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The purpose of this analysis is to determine, based on a few indicators, which software developer would be the best investment. The software developers included in this analysis are Oracle (NYSE:ORCL), Microsoft (NASDAQ:MSFT), and SAP AG (NYSE:SAP); all three firm's primary business activity is software development and distribution, and all three firms are comparable in terms of market capitalization. Thus, I define them as being in the same peer group.

The measures of leverage, operating leverage and total leverage, are used to compare the companies; a comparison using the cost of equity and return on equity is included. Finally, the fiscal 2014 forecasts conclude the report.

The results suggest that Microsoft is the best investment of the three companies. That said, the short-term valuations are a little bit high, but, based on these results, Microsoft would be the best addition to a portfolio during a substantial systemic risk based market decline.

Measuring Leverage

(click to enlarge)

Between fiscal 2004 and fiscal 2012, Microsoft had the highest operating leverage. SAP had the lowest operating leverage. Microsoft's operating leverage was more volatile than the operating leverage of the other firms. Thus, as revenue grows or declines, Microsoft's operating income should increase or decrease at a faster pace than the other firms.

During the same time period, Microsoft had the highest total leverage. SAP had the lowest total leverage. Microsoft's total leverage was more volatile than the total leverage of the other firms. Consequently, as sales grow or decline, Microsoft's net income should grow or decline more than the other firms.

Based on the measures of business risk and total risk, Microsoft is the most risky firm. So, investors would want to be long Microsoft in a period of industry expansion. Some assets could be allocated to Oracle, but, based on this measure, Microsoft's bottom line would benefit the most from increasing revenue.

That is a general conclusion; investors would also have to factor in the expected revenue growth rates and any changes in the financial and operating structures of the companies, which is beyond the scope of this paper.

Required Return versus ROE

MSFT Return on Equity Chart

MSFT Return on Equity data by YCharts

Oracle has the highest required rate of return on equity at 7.24%; SAP has the second highest required rate of return on equity at 6.66%; Microsoft has the lowest required rate of return on equity at 5.49%.

Oracle's return on equity has been trending lower since 2004, but return on equity was 24% in fiscal 2012. Microsoft's return on equity peaked in 2008 and has been trending lower; return on equity was 28% in 2012. SAP's return on equity has been trending lower; in 2012, return on equity was 21%.

Oracle's return on equity in fiscal 2013 could be 22% to 23%. Microsoft's return on equity should be about 30% in fiscal 2013. I do not have a full-year forecast for SAP, but, given the historic results, SAP's return on equity should be below Microsoft's return on equity.

Given the historic performance and cost of equity, Microsoft will probably have the highest difference between return on equity and cost of equity. Thus, the return on equity analysis suggests Microsoft is a better investment than Oracle. These results agree with the previous results from the operating leverage section.

Readers, and followers, will probably want a full-year fiscal 2014 forecast for ROE, but that will come later. Also, this market remains pricey, allowing time for more thorough investigation. For right now, Microsoft's cost of equity is substantially lower than Oracle's cost of equity.

Forecasted Financial Performance

For fiscal 2014, the street is expecting Oracle's revenue to grow 5.7% with EPS growth of 9.2%, according to data from ThomsonRetuers. Microsoft is forecasted to grow revenue 7.7% with EPS growth of 11.1%. At this point SAP has been eliminated as an investment option.

Looking back at the leverage measures, and the ROE and cost of capital analysis, Microsoft is the best investment. The street's fiscal 2014 forecasts adds to the evidence. That said, Microsoft is a little bit overvalued near term; this is not a good time to increase long positions. Based on this analysis, and some of my other research, Microsoft is a long candidate on the next systemic risk based substantial decline in the share price.

Source: Which Software Company Could Be A Better Investment Than Oracle?