Where Will Microsoft Shares Go?

Jun. 4.13 | About: Microsoft Corporation (MSFT)

This seems like a great time to buy more Microsoft Corporation (NASDAQ:MSFT) stock at $35.59 a share. The EV/EBITDA offers further verification for investors. The EV/EBITDA is the enterprise multiple and it takes into account a company's debt and cash levels in addition to its stock price and relates that value to the firm's cash profitability. The enterprise multiple is seen as the most encompassing and is generally considered the most useful in analyzing the current valuation of a stock.

Earnings Before Interest, Taxes, Depreciation, and Amortization [EBITDA] is often more desirable than P/E because it is considered less docile than earnings and P/B because it is a better measure of cash profitability than book value. However, it is not without its flaws.

Taking out interest, taxes, depreciation and amortization can make even completely unprofitable companies appear to be financially healthy. A look back at the dotcoms offers numerous examples of firms that actually had no future, no hope and certainly no earnings, but became the darlings of the investment world. The use of EBITDA as a measure of fiscal health made these companies look attractive.

It is always best to look at several different multiples. Still, the EV/EBITDA gives a good picture about the value of a stock like MSFT. It must be said that the EV/EBITDA is great for technology companies since they have low capital expenditure and depreciation and amortization numbers.

Windows 8.1 to Save the Day?

Before delving deeper into the EV/EBITDA, let's highlight some of the challenges that Microsoft faces and the strategic investments the computer software firm has made in the recent past.

We are in a dying PC market. Gartner has reported that global PC shipments in Q1 2013 have fallen to levels not seen since Q2 2009. Microsoft has been aware of this for some time and has tried to make inroads into the highly competitive mobile arena with Apple Inc. (NASDAQ:AAPL) and Google Inc. (NASDAQ:GOOG) being the front-runners. Windows 8 came out last October and Microsoft thought it had finally put out a product that could be relevant for PCs as well as tablets. But the problem is that the sales haven't been what the software giant expected. There were over a 100M Windows 8 licenses sold, but there wasn't a whole lot of interest among tablet users.

There have been a lot of user complaints with the 'steep learning curve' being the biggest concern. This has forced Microsoft to come up with a Windows 8.1 update that will be released soon. It will have a "Start Tip", but it won't be like the Start menu we've come to know and love. There is one thing, however, that Microsoft has got right in terms of satisfying consumers and that is to include the choice to boot directly to the desktop.

The big thing that MSFT has going for it and why I am quite upbeat on the stock is that it is well positioned on the internet. There will be more people who will have an internet connection in the future. Right now, the world population stands at 7B, but shockingly only 2.4B, or 34% of people actually have access to the internet. It is true that the low internet penetration levels in Asia and Africa have a lot to do with this at 15.6% and 27.5% respectively. But the thing is even in the United States, 22%, or about 68M people still aren't connected to the internet!

There is a lot of room for growth and more people will come online and this will make Microsoft's social media ventures like Socl increase in popularity. Moreover, there will be a worldwide shift in ad dollars. In 2012, digital ad spending hit a record high when it went past $100B, but this only accounted for 19.8% of the total ad spend. In time to come, company executives are going to move from "traditional advertising" - TV programming, radio, and print - to the fast growing digital ad market.

Furthermore, I feel that the $8.5B purchase price for Skype was reasonable. Skype fits in well with Microsoft's tradition of bundling its services. Microsoft knows that Windows will need to be topped off with valuable software and services to remain relevant.

Now let's take a look at Microsoft's EV/EBITDA.

EBITDA Calculation

To compute EBITDA, equity analysts start with net earnings. Interest expenses, taxes, depreciation and amortization are then added to that earnings number.

12 months ended

Dec 31, 2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Net income

16,978

23,150

18,760

14,569

17,681

Interest Expense

380

295

151

-

-

Provision for Income Tax

5,289

4,921

6,253

5,252

6,133

Earnings before interest and tax (EBIT)

22,647

28,366

25,164

19,821

23,814

Depreciation and amortization

2,967

2,766

2,673

2,562

2,056

Earnings before interest, tax, depreciation and amortization (EBITDA)

25,614

31,132

27,837

22,383

25,870

Click to enlarge

Source: Microsoft's Annual Report

Microsoft Corp.'s EBITDA increased from 2010 to 2011, but then declined from 2011 to 2012.

Current EV/EBITDA

Microsoft Corp.

Technology

Selected Financial Data (USD $ in millions)

Enterprise value [EV]

235,010

Earnings before interest, tax, depreciation and amortization (EBITDA)

25,614

Ratio

EV/EBITDA

9.18

9.33

Click to enlarge

Microsoft has a lower EV/EBITDA than the technology industry with a 9.18 value. Microsoft is relatively undervalued. Microsoft has actually had an EV/EBITDA value lower than the technology industry average 4 times in the last 5 years. In the last two years, the enterprise multiple has clearly indicated that MSFT is a good investment idea.

EV/EBITDA Historical Ratios

Dec 31, 2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Selected Financial Data (USD $ in millions)

Enterprise value

169,540

172,900

202,950

238,460

154,210

Earnings before interest, tax, depreciation and amortization (EBITDA)

25,614

31,132

27,837

22,383

25,870

EV/EBITDA, Comparison to Technology Industry

Microsoft Corp.

6.62

5.55

7.29

10.65

5.96

Industry, Technology

8.21

7.15

7.45

8.95

6.86

Click to enlarge

The EV/EBITDA is useful for transnational comparisons because it ignores the distorting effects of individual countries' taxation policies. Let's now look at how the Enterprise Value is obtained.

Current EV calculation

Current share price

$ 35.59

No. shares of common stock outstanding

8,284,349,536

Market Cap

294840

Add: Short-term debt

1,231

Add: Long-term debt

10,713

Less: Cash and cash equivalents

6,938

Less: Short-term investments

56,102

Enterprise value

243,744

(USD $ in millions)

Click to enlarge

EV is the market value of common equity, preferred equity and debt minus the cash and short-term investments value. Microsoft's EV has been a little volatile over the last five years.

Conclusion: Microsoft has been making some savvy investments

Microsoft's biggest weakness is its inability to shed its old-fashioned image as we enter a period in technology that is basically dominated by touch and social. Going forward, MSFT's share price will definitely reflect the performance of Socl and Skype. The good thing going for MSFT for the moment is that it will have its corporate clients who need the PCs. Additionally, the dividend yield of 2.61% is pretty nice and this makes MSFT even more attractive at $35.59 a share.

When looking at the technical chart for Microsoft, the price action indicates an uptrend over the long term. The share price had gone slightly above the 52-week high when trading closed on Monday. It is true that the Moving Average Convergence Divergence [MACD] indicator has entered into bearish territory, but it still signals upward momentum. This is an encouraging sign for MSFT bulls.

After considering the relatively low EV/EBITDA value of 9.18, options traders might look to buy calls on MSFT with near to mid-term expirations. This is also a good time for value investors to dollar cost average on MSFT stock.

Note: All material sourced from Morningstar and MSN Money.

Disclosure: I am long MSFT.

Business relationship disclosure: This article was written by a research analyst at Investor Aide. Investor Aide is not receiving compensation for it (other than from Seeking Alpha). Investor Aide has no business relationship with any company whose stock is mentioned in this article.