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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Microsoft's (MSFT) case, we think the firm is undervalued. We think it is fairly valued at $46 per share, representing over 20% upside from today's levels based on our point fair value estimate.

At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

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If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Microsoft posts a VBI score of 6 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its neutral relative valuation versus peers, and neutral technicals. We compare Microsoft to peers Adobe Systems (ADBE), F5 Networks (FFIV), and Oracle (ORCL). In the spirit of transparency, we show how the performance of the VBI has stacked up per underlying score:

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Our Report on Microsoft

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Investment Considerations

Investment Highlights

• Microsoft's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• Microsoft's products include operating systems, server applications, desktop and server management tools, software development tools, video games, and online advertising. Its hardware devices include the Surface RT and Surface Pro, and the Xbox 360 gaming and entertainment console.

• Microsoft has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 28.5% in coming years. Total debt-to-EBITDA was 0.5 last year, while debt-to-book capitalization stood at 16.5%.

• Investors continue to focus on Microsoft's Windows business because it's been the bread-and-butter of the company for such a long time, but we think the company's other segments continue to be underappreciated. Shares look incredibly cheap at current levels, while providing investors with a fantastic dividend growth opportunity.

• The firm sports a very nice dividend yield of 3.1%. We expect the firm to pay out about 42% of next year's earnings to shareholders as dividends. Its Dividend Cushion score is a remarkable 3.4. Learn more about the Dividend Cushion here.

Business Quality

Recent Performance

Microsoft exceeded top- and bottom-line expectations in its fiscal first quarter, results released mid-October, by a significant margin. Revenue jumped 15.8%, while diluted earnings per share leapt nearly 17%. These are staggering growth figures for a firm that is supposed to be a tech dinosaur. CEO Steve Ballmer was quite enthusiastic about the potential for new product releases this fall and spoke positively about Xbox One, Surface, as well as the full spectrum of Windows 8.1 and Windows Phone devices.

Looking at Microsoft's fortress balance sheet, total cash and short-term investments totaled a massive $80.7 billion at the end of the period. Though many investors care about where the cash is domiciled, we don't. Business is global, and Microsoft will be able to apply cash in areas of need or issue relevant debt to repatriate cash (as in this example). Net cash from operations was $8.2 billion and capital spending was $1.2 billion during the quarter, resulting in free cash flow of about $7 billion, a whopping 37.6% of sales. It really doesn't get better than this when it comes to free-cash-flow generation.

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Microsoft's 3-year historical return on invested capital (without goodwill) is 122.2%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Microsoft's free cash flow margin has averaged about 35.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Microsoft, cash flow from operations increased about 7% from levels registered two years ago, while capital expenditures expanded about 81% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Microsoft's shares are worth between $37.00 - $55.00 each. You'll notice that Microsoft's shares are trading below this range, suggesting to us that there is a significant mispricing in the market. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $46 per share represents a price-to-earnings (P/E) ratio of about 17.8 times last year's earnings and an implied EV/EBITDA multiple of about 10.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.6%. Our model reflects a 5-year projected average operating margin of 33.2%, which is below Microsoft's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Microsoft, we use a 10.5% weighted average cost of capital to discount future free cash flows. Click here for how we think about forecasts in our DCF model.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $46 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Microsoft. We think the firm is attractive below $37 per share (the green line), but quite expensive above $55 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Management Considerations

After months of unnecessary speculation that dominated headlines, reports indicate that turnaround expert Ford CEO Alan Mulally isn't leaving Ford for Microsoft , the latter looking for a replacement for Steve Ballmer. We didn't think Mulally's transition to Microsoft made any sense, unlike Mulally's move to Ford from CEO of Boeing (BA) Commercial Airplanes, where the similarities in precision manufacturing were evident. We're viewing Mulally's decision to stay as a net positive for both companies. Mulally can make a much bigger impact at Ford and may have even been a distraction heading up the software giant. The list of candidates to take the head job at Microsoft includes server/cloud chief Satya Nadella, COO Kevin Turner, ex-Nokia CEO Stephen Elop, Facebook (FB) COO Sheryl Sandberg, and ex-Skype CEO Tony Bates. According to reports, Elop is the frontrunner.

Future Path of Fair Value

We estimate Microsoft's fair value at this point in time to be about $46 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Microsoft's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $58 per share in Year 3 represents our existing fair value per share of $46 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Why We're Huge Fans Of Microsoft

Additional disclosure: MSFT is included in the portfolio of our Dividend Growth Newsletter.