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Microsoft (MSFT) has been a strong performer this year, delivering a return of 30% to its shareholders year to date compared to the 18% rise in the broader NASDAQ index. The company currently has a market capitalization of $289 billion and provides a dividend yield of 2.65%. The stock has been range-bound for a few years now and is close to its 52 week high of $35.27 at the time of writing. In this article, I will perform valuation analysis to calculate the fair value and determine if it makes sense to invest in MSFT at current levels.

Growth Rates:

MSFT grew its revenues at an annual rate of 6% during the last 3 years, while its EPS increased by 5% on an annualized basis during the same time period. On a year on year basis, EPS declined by 6% while the revenues increased 5%. However, looking at the most recent quarter and comparing it to the same period last year, revenues and EPS were both up by a respectable 18% and 20%.

MSFT has historically returned earnings to the shareholders via a combination of dividends and stock repurchases. The payout has hovered in the 55-65% range over the last 3 years. Assuming a long term sustainable return on equity of 22% to 28%, I project a long term growth of 8% and 10%. This is in line with the average analyst expectation of 9%. For reference, the software industry is expected to grow at an annual rate of 19% during the next 5 years compared to the 9.4% predicted growth rate of the S&P500.

Margins and Profitability

MSFT's gross margins have decreased over the last 3 years from 80% to TTM gross margins of 75%. The operating margins have experienced an even greater decline falling from 39% to 27%. The net margins were also lower decreasing from 30% to 22% over the last 3 years.

To compare MSFT's to its peers, I evaluated the margins, valuation and operational aspects of some of the other companies in the competing industry segments. The peers selected for analysis included IBM (IBM), Hewlett Packard (HPQ), Sony Corporation (SNE), Oracle (ORCL), Cisco (CSCO) and Adobe Systems (ADBE). The table below presents the peer analysis.

Ticker

Mkt Cap

Price

P/E

P/S

ROA

ROI

GM

OM

IBM

228.10B

205.72

14.19

2.18

14.09

22.19

48.13

20.96

HPQ

47.06B

24.21

-

0.39

-10.62

-18.02

22.95

-9.19

SNE

21.19B

20.96

71.43

0.32

0.76

1.18

34.05

3.38

ORCL

160.40B

34.05

15.85

4.32

13.14

16.44

78.83

36.92

CSCO

125.46B

23.53

13.07

2.73

8.99

11.2

61.24

21.85

ADBE

21.30B

42.43

29.87

4.84

8.78

10.13

89.01

26.8

MSFT

286.18B

34.27

17.66

3.88

14.77

20.15

76.22

29.92

As shown in the table above, MSFT's operational numbers are fairly competitive compared to its selected peers. The firm does trade at a premium to IBM and CSCO on earnings multiple basis.

Valuation:

Valuation analysis was performed using residual income analysis and three scenarios identified below:

  • Optimistic Scenario: In this scenario, I assumed that MSFT would report 2013 and 2014 EPS meeting the high end of analyst expectations. A growth rate of 10% was assumed for the next 5 years beating market expectations.
  • Realistic Scenario: This scenario is based on my expectations. I started my analysis in this scenario employing the average 2013 and 2014 EPS estimates. A long term growth rate of 9% was used as part of this analysis.
  • Pessimistic Scenario: In this scenario, I assumed that the company would miss average forecasts for 2013 and 2014 and report an EPS matching the low end of analyst expectations. A long term growth rate of 8% was assumed as part of this analysis.

A cost of equity of 13.6% and a stable growth rate of 3% was applied in the case of all three scenarios. The analysis results are present below:

Optimistic Scenario:

EPS 2013 - $2.85

EPS 2017 - $4.39

PV of Residual Income = $14.6

PV of Terminal Value = $11.3

Existing Book Value = $9.2

Intrinsic Value = $35

Realistic Scenario:

EPS 2013 - $2.76

EPS 2017 - $3.91

PV of Residual Income = $12.5

PV of Terminal Value = $9.1

Existing Book Value = $9.2

Intrinsic Value = $31

Pessimistic Scenario:

EPS 2012 - $2.68

EPS 2021 - $2.83

PV of Residual Income = $10.3

PV of Terminal Value = $6.5

Existing Book Value = $9.2

Intrinsic Value = $26

As shown in the above, MSFT's fair value is in the broad range of $26 to $35. Using my realistic scenario based intrinsic value of $31, the stock trades at a premium of 11%. I would use the current strength and sell my existing position.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision)

Source: Microsoft: Time For Some Profit Booking