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My thesis for investing in Microsoft Corp. (MSFT) now is that its stock price will neither jump significantly higher, nor will it collapse, in the next 12 months or so. Specifically, I expect MSFT to move within plus and minus 20% from its current price of $36.56, as quoted on February 7, 2014. I also think that this range-bound price variation will have an upward bias, trading essentially in step with the general market. While this does not seem to be a difficult assumption to make and accept, I will present the reasons behind the thesis in this article, from qualitative discussions of the macro trends of the company, to quantitative valuations of its stock price. Furthermore, I will present a strategy that can enhance the investment total return.

Macro Trends

MSFT is probably one of the most extensively covered and discussed company, both in the investment community and in the general public. For example, Seeking Alpha has a large number of articles, covering almost every aspects of the company. Thus, I will not repeat these discussions here. Instead, I will only present some discussions to support my thesis that MSFT will be a range-bound stock with a slight upward bias in the next 12 months or so.

For the macro economy, the US is entering a period of slow but healthy growth, Europe is recovering from an economic recession, and China is stabilizing its growth pace. In this environment, large companies with solid businesses can be expected to show respectable growth. MSFT is in this category. From the average projection of analysts compiled by Yahoo Finance, MSFT is expected to grow revenue by 6.3% and earning by 7.7%. In the business of technology, this kind of growth is by no mean super, but it is growth nevertheless, and it is consistent with the expected growth of the general market. If the stock price of MSFT is simply to respond to this kind of growth, it is easy to expect a slow upward drift, with gains of the same order of magnitude, in the high single digit range.

This is of course an over-simplified way of estimating a stock price, especially for a company as complex as MSFT. There are a large number of factors that can significantly move the stock price. For example, the change of CEO at MSFT was expected to be a catalyst for significant improvements in its businesses, and thus, significant gains in its stocks. With the choice of the MSFT insider Satya Nadella as its next CEO, the emphasis on the company's business strategy seems to be more on continuation than disruptive changes. The stock market responded to the choice precisely as such, without any wide swings.

There is no doubt that the new CEO will introduce new initiatives and/or refocus company resources to grow MSFT, the cloud service and the ecosystem of products, for example. While MSFT certainly has the resources and technical expertise to make these businesses successful, these are all areas of strong competition, and there does not seem to be any indication that MSFT would be leading these areas in the next 12 months or so. Thus, I do not foresee any significant effects of these areas on MSFT's businesses, and thus, any significant jumps in its stock price due to these business segments. MSFT has depended and is still depending largely on its cash cow, the software business, which also puts a safety floor on the company's stock price.

Another way for rapid stock price appreciation is to shed non-core businesses, which can strengthen the company's balance sheet, reduce cost and improve operation efficiency. This has also been postulated over the years for MSFT, to spin off the Xbox division, for example. This, however, does not seem to be happening, at least in the near term, as MSFT is further developing Xbox applications.

Thus, my view of MSFT in the next year or so is that it will trade slightly up, probably in step with the general market, because of the favorable economic conditions in the market and the strengths of the company, including its pristine balance sheet and its enviable cash generation products. Its stock price appreciation, however, will not be significantly higher than the general market, due to the lack of near term catalysts.

Valuation Analyses

To see how MSFT's valuation compared with other large technology companies, its price/earnings ratio is plotted in the figure below, together with those of a group of technology companies, including Cisco Systems Inc. (CSCO), Intel Corp. (INTC), Qualcomm Inc. (QCOM), International Business Machines Corp. (IBM), Hewlett-Packard Co. (HPQ), and Oracle Corp. (ORCL). The P/E values are computed using the closing prices of the stocks on February 7, 2014, and the respective averaged earnings estimates for 2014 from analysts compiled by Yahoo Finance (data linked by the company names above). At 13.5, MSFT's P/E ratio is on the high side for this group of companies, only lower than QCOM's 14.6 but higher than all the others. It is higher than the average of 11.6 for these companies, implying that it is about 14% over-valued based on the P/E ratio.


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As is known in security analysis, the P/E ratio alone can sometimes be misleading because it does not reflect the growth potential of a company, for which the PEG ratio can be used, defined by the P/E ratio divided by the growth rate. To see how MSFT compares with other companies in reference to its growth potential, the PEG ratios are computed and plotted in the figure below, for the same group of companies. In terms of this metric, MSFT is cheaper than CSCO and HPQ, about the same as INTC, and more expensive than the rest. It is slightly over-valued compared with the average of the group.


(Click to enlarge)

While the figures above show the relative value of MSFT in comparison with other large technology companies, it is also important to examine the valuation in the historical content, to avoid the situation where an entire industry sector is overvalued. To this end, the average price/earnings ratios of MSFT are plotted in the figure below for the past few years. The ratios are computed by using the average stock price for each individual fiscal year and the annual earnings reported in the years, which can be found in MSFT annual reports. For the 2014 average P/E, the stock price average is done from July 2013 to now (MSFT's fiscal year is from July to June) and the 2014 earnings is the analyst average projection. At a current P/E of 13.5, MSFT is about 18% over-valued compared with its own historical values.


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Target Prices

The qualitative discussions on the macro trends related to MSFT indicate that its stocks will likely be range-bound in the next year or so, probably with a slight upward bias, in responses to the favorable general economic conditions and trading in step with the general market. The valuation analyses, on the other hand, indicate that MSFT is slightly over-valued, in comparison with both its peers and its own history. Yet another comparison can be made between MSFT and the overall market, in terms of the P/E ratio. The former is 13.5 while the latter is 14.3 for the information technology industry and 14.9 for the entire S&P 500 index, indicating the MSFT is slightly under-valued.

If these average P/E ratios of various kinds are used to project target prices for MSFT, the results are summarized in the table below. Obviously, the various cases of under- or over-valuation lead to target prices higher or lower than its current price of $36.56. The price variations, however, are no more than 20% either way.

P/E Ratio

Difference (%)

Target Price ($)

MSFT Current

13.54

36.56

MSFT 5-Year Average

11.15

-17.7

30.11

Group Average

11.61

-14.3

31.35

Info Tech Average

14.32

5.8

38.67

S&P 500 Average

14.85

9.7

40.10

Investment Strategy

Because I believe MSFT will trade essentially in step with the general market in the next year or so, with probably a gain of about 10%, and there is a dividend of $1.12, corresponding to a yield of about 3%, I think that the argument for investing in MSFT is favorable. Furthermore, the total return can be enhanced from the stock price gain and the dividend by using options, a strategy that I also recommended for CSCO in a recent article.

The strategy is constructed by buying MSFT (or holding it if you are already long on the stock) and selling covered calls and puts with the option expiration date about a year away and the expiration prices bracketing MSFT's current stock price respectively from above and below by about 10%. The transaction from selling the options will generate premium as investment income. If the stock price moves within the price range bounded by the covered calls and puts, the premium income is for the investor to keep. If the MSFT moves outside this price range, the total investment will either give up some gains or suffer from extra loss, depending on whether it breaks out of this price range upward or downward, and by how mush. Thus, the premium from selling the covered calls and puts can be viewed either as an enhancement of the investment return if the stock price moves higher or as a cushion if it drifts downward.

In the table below, I listed MSFT's stock price on February 7, 2014, as well as the premium income for the January 2015 40 calls and the January 2015 32 puts. The transaction involves buying MSFT at $36.56 (or holding it if you are already long on it), selling its January 2015 40 call, and selling its January 2015 32 put. The premium from selling the options, together with the $1.12 dividend, will generated $4.61 per share if MSFT is held to January 2015, less than a year from now, which amounts to approximately 12.6% of its current price.

Stock Price on 2/7/2014

$ 36.56

Jan 2015 40 Call

$ 1.65

Jan 2015 32 Put

$ 1.84

Dividend

$ 1.12

The total return of the investment will of course depend on the stock price next January at the option expiration. The calculations are given in the figure below, which plots the total return ($ per share) as a function of MSFT's stock price on January 17, 2015. For comparison, the blue diamond symbols represent the return for holding MSFT alone without the option selling strategy, and the red squares are the results with the option premium income. A simple way to explain this figure is that if MSFT moves around its current price of $36.56, the option selling strategy will come out about 9.5% ahead of the case of holding the stock alone. If you are convinced by my arguments that MSFT will be range-bound in the next year or so, this 9.5% extra is not insignificant.


(Click to enlarge)

The outcome of the investment will be a little more complicated if MSFT moves far away from its current price. As the two curves show in the figure, if MSFT jumps above about $43 by next January, the option strategy will start to make less money than the stock alone case. Similarly, if MSFT collapses below about $29 by next January, the option strategy will start to loss more than the stock alone case. Though both of these cases are possible, I don't think the probabilities for these to happen are high, for the reasons I discussed above in this article. To further illustrate this, the total retune comparison is re-plotted in the figure below in terms of percentages. The main point of this figure is that the option selling strategy will be worse than the stock alone case only if MSFT moves more than 20% from its current price by next January, either up or down, which again does not seem to be a high probability event.


(Click to enlarge)

Summary

MSFT may be considered as a technology holding for long term investment, but its growth potential in the next year or so seems to be limited. Thus, its stock price is likely to be range-bound, probably trading in step with the general market. Under these conditions, selling options can be a good strategy to enhance the total return. The strategy discussed in this article can enhance the return by about 9.5% if MSFT trade plus and minus about 10% from its current price, and it will still come out ahead of the stock-alone case as long as MSFT is within plus and minus 20% of its current price by next January.

From what I presented in this article, both the qualitative discussions of the macro trends and the quantitative valuation analyses, a very likely scenario is that MSFT will appreciate about 10% in stock price. In this case, the dividend and the premium from the option selling will enhance the total return to about 22%, a return that is not unattractive for less than one year of time.

Source: Enhancement Strategy For Investing In Microsoft Corp.