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In this article I present a real time quantitative analysis of Microsoft (NASDAQ:MSFT) that will demonstrate the power of free cash flow in the investment process.

I plan to show that even while there is a major shake up occurring in reference to Microsoft's Board of Directors trying to locate a new "highly qualified" replacement for their outgoing CEO Steve Ballmer, that the underlying fundamentals of the company, from a free cash flow point of view, are very strong.

This analysis will use the following six free cash flow ratios:

  • CapFlow
  • FROIC
  • Price to Mycroft Free Cash Flow
  • Mycroft/Michaelis Growth Rate
  • Free Cash Flow Payout Ratio
  • Free Cash Flow Reinvestment Rate

Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.

(click to enlarge)

The "2014 Mycroft Free Cash Flow Per Share" estimate in the table above is generated by taking the trailing twelve months (NYSE:TTM) free cash flow result for Microsoft and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward looking estimates for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed. Microsoft has a FROIC of 27%, which means that for every $100 of invested capital, they generate $27 in free cash flow. Now my Mycroft/Michaelis Ratio takes that 27% and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:

Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).

Or;

Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).

By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.

Therefore from this we can determine that Microsoft has a reinvestment rate of 68.5% and went on to use 31.5% of its free cash flow to pay out its dividend. Thus by taking 27.4 %( FROIC) x 68.5% = 18.77%, rounded off at 19%. From there we add the dividend yield of 3% and we have a Mycroft/Michaelis growth rate of 19% + 3% = 22%.

Microsoft's Mycroft Free Cash Flow per share of $3.59 is generated by taking its TTM free cash flow per share and multiplying it by (100% + 22% or 1.22). Once we have our result, we then take its current market price of $37.59 and divide it by $3.59 and get a Price to Mycroft Free Cash Flow result of 10.47. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.

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The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.

An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.

Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.

The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.

Hold (opinion) = 15 to 22.5 (I use 15 in the tables).

Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the tables).

Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the tables).

Therefore in the table above you will see that Microsoft with a Price to Mycroft Free Cash Flow number of 10.47 is very attractive right now and explains the nice recent run it has had. Microsoft in the end is a tremendous free cash flow generator and this clearly explains why it is one of the most widely held companies by institutional investors.

The CapFlow ratio result that you see in our first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Microsoft coming in at just 15%, means that 85% of the company's cash flow is actually free cash flow and can be used to buy back stock, which I am a big fan of.

In conclusion it is my opinion that the current stock price for Microsoft is very attractive right now. I believe that if the Board of Directors of the company can find a very qualified replacement for Mr. Ballmer, such as Ford (NYSE:F) CEO Alan Mulally for example, that Microsoft will have a very bright future going forward. By bringing in a turnaround specialist like Mr. Mulally, it will go a long way in assuring that Microsoft's Board is very serious about restructuring the company and taking on competitors like Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) head on. Such news will surely benefit the stock price as it will show current and future shareholders that Microsoft is very serious about doing the right thing by them. This in the past has always been a major problem.

Source: Microsoft: A Free Cash Flow Analysis