT) is worth according to a Warren Buffett "owner earnings" style analysis.
I will be posting a link to the valuation model (in an excel file) that I used along with describing the assumptions that went in it. This file will contain all the cash flow data from Microsoft going back to 1992. (The last year in which there is EDGAR data for MSFT in the SEC website.)
I built an excel file with a valuation model using Buffett's measure of "owner's earnings." Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price-to-earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract.
In order to make it consistent with his conservative approach, I will be using safe assumptions in order to make sure a buy or sell rating in the stock is not based on predictions that are difficult to make. Please note that this article is not a suggestion that Buffett would value the stock exactly like suggested or that he would buy MSFT, he already said he looked at it many times but decided not to invest. I'm simply using a model that is similar to how he described his valuation method.
The assumptions that went into the DCF-like model were:
-I defined owner earnings as Operating Cash flow minus Capex minus "other assets" minus "M&A" plus asset sales (when there is any). Why subtract M&A? M&A is a major way in which shareholder value gets destroyed (think Autonomy), the whole idea of a Buffett style valuation is to make a valuation that is based on safe assumptions. I don't want to have to assess how much, for instance, the Skype buyout will be worth because I just believe that is just too difficult. Why add back asset sales? They represent a recovery from old capex and M&A so in a way, its old operating cash flow coming back home.
-I assume Microsoft will have another 10 years of above average owner earnings growth of 8% then normalize to 3%. The average rate of growth in owner earnings for Microsoft over the last 6 years is 11.85% (24.49% since 92), the compounded rate of growth over the last 6 years is 4.94% (18.5% since 92). I believe 8% is a conservative number.
-Microsoft required return is 12% (the rate at which the future cash flows are discounted back to the present). I'm assigning a higher discount rate than CAPM would suggest due the risks of the technology sector and its volatility. I don't think the market has been very good at predicting the pace in which technological changes impact corporations in that sector, so 1 year beta is understated, in my view.
-Long-term normalized growth is 3%. This is even lower of what World Nominal GDP is likely to be going forward. Earnings growth tends to be quite similar to Nominal GDP growth over long periods of time.
-As margin of safety at the start of the valuation, I took Microsoft owner's earnings and decreased by 20%. This 20% decrease takes into account cash liabilities that are unexpected like lawsuits (and Microsoft has its share of issues in Europe), government fines, patent violations, dumb M&A and other unexpected charges. This adds a margin of safety in estimating future cash flows and is consistent with Buffett's skepticism of not subtracting enough from cash flow figures.
Plugging all these in, projecting the owner cash flows and discounting it back to the present at the chosen discount rate yields a fair value price of $29.51. With the stock currently trading at $28 or so, I would call the stock fairly valued.
Does that mean the stock is not a buy? Well, a conservative estimation of owner cash flows tells me that the stock is fairly valued but if the investor has special insights and knowledge in the tech sector, he might want to plug in a higher or lower growth rate going forward depending on his outlook for Windows 8, the Surface Pro, etc. Estimating these types of trends is not my specialty, so I rather use safer assumptions. I encourage readers to use their own numbers and come up with their own exact fair value if they disagree with my assumptions.
According to a safe set of assumptions and a Buffett like valuation model, Microsoft stock is currently fairly valued. I wouldn't be personally buying stock right now as I believe there are better opportunities out there currently (like Apple). However, if the stock drifts down to the low $20s I might start to build up a position, especially if people start to get overly pessimistic in the stock. If you have any questions about the model, you can private message me.
Additional disclosure: I can't guarantee the accuracy of every data point included in this article, I encourage the reader to double check the data. This article does not constitute investment advice.