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Microsoft (MSFT) shares have continued their famous "range bound" nature over the past year, oscillating between $26 and $32. Shares had been punished in recent months based upon the "death of the PC" argument and the idea that the software giant would not be able to reinvent itself in order to compete in the new world of mobile computing. After recent earnings and affirmation from ValueAct Capital, the stock has moved back to nearly $31 in fairly rapid succession at the time of this writing. Given this information, is the move up over for MSFT? This article will take a look at Microsoft's valuation in relation to its prospects and determine whether or not shares deserve your capital.

To determine a fair value for Microsoft shares, we'll use a DCF-type analysis that requires some assumptions: 1) book value and analyst growth rates from Yahoo! Finance 2) perpetual growth rate of 4% (my estimate) 3) dividend growth rate of 7% per annum (my estimate) and finally 4) discount rate of 10% (my estimate). Of course, you may disagree with some or all of my estimates but I used what I believe to be reasonable approximations for Intel's prospects given available information. Keep in mind that all forecasting is subject to conjecture.

  

2013

2014

2015

2016

2017

2018

Earnings Forecast

       

Reported earnings per share

  

$2.75

$3.10

$3.37

$3.66

$3.98

x(1+Forecasted earnings growth)

  

12.75%

8.65%

8.65%

8.65%

8.65%

Forecasted earnings per share

 

$2.75

$3.10

$3.37

$3.66

$3.98

$4.32

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$9.19

$10.96

$13.00

$15.24

$17.70

$20.39

Earnings per share

 

$2.75

$3.10

$3.37

$3.66

$3.98

$4.32

-Dividends per share

$0.92

$0.98

$1.05

$1.13

$1.21

$1.29

$1.38

Equity book value at end of year

$9.19

$10.96

$13.00

$15.24

$17.70

$20.39

$23.33

x Equity cost of capital

 

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

 

$1.10

$1.30

$1.52

$1.77

$2.04

$2.33

        

Forecasted EPS

 

$2.75

$3.10

$3.37

$3.66

$3.98

$4.32

-Normal earnings

 

$1.10

$1.30

$1.52

$1.77

$2.04

$2.33

Abnormal earnings

 

$1.65

$1.80

$1.84

$1.89

$1.94

$1.99

x discount factor (10%)

 

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

 

$1.50

$1.49

$1.39

$1.29

$1.20

$1.12

        

Abnormal earnings in year +6

      

$1.12

Assumed long-term growth rate

      

4.00%

Value of terminal year

      

$29.16

        

Estimated share price

       

Sum of discounted AE over horizon

 

$7.99

     

+PV of terminal year AE

 

$16.44

     

PV of all AE

 

$24.44

     

+Current equity book value

 

$9.19

     

Estimated Current share price

 

$33.63

     

Given my model's inputs, Microsoft has an approximate fair value of $33.63 today. With shares trading at $30.79 as of this writing, the stock is trading at a 9% discount to my fair value estimate. It is important at this point to understand what the fair value estimate means. The model's output is a price at which, given the parameters specified, shares can be bought at a "good price" today. The estimated fair value is the net present value of the company's cash flows plus its current book value. Therefore, the fair value of the business today, according to my estimates, is about 9% higher than where shares are trading.

There could be many reasons for this discrepancy. For instance, indices are near major highs, fears about the company's inability to adapt to the new computing market that is focused heavily on tablets and smartphones, fears about IT spending in general going forward, repeated failures by Microsoft to produce a mobile device (tablet or smartphone) that consumers and businesses will actually buy and others are all valid risks for the stock. However, with a 9% estimated cushion, some of these fears are probably priced in already.

In addition, it is important to note that $33.63 is not a nominal price target; rather, it is the net present value of all the company's estimated future earnings and current book value. Given Microsoft's current forward PE of 10, if the company achieves $4.32 in earnings per share in 2018, a price of $43+ is implied with no multiple expansion.

In addition, my model is forecasting that over this same period, shareholders will receive approximately $7.04 per share in cash dividends, or about 23% of the current share price. This offers huge downside protection in the shares and provides loads of current income in the process.

There are risks, of course, to my estimates. First, Microsoft may not achieve the 8.65% earnings growth annually that analysts are forecasting. If that does not happen, there is potentially significant downside risk to my fair value. For instance, if only 4% earnings growth is achieved, the fair value decreases to just over $28, implying Microsoft is overvalued by about 8%. If no earnings growth is achieved whatsoever, in a sort of PC Armageddon scenario that some investors think may materialize, look out below as it will get ugly for holders of the stock. However, given the fact that shares are very attractively priced with a reasonable 10% discount rate and the enormous amount of dividends that are due shareholders in the coming years, I believe the margin of safety is large enough to warrant taking the risk at this point. Also remember that this analysis assumes no share repurchases and MSFT is seemingly perpetually engaged in buybacks so that could be an additional tailwind for EPS in the future. There are certainly risks to owning MSFT as the company's solutions for the move away from desktop computing are currently a bit questionable. However, enterprise mobile computing is nowhere near sizable enough at the moment for it to sink Microsoft. The company is still basically a monopoly in many types of software and that will be very, very difficult for a competitor to break as switching costs are prohibitively high for most customers. The combination of share repurchases, dividends, earnings growth, economic moat and current reasonable valuation means Microsoft shares have a sizable enough margin of safety to mitigate future earnings risk under most scenarios.

Source: Profit From This Dividend King's Monopoly