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By Jit Wijayapura

I felt that Microsoft Corporation (NASDAQ:MSFT) was a good investment idea and here is more information on the giant tech stock. There will be a lot of web based growth with more people coming online in the future and this will make Bing Search and Microsoft's social media ventures like Socl increase in popularity.

The worldwide shift in ad dollars is what MSFT shareholders are hoping that the Redmond, WA based firm will target. 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.

Microsoft will need to capitalize on these consumer trends. MSFT already knows that Windows will need to be topped off with valuable software and services to remain relevant. The $8.5B shelled out on Skype was a move in the right direction. Skype fits in well with Microsoft's tradition of bundling its services. As more people get online, the Voice over IP service will be even more widely used. Let us now examine MSFT using DuPont Analysis.

DuPont analysis is named after the U.S. chemical company that created this method of analysis in the 1920s to gain more in-depth knowledge of Return on Equity [ROE]. In DuPont Analysis, the ROE is decomposed into factors that can be further analyzed. These factors are commonly a profitability measure, a turnover measure, and a leverage measure.

Three-Step DuPont

The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

These components include:

  • Operating efficiency - as measured by profit margin.
  • Asset use efficiency - as measured by total asset turnover.
  • Financial leverage - as measured by the equity multiplier.

Let me briefly touch on the math here.

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont equation.

ROE = (net income / sales) * (sales / assets) * (assets / shareholder\'s equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

ROE

=

Net Profit Margin

×

Asset Turnover

×

Equity Multiplier

Jun 30, 2012

25.71%

23.03%

0.61

1.83

Jun 30, 2011

40.25%

33.10%

0.64

1.90

Jun 30, 2010

40.76%

30.02%

0.73

1.86

Jun 30, 2009

36.83%

24.93%

0.75

1.97

Jun 30, 2008

48.81%

29.26%

0.83

2.01

Source: Microsoft Corp Annual Reports

As you can see, the ROE has decreased and it can be attributed to the profitability decline as measured by the Net Profit Margin. Asset turnover has also decreased and these are two very negative signs for MSFT.

Five-Step DuPont

This is called the Extended DuPont Analysis.

As we have seen:

Net Profit Margin = Net Income / Sales

23.03% (2012 value) = $16,978 / $73,723

This can be rewritten using another mathematical identity:

Profit Margin = (Net Income / Sales) = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes(EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Sales)

Tax Burden = (Net Income / Earnings Before Taxes)

$16,978 / $22,267 = 76.25%

Tax Burden is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line. This calculation indicates that as of the most recent fiscal year, Microsoft kept just over 76% of every dollar it makes after expenses.

Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)

$22,267 / $22,647 = 98.32%

Interest Expense reduces Net Income and therefore, lowers ROE.

Sales Margin = (EBIT / Sales)

$22,647 / $73,723 = 30.72%

Sales Margin is yet another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes.

So again, putting the three ratios together we get:

Net Profit Margin = Tax Burden * Interest Burden * Sales Margin

23.03% = 76.25% * 98.32% * 30.72%.

And finally, the complete Extended DuPont Analysis:

ROE1 = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)

25.58% = ($16,978 / $22,267) * ($22,267 / $22,647) * ($22,647 / $73,723) * ($73,723 / $121,271) * ($121,271 / $66,363)

ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Equity Multiplier

1 Values are for 2012

ROE

=

Tax Burden

×

Interest Burden

×

Sales Margin

×

Asset Turnover

×

Equity Multiplier

Jun 30, 2012

25.58%

76.25%

98.32%

30.72%

0.61

1.83

Jun 30, 2011

40.25%

82.47%

99.00%

40.56%

0.64

1.90

Jun 30, 2010

40.76%

75.00%

99.40%

40.27%

0.73

1.86

Jun 30, 2009

36.83%

73.50%

100%

33.98%

0.75

1.97

Jun 30, 2008

48.81%

74.25%

100%

39.59%

0.83

2.01

The ROE has decreased and it can be attributed to the profitability decline as measured by the Sales Margin.

Three-Step Net Profit Margin

You can take your analysis further by taking individual components of the DuPont Identity and breaking them down to gain additional insight.

Net Profit Margin

=

Tax Burden

×

Interest Burden

×

Sales Margin

Jun 30, 2012

23.03%

76.25%

98.32%

30.72%

Jun 30, 2011

33.10%

82.47%

99.00%

40.56%

Jun 30, 2010

30.02%

75.00%

99.40%

40.27%

Jun 30, 2009

24.93%

73.50%

100%

33.98%

Jun 30, 2008

29.26%

74.25%

100%

39.59%

I hope you get the idea by now. It can be clearly seen that the Sales Margin has had the biggest impact on the Net Profit Margin and its decline from 2011 to 2012.

Conclusion: Microsoft will have to focus on profitability

Investors are always on the lookout for companies that generate profits more efficiently than their rivals. ROE is a key indicator that signifies to investors that a firm is a profit creator and not a profit burner. A DuPont analysis helps in painting a true picture about the ROE value obtained. It was a very helpful exercise indeed to perform the Extended DuPont Analysis on Microsoft Corp. going back over time to see how the trends have been going with the individual components over time.

As a shareholder of Microsoft, here is what I want to see the tech giant do. It is agreed that 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.

Microsoft will have to shed its old-fashioned image as we are now in a technology era that is basically dominated by touch and social. The good thing for MSFT is that it has the wherewithal and the strong management team capable of steering the company back to industry leading profits.

Note: All material sourced from Morningstar and MSN Money.

Source: Taking A Closer Look At Microsoft Using DuPont Analysis