Microsoft: Free Cash Flow Analysis 19 comments
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The following is a Free Cash Flow Analysis of Microsoft (MSFT) from 1993-2011. The key ratios that I will use in the analysis are price to free cash flow (PFCF) and Free Cash Flow Return on Invested Capital (FROIC) as well as debt to equity.
When investing I look for PFCF below 15 times and FROIC above 20%+. When you are lucky enough to find a combination of the two you find a perfect balance of growth + value and you get capital appreciation through capital preservation.
For those who don't know:
- PFCF = Market Price/ (Cash flow per share-Capital Spending per share)
- FROIC = FCF per share/ (long term debt per share + shareholders equity per share)
FROIC basically tells you how much return in free cash flow a company generate for every dollar of Total Capital they employ.
I consider FROIC the primary determining factor in identifying growth companies as you can compare every company (except financials) on an equal basis. The question I ask every company I analyze is "how much return (in percent) in FCF are you going to give me for every dollar of total capital you invest?"
First here are the numbers:
YEAR | STOCK PRICE 12/31 | FCFPS | P/FCF | FROIC |
1993 | $3.82 | $0.09 | 42.44 | 25% |
1994 | $3.86 | $0.13 | 29.69 | 27% |
1995 | $5.48 | $0.13 | 42.15 | 23% |
1996 | $10.32 | $0.23 | 44.87 | 32% |
1997 | $16.15 | $0.36 | 44.86 | 35% |
1998 | $34.67 | $0.52 | 66.67 | 31% |
1999 | $58.38 | $0.78 | 74.85 | 28% |
2000 | $21.68 | $0.90 | 24.09 | 22% |
2001 | $33.13 | $0.99 | 33.46 | 22% |
2002 | $25.85 | $1.00 | 25.85 | 21% |
2003 | $27.37 | $1.04 | 26.32 | 18% |
2004 | $26.72 | $1.05 | 25.45 | 15% |
2005 | $26.27 | $1.19 | 22.08 | 26% |
2006 | $29.86 | $1.18 | 25.31 | 30% |
2007 | $35.60 | $1.41 | 25.25 | 43% |
2008 | $19.44 | $1.81 | 10.74 | 46% |
2009e | $28.05 | $1.86 | 15.08 | 39% |
2010e | $28.05 | $1.93 | 14.53 | 35% |
2011e | $28.05 | $2.19 | 12.81 | 39% |
As you can see from the table above that Microsoft has always done an amazing job on Main Street, but the reason that the stock did not do much from 1998 to today is because it was very overvalued in 1998 and took some ten years to get back to being attractively priced. The company’s FROIC suffered tremendously from 2000-2004 because they were making just too much cash and didn’t have anywhere to park it. Eventually they made the smart move and paid out about $30+ billion in a one time dividend to shareholders and their FROIC then went back to its high growth range.
Management has made some mistakes in the last couple of years, such as running certain divisions at a loss, to retain market share and trying to buy Yahoo (YHOO) outright.
They then made the mistake with Vista , which I still use and still have problems with. I am planning to upgrade to Windows 7 soon as I have read nothing but rave reviews from IT pros on how well it works.
As for the statistics on Windows 7, there are close to 1 billion computers worldwide using the Windows operating system. On top of that there will be over 300 million new computers sold this year with the Windows 7 operating system pre-installed. Apple (AAPL) for example will sell 10 million with its operating system loaded on them (a 30 to 1 difference). As for global operating system market share, Microsoft has a 91.61% share while Apple has a 4.59% share and Linux at 0.95%.
In Conclusion when you can get a company that is so dominant globally and is selling at close to its record low Price to Free Cash Flow and record high FROIC historical numbers, I would look into it as a potential stock for one’s portfolio.
To assist you I would also link to Seeking Alpha's transcript of Microsoft's latest earnings conference call (thank you Seeking Alpha for providing it free).
FROIC gives me a company's real return on Main Street and if I can get a 20%+ return on Main Street and at the same time buy a stock that is selling for less than 15 times its FCF then there is a very high probability that it should be very successful investment.
By choosing 20%+ as my minimum FROIC I have built a portfolio of 29 holdings for my clients that has a combined portfolio FROIC of 32% and sells as a group for 12.35 PFCF.
As for PFCF I came up with the 15 or less number as being Ideal after performing a 58 year backtest.
Disclosure Long MSFT. No Position AAPL, YHOO.
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This article has 19 comments:
There are a variety of ways to do FROIC, but I like to keep it simple and have had great success with the formula the way it is. I write these posts for the non-professional as well, so they can do the calculations themselves with little trouble. I was very impressed growing up with Benjamin Graham in that he would only use the S&P Stock Guides to do his calculations and then gave his formulas for Net Net Working Capital out for free.
Wall Street is a very dangerous place to operate if you don't have the ability to compare one stock with another on an equal footing. By keeping FROIC as simple as I can, the average investor can do a quick calculation using Value Line and compare, for example Coca-Cola to Pepsi with little effort.
I have been working with FROIC and P/FCF for years and have had great success with them just the way they are designed and though they may be a little abstract in nature, they work like a charm. I give them out for free so I can give something back to the field of finance, which has been very good to me, and level the playing field for the average investor, like Graham did. His book the Intelligent Investor, Philip Fisher's work and ofcourse Charlie Munger and Warren Buffett have done more for the modern investing community then all the business schools combined could have. FROIC is my way of giving something back and by keeping it simple, everyone can use it.
On Nov 03 07:13 AM Sunil Shah wrote:
> nice work Peter!. but doesn't msft have net cash per share. do you
> subtract this from invested capital (ie enterprise capital). then
> you should do the calc above(strictly speaking, less interest earned
> on cash) to get FROIC and just subtract the cash per share as per
> bal sht from share price to compare valuations over time. Right?
> Your opinion would be appreciated. And your work again using this
> methodology!!
Do you ever break your rule of going outside the <15 PFCF and >20 % ROIC?
Microsoft in 1993 was at 42 and 25% so you wouldn't wouldn't fit your criteria but could have been a 15 bagger.
Do you think your valuation criteria works better for the bigger mature companies, or do you sometimes find smaller/mid cap/growing companies that meet your standards as well?
Also, I think you've mentioned Ben Grahmn or the Intelligent Investor before. So as an active investor, do you believe in 5% to 10% speculation ( say on a stock that doesn't meet your value metrics like Microsoft in 1993) or do you stick to your guns?
Thanks for the work, great analysis.
On Nov 03 08:05 AM BlueOkie wrote:
> Why is the price the same for 2009/10/11?
I own MSFT and will carefully add to my position in the near future (i think the market is going lower in the short term and you might be able to get in at a better price)
On Nov 03 08:50 AM John Galt wrote:
> Peter-
>
> Do you ever break your rule of going outside the <15 PFCF and >20
> % ROIC?
>
> Microsoft in 1993 was at 42 and 25% so you wouldn't wouldn't fit
> your criteria but could have been a 15 bagger.
>
> Do you think your valuation criteria works better for the bigger
> mature companies, or do you sometimes find smaller/mid cap/growing
> companies that meet your standards as well?
>
> Also, I think you've mentioned Ben Grahmn or the Intelligent Investor
> before. So as an active investor, do you believe in 5% to 10% speculation
> ( say on a stock that doesn't meet your value metrics like Microsoft
> in 1993) or do you stick to your guns?
>
> Thanks for the work, great analysis.
I was under the impression that Buffet didn't set a nominal price and wait. He said something to the effect of, "how do you know if somebody is overweight, I couldn't give you an exact figure, but I could tell you if I see it".
I understand you set your price and wait for it, but do you "speculate", with 5 to 10% of your money that doesn't fit the bill? It seems like you don't and are very disciplined with your investing to get your "27' Yankees".
I am very disciplined as I have to be, as I am investing other peoples money for a living. I do the FROIC and P/FCF as part of my Quantitative work and then rip apart the workings of management with my Philip Fisher (Qualitative) work.
I am always looking for prospects and am always trying to create the 1927 Yankees and hold them until they hit 30 PFCF. If I can't find a replacement once I sell one, then I just go to cash and wait. The stocks in the end tell me when to get in and when to get out.
Buffett has a punch card and is very selective at what prices he will pay. He has talked about his "punch card" for as long as I can remember.
On Nov 03 09:56 AM John Galt wrote:
> Thanks your your reply.
>
> I was under the impression that Buffet didn't set a nominal price
> and wait. He said something to the effect of, "how do you know if
> somebody is overweight, I couldn't give you an exact figure, but
> I could tell you if I see it".
>
> I understand you set your price and wait for it, but do you "speculate",
> with 5 to 10% of your money that doesn't fit the bill? It seems
> like you don't and are very disciplined with your investing to get
> your "27' Yankees".
Thank You for helping a new, non-professional investor!
Have a couple of questions and comments that I would like your input on. My comments are not meant to criticize your methods; I am interested in learning about the methodology you use.
The FROIC seems a good measure of returned value, however, it is essential to compare it to a hurdle rate such as WACC (weighted average Cost of Capital) You state that you look for min 20% FROIC but it would appear to be more meaningful it you were to subtract a company’s capital cost from the cash flow returns. If a company has a FROIC of 20% but has a WACC of 15%, it means for every dollar the company returns internally (IRR) the company is only creating $ 0.05 added value. When FROIC minus WACC is positive it indicates a company is adding value, if negative it is losing value and investors would be better off looking elsewhere.
Regarding the 15 x FCF minimum, I am wondering why 15 x, not 12.5 x or 10 x? What is the significance of 15 x FCF? There are two ways to express any ratio of course, as a factor or as a yield.
When using a P(rice)/FCF of 15 x, FCF/P(rice) equals .066%, so essentially when you are using a static factor you are just discounting the average FCF in perpetuity by .066%. While there is no problem with using an average discounted FCF in perpetuity, again it would make more sense to use WACC as the discount factor. The WACC can vary significantly between companies and provide a more accurate picture of the true Cash Flow of a company.
Or expressed the other way, to determine maximum price you wish to pay for a Company, once the WACC is found for a company, use the inverse number as the multiplying factor x FCF. As an example, Company XYZ has a WACC of 8% so multiplying it’s FCF of let’s say $5.45 by a factor of 12.5 it will give $68.12 or the max value you should pay for company XYZ
It doesn't matter how you dress it up, using whatever arithmetic you want to use, but it's extremely hard to see Microsoft going back to its heyday.
I want everyone to understand that it is an abstract tool and that one should also attempt to do a multi year analysis as I have done above and see if a consistent pattern develops. Then one should also understand what the company's management is trying to do and if you as an investor agree with it. I do both Quantitative and Qualitative analysis (50-50) for each company I analyze and I want a long record of consistency.
As for the PFCF of 15 I have come to that number after doing the following backtest;
mycroftresearch.com/up...
If I buy a stock at 15 times and it goes to 12 times I buy more. If I liked it at 15 then I will love it at 12 and then more at 9. Since I know what the company is worth on Main Street I can take advantage of the mistakes that Wall Street makes in pricing my companies.
For example Coach, which is a stock that took me years to buy never fell down to the price I wanted until this recession hit and not only did COH go down to 15 times its PFCF but eventually fell to 7.5 times, so I was a buyer all the way down to $12. It now trades around $33 so that was a buying opportunity of a lifetime as was Aeropostale (ARO).
I hope that helps you understand my philosophy towards investing. I like to keep things simple as the world is complicated enough when you are in an arena (Wall Street) where people are making decisions based on the movements of lines on a chart. I do my own cooking and love it as I understand 100% how my methods work and don't stray as I am very happy with my results.
Disclosure; Long ARO, COH
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice.
It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.
On Nov 03 12:11 PM TLassen wrote:
> Thank you for an interesting article. I consider myself a fellow
> value investor and I also focus mainly on Cash Flows in order to
> determine intrinsic value. As we both know one of the pitfalls with
> discounting cash flows is determining growth and discount rates.
> Having said that, investors have to also keep in mind that Free Cash
> Flow is not extra cash leftover at the end of the cycle, but an indicator
> of how well a company managed its profit (net income)
>
> Have a couple of questions and comments that I would like your input
> on. My comments are not meant to criticize your methods; I am interested
> in learning about the methodology you use.
>
> The FROIC seems a good measure of returned value, however, it is
> essential to compare it to a hurdle rate such as WACC (weighted average
> Cost of Capital) You state that you look for min 20% FROIC but it
> would appear to be more meaningful it you were to subtract a company’s
> capital cost from the cash flow returns. If a company has a FROIC
> of 20% but has a WACC of 15%, it means for every dollar the company
> returns internally (IRR) the company is only creating $ 0.05 added
> value. When FROIC minus WACC is positive it indicates a company is
> adding value, if negative it is losing value and investors would
> be better off looking elsewhere.
>
> Regarding the 15 x FCF minimum, I am wondering why 15 x, not 12.5
> x or 10 x? What is the significance of 15 x FCF? There are two ways
> to express any ratio of course, as a factor or as a yield.
>
> When using a P(rice)/FCF of 15 x, FCF/P(rice) equals .066%, so essentially
> when you are using a static factor you are just discounting the average
> FCF in perpetuity by .066%. While there is no problem with using
> an average discounted FCF in perpetuity, again it would make more
> sense to use WACC as the discount factor. The WACC can vary significantly
> between companies and provide a more accurate picture of the true
> Cash Flow of a company.
>
> Or expressed the other way, to determine maximum price you wish to
> pay for a Company, once the WACC is found for a company, use the
> inverse number as the multiplying factor x FCF. As an example, Company
> XYZ has a WACC of 8% so multiplying it’s FCF of let’s say $5.45 by
> a factor of 12.5 it will give $68.12 or the max value you should
> pay for company XYZ
>
>
But if Windows 7 is as powerful as they say it is MSFT may move up. You never know but when you have such an amazing market share to start with you can sleep a lot better. Its very similar to what Google is experiencing.
Here is some data;
marketshare.hitslink.c...
Do you think Google is worried about Baidu? Maybe but when your advantage is 85 to 3 you have the ball in your court for a while.
Always remember "the numbers don't lie, only people do".
Disclosure ; No GOOG, BIDU, YHOO, AAPL or any Linux providers.
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice.
It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.
On Nov 03 12:37 PM Jon T wrote:
> Do you not expect Microsoft's market share to decline under hugely
> more competition from many fronts?
>
> It doesn't matter how you dress it up, using whatever arithmetic
> you want to use, but it's extremely hard to see Microsoft going back
> to its heyday.
On Nov 03 08:51 PM Game wrote:
> If you are accumulating on the way down once the stock hit your two
> criteria, what will be your exit criteria or exit multiple?
Nothing wrong with that, just don't see MSFT as somewhere to make strong gains when there is a big hole in the bottom of the tub
...would be seriously distorted for a company with significant cash on bal sht- particularly when two yrs ago it earned 4% and now close to 0... and these nos obviously reduce the FROIC.
Pl oh pls use this methodology for msft, and lets see what the real P/FCF is. It should be a relatively simple adjustment to your work.
thank you!