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Summary

  • Microsoft is one of our favorite ideas in our coverage universe.
  • The company has a pristine balance sheet, a strong and growing dividend, and valuation upside.
  • Microsoft is a holding in both the Best Ideas portfolio and Dividend Growth portfolio.

Very few firms have as attractive of an investment profile as Microsoft (NASDAQ:MSFT). The company has a mountain of cash on the balance sheet that covers its annual dividend with total cash 10 times on a pure annual comparison (total cash versus cash dividends paid). The software giant generate gobs of free cash flow, and its capital commitments are far from demanding. The company's shares have been underpriced for a while, but it has just recently garnered investor interest, reaching $40 per share. Microsoft has fit the Valuentum style through much of its upward price advance, and dividend growth investors have been handsomely rewarded by its healthy payout. Let's walk through why Microsoft fits the Valuentum style of investing and derive its intrinsic value on the basis of an enterprise free cash flow model.

For those that may not be familiar with Valuentum, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Microsoft posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We prefer equities that register a 9 or 10 on the Valuentum Buying Index (a "we'd consider buying" rating). Microsoft has registered this coveted rating in the past, and by extension, it has been added to both the Best Ideas portfolio and Dividend Growth portfolio, the latter because of the size and strength of its dividend. The software giant's shares have performed fantastically since that time. We'd only consider removing Microsoft if the company registers a 1 or 2 on the index (a "we'd consider selling" rating). With that said, let's dig into our report on the firm.

Microsoft's 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. The company also has one of the strongest Economic Castle ratings.
  • 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 28.3% 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 still look inexpensive at current levels, while providing investors with a fantastic dividend growth opportunity.
  • The firm sports a very nice dividend yield of 2.8%. We expect the firm to pay out about 41% of next year's earnings to shareholders as dividends. Its Dividend Cushion score is a remarkable 3.4.

Business Quality

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 with its weighted average cost of capital. 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 $38-$58 each. We think this is a reasonable fair value range for the software giant. For one, its net cash balance alone is a large contributor to equity value. With shares trading at roughly $40 at the time of this writing, its upside/downside risk is tilted significantly in investors' favor. We like its investment profile quite a bit.

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 $48 per share (which is the mid-point of the fair value range) is supported by a reasonable price-to-earnings and EV/EBITDA multiple. Our model reflects a compound annual revenue growth rate of 6.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.6%. We think a mid-single-digit top-line advance is reasonable in coming years.

Our model reflects a 5-year projected average operating margin of 33.1%, which is below Microsoft's trailing 3-year average. In the land of technology, we think it is prudent to build in some margin pressure, even for a software giant like Microsoft that has significant operational flexibility.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% 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. Our long-term assumptions are reasonable for such a large firm, and the discount rate may be a bit on the conservative side given Microsoft's competitive-advantage profile.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Microsoft to peers Adobe Systems (NASDAQ:ADBE) and Oracle (NYSE:ORCL), among others.

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Recent Events

Microsoft is one of the largest weightings in the Dividend Growth portfolio, and very few other firms pack the punch of its elevated Valuentum Dividend Cushion score. Its name should be synonymous with dividend growth and safety. The company's calendar first quarter (fiscal third quarter) results were solid, and we don't have any qualms with its conservative fourth-quarter outlook. We think the real story with Microsoft, however, is its undervaluation coupled with a fortress balance sheet that will propel years and years of future dividend growth. Microsoft will be one of the best dividend growth gems over the next two decades, in our view, and we continue to like shares a lot.

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 $48 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 $38 per share (the green line), but quite expensive above $58 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.

Future Path of Fair Value

We estimate Microsoft's fair value at this point in time to be about $48 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 $60 per share in Year 3 represents our existing fair value per share of $48 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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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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

Source: Why We're Still Huge Fans Of Microsoft