Why Microsoft Is a Buy

One of the things that we frequently observe in discussions about stocks is a focus on the qualitative story - “I like my iPhone, buy Apple (AAPL)”.

Now the story behind a stock is important. That Apple (or any other company) makes great products that people want to buy is very relevant to the value of the company.

BUT - to make good investment decisions you need to understand how the financial markets value this story. Markets can have an overly optimistic or pessimistic view of a company. To understand value - you need to look at the numbers.

Let’s look at an example - Microsoft (MSFT)

We have previously looked at $MSFT and the comments on those posts have reflected the challenges that $MSFT faces as a company moving forward. These comments have mostly reflected the story of these challenges - the view that $MSFT will not be as successful in the future as it has been in the past. Because of these challenges - $MSFT must be a bad investment.

Let’s have a look at that assumption - from a valuation perspective.

Remember - the market should value companies on future expected prospects (measured in future expected cash flows). Where opportunities exist, either buying or selling, is where companies expected future cash flows are viewed either excessively optimistically or pessimistically. Over the long-run it should correct.

“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” (Benjamin Graham, The Intelligent Investor)

Now looking at $MSFT. It has been an amazing business - it has the second largest market capitalization in the world after Exxon Mobil (XOM) [$XOM US$336.41 Bn, $MSFT US$218.31 Bn, PetroChina (PTR) US$208.37 Bn]. Since 2005 (to 2008) the company has grown revenues at a compound annual growth rate (CAGR) of 15% with EBITDA margins of 40%.

Now $MSFT has a raft of potential challenges to their business - only one recent example: Google Chrome OS.

But how is the $MSFT story being valued? We will look at this from two angles - $MSFT vs a set of peer companies and $MSFT as a standalone entity using a discounted cash flow valuation model.

Comparator Analysis

At Valuecruncher we provide a range of different valuation metrics for each company and a starting set of peer companies (that can be changed). Here is the $MSFT comparator tool - and some explanation on how to use the tools. Our tools are interactive - you can adjust the valuation outputs to see the impact on the share price.

I am going to look at two of the metrics - Enterprise Value (EV)/Revenue and EV/EBITDA. Enterprise Value (EV) is simply market capitalization plus net debt [long-term borrowings less cash]. We use EV to capture the impact of debt and cash on a company’s balance sheet - market capitalization doesn’t capture different capital structures when comparing companies.

For $MSFT we will look at four comparators - IBM (IBM), Apple (AAPL), Google (GOOG) and Hewlett-Packard (HPQ).

EV/Revenue shows how a dollar or revenues is being valued by the market against the comparator set. On an EV/Revenue basis $MSFT is trading at 3.2x. This compares to $IBM at 1.7x, $AAPL at 3.5x, $GOOG at 5.5x and $HPQ at 0.9x. $MSFT’s profit margins (at the EBITDA line) are 43.3% of revenues compared to 20.6% and 12.0% for $IBM and $HPQ respectively - so those feel right. $GOOG has similar margins to $MSFT and significant growth options - but a dollar of $GOOG revenues being worth 70% more than a dollar of $MSFT revenues feels rich.

But the standout - to us - is that $AAPL with profit margins half that of $MSFT is valued similarly on an EV/Revenue basis. A dollar of $AAPL revenues is being valued slightly more than a dollar of $MSFT revenues - despite that dollar of revenues producing less than half the profit of the $MSFT revenues. That is some big growth expectations for $AAPL.

EV/EBITDA shows how a dollar of profit (measured in as Earnings Before Interest Taxes Depreciation and Amortization) is being valued by the market against the comparator set. On an EV/EBITDA basis $MSFT is trading at 7.4x. This compares to $IBM at 8.2x, $AAPL at 16.5x, $GOOG at 14.8x and $HPQ at 7.4x. Talk about no respect - a dollar of $MSFT EBITDA is worth only slightly more than a dollar of $HPQ EBITDA and less than the other comparators.

Discounted Cash Flow (DCF) Analysis

We have completed a discounted cash flow valuation using our interactive tools (there is a “discounted cash flow analysis” link just under the company name on the company page). We have populated our model with a mixture of consensus analyst estimates and Valuecruncher estimates.

Our analysis produces a valuation of US$29.43 for $MSFT - 18.5% above the current share price. A key input to that calculation is an estimate of long-term growth of 4.0% - which we don’t feel is too aggressive. Remember revenues have grown at a CAGR of 15% since 2005. The US economy grew at a 3.6% CAGR between 2003 and 2007.

Summary

Our DCF analysis produces a valuation of US$29.43 for $MSFT - 18.5% above the current share price. This equates to an EV/EBITDA multiple of 9.1x. This appears reasonable in comparison to the peer group of companies that we have examined.

Based on our analysis it appears that $MSFT is undervalued. There are certainly challenges facing the business - but the market currently has an overly pessimistic view on the company. $MSFT currently represents a good buy. All our tools are interactive - you can complete your own analysis.

Disclosure: No Positions.

Comments

[BrianSJ:]

The only input on expectations for the future is 4% growth with an expectation of continuing profit at the same margins. On that basis, MS will do well. Gosh, I don't think I need any cruncher tools for that. How well-founded is this input? Well, they have had higher growth in the past, so it must be safe. Hmm. Not convinced about growth or margin. The server market is becoming much tighter. The corporate desktop market may well go for windows 7 but the Do Nothing Option will be very attractive Domestic PCs will continue to resent the MS tax more and more. Are they making money out of games yet?

Jul 22 06:39 AM

[Josh Giggs:]

MarketGuru says Microsoft is going down.. Interesting read:
www.marketguru.com/opi...

Jul 22 09:08 AM

[JWolf:]

The comparables are poorly chosen here. HP and IBM are hardware and services companies. Google is an advertising company. A better comp would be Oracle, really. At 10.9x EV/EBIDTA they're more expensive than Microsoft, but that's just one consideration in what should be a more thorough analysis.

Jul 22 10:54 AM

[brewer:]

Microsoft has been running on fumes since the Vista release, at least.

Windows 7 is just a service update for XP, no technological threat to OS X. Apple's new OS will finally work around all the monopoly advantages MSFT built into Outlook, and will actually be less expensive for businesses to deploy than much cheaper, generic PC hardware due to the astronomical server license costs MSFT have enjoyed for so long.

Apple hasn't even begun to tie iPhone to Mac OS X.

Jul 22 11:06 AM

[jack dee:]

It comes down to this,


everyone uses Windows and everyone knows that everyone uses Windows. And there are few salesman/RE people etc stupid enough to risk losing even one client, by jumping platforms.

the JNJ stent sales guy that would risk losing sales just to use a mac? The car salesman that wants to make things harder by using mac?

In fact it appears 95% of people agree with Billy boy and not stevie...

Jul 22 02:02 PM