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I have two tasks that I am setting out to accomplish in this article, the first task is valuing shares of Microsoft (NASDAQ:MSFT) using multiple methods, and the second task is looking for potential acquisition targets that would fit well with Microsoft with new CEO Satya Nadella leading the way.

Valuation

Valuation Method #1: Discounted Cash Flow

To value MSFT I will be using a DCF calculator, with data for earnings and growth coming from Zacks.com, benchmark data from longrundata.com, and CPI data from the BLS. The DCF table below shows the fair value of MSFT is $49.76, which is 31.02% above current the current price.

EPS [ttm]: $2.71

Long-term Growth Rate: 8.53%

Earnings grow for next: 5 years

Level off: to 1% after

Benchmark return: 10 yr annualized SPY return of 6.95%+1.60% inflation= 8.55% benchmark

Valuation Method #2: Forward PE comparison

For this valuation method, I will compare the forward PE to the 5-year historical average PE for Microsoft. I will be using the forward PE ratio & historical average PE from the Microsoft valuation page on Morningstar, and it showed Microsoft is currently trading at a forward PE of 12.5, and over the last 5 years has historically traded at a PE of 13.4. Based on the forward PE ratio in comparison to the historical average it shows that Microsoft is 7.2% undervalued which represents a fair value of $40.71. Here is the math [[13.4-12.5]/12.5]=[7.20%*$37.98]+$37.98=$40.71

Valuation Method #3: Trefis

For this valuation method, I will be using the Trefis page for Microsoft to see what the value of Microsoft is, based on the value of each of its underlying businesses. The chart below shows that based on the underlying divisions of Microsoft shares have an estimated fair value of $42.43/share, which is 11.72% above its current price of $37.98. In addition, the table shows that Cash [net of debt] accounts for $9.20/share of the value of Microsoft, which leads to the inevitable question of what should Microsoft do with all that cash, which is what I will cover in the second part of this article.

Valuation Conclusion

Each of the three valuation methods I used showed shares of Microsoft were undervalued. I took an average of the prices I calculated for each valuation method to get an upside price target of $44.30. Even if Microsoft stays on its current course and does not use its cash for anything other than buybacks & dividends as it currently does, I believe shares can still hit my target price.

Potential Acquisition Targets

Below are three companies from current growth areas in technology: security, big data, and enterprise solutions. I believe these companies would fit well with Microsoft given the enterprise & cloud focus of new CEO Satya Nadella. Below I will give my reasoning behind why each of the following companies would be a good fit with Microsoft.

Security: Check Point Software Technologies (NASDAQ:CHKP)-Market Cap $13.24 Billion

The reason Check Point Software would be a good fit with Microsoft is because it would allow Microsoft to be a "one-stop shop" for security and data storage. Check Point Software provides enterprise security & traffic management services to businesses. This would fit well with Microsoft strategy of providing companies with cloud services on Microsoft Azure, and providing security software as well. Check Pont is in a growth business but unlike traditional growth companies Check Point generates significant levels of free cash flow, which would fit well with Microsoft. In addition, Check Point has a profit margin for the TTM of 46.83%, and Microsoft has a profit margin of 27.35% according to Morningstar. In closing, by acquiring Check Point, the valuation of Microsoft should increase because Check Point is in a growing industry, generates large amounts of free cash flow, and has a higher margin business.

Big Data: Teradata (NYSE:TDC)-Market Cap $7.53 Billion

The reason Teradata would be a good fit for Microsoft is it would make Microsoft the leader in big data. The following chart from a recent Teradata investor presentation shows that Microsoft & Teradata are competitors in enterprise data warehousing. With Microsoft focusing on enterprise, Teradata would make sense because according to the second chart below, Teradata is the top company in enterprise data warehousing, and Microsoft is fifth, therefore if Microsoft were to acquire Teradata that would make Microsoft the clear leader in enterprise data warehousing.

(click to enlarge)

[Chart from Teradata Investor Presentation]

(click to enlarge)

[Chart from Teradata Investor Presentation]

Enterprise Solutions: Workday (NYSE:WDAY)-Market Cap $17.52 Billion

The reason Workday would be a good fit for with Microsoft is because Workday "is a leading provider of enterprise cloud-based applications for human capital management (HCM), payroll, financial management, time tracking, procurement, and employee expense management." [Workday Company Description from their Website]

With Microsoft, having the Azure cloud platform an acquisition of Workday would make sense for two reasons; the first is that Workday could use Azure for its cloud-based applications. The second reason is that in the fall of 2013 Workday and Salesforce.com (NYSE:CRM) announced a partnership in which they "announced plans to integrate the entire Salesforce and Workday product lines to enable their customers' mutual success."[Partnership Announcement press release]

If Microsoft were to acquire Workday, it would be as if Microsoft was getting a piece of Salesforce as well since Salesforce & Workday will have integrated products. In addition, Salesforce & Oracle (NYSE:ORCL) have an existing partnership in which Salesforce will use Oracle databases, which are a competitor to Microsoft. While it may be difficult if Microsoft were to buy Workday to move Workdays enterprise cloud applications to Azure, buying Workday would be a good hedge against Oracle or Salesforce buying them.

Closing Thoughts

In closing, I believe if Microsoft does not make any major changes and stays on its current course, shares still have room for price appreciation, with the additional dividend growth kicker. However, if Microsoft continues its move towards being more of an enterprise and cloud company through the acquisition targets I provided above or others targets, I believe Microsoft would see an increase in growth rate which would lead to a higher valuation and thus a higher stock price.

Disclaimer

Source: Microsoft Valuation And Acquisition Targets