Microsoft (NASDAQ:MSFT) is one the largest software companies in the world with its Windows Operating System running on more than 90% of the computers operating today. There are hardly any companies in the free world that enjoy a monopolistic position of this magnitude. In this article, I will attempt to determine the fair value of MSFT using discounted cash flow analysis and relative valuation.

**Company Basics**

Microsoft can be broken down into five (5) major revenue sources which are as follows:

- Windows Operating System (40% of stock price)

- Microsoft Office (33.3% of stock price)

- Windows Server and SQL Server (7.7% of stock price)

- Bing Search, MSN & aQuantive (1.8% of stock price)

- Xbox and Zune (1.2% of stock price)

(Source: Trefis)

The remaining 16% of stock price is contributed by the $36.7 Billion ($4.2/share) that MSFT had in cash and short term investments as of June 30, 2010. Since MSFT is a fairly mature company with relatively few opportunities for growth, investors have been making a case for an increase in dividend from the current yield of 2.06%. Recently, there were rumors that MSFT would borrow money from the market to take advantage of the prevailing low interest rates and use the proceeds to issue dividends and/or buy back stock. Analysts estimate that MSFT could borrow up to $6 Billion without putting its AAA credit rating at risk.

*Fundamentals/Earnings*

Market Cap = $220.1 Billion

Sales (TTM) = $62.5 Billion

Income (TTM) = $18.8 Billion

Net Profit Margin = 30%

LT Debt to Equity ratio = 0.11

Return on Equity = 44%

Current Ratio = 2.13

TTM EPS = $2.10

My 2011 EPS Estimate = $2.25

Average Analyst 2011 EPS Estimate = $2.36

Average Analyst 2012 EPS Estimate = $2.63

Current P/E = 12.1

Current P/E (Peers) = 25.31

Current P/E (S&P 500) = 18.68

*Discounted Cash Flow Valuation*

DCF valuation of Microsoft was performed by employing a two-stage model with a high growth period of 5 years. The major inputs and the valuation results are presented below.

High Growth Period:

- Bottom-Up Beta for High Growth Period – 1.33

- Risk Free Rate – 2.75% (10-Year Treasury Bond)

- Risk Premium – 6.0%

- High Growth Rate (based on fundamentals) – 7% (kindly note that analysts estimate a 11% growth rate)

- Cost of Equity during High Growth Period = 10.73%

The projected free cash flow to equity during the high growth period is as follows:

Year 1 – 2.12

Year 2 – 2.27

Year 3 – 2.43

Year 4 – 2.60

Year 5 – 2.78

Present Value of free cash flow to equity in High Growth Period – $8.95

Stable Growth Period:

- Bottom-Up Beta for Stable Growth Period – 1.2

- Risk Free Rate – 4%

- Risk Premium – 6%

- Stable Growth Rate – 3%

- Cost of Equity during Stable Growth Period = 10.6%

Present Value of Terminal Price = $22.29

Summary:

Present Value of FCFE in High Growth Period = $9

Present Value of Terminal Price = $22

Cash = $4

Fair Value of Stock = $35

*Relative Valuation*

The estimated fair value using various relative valuation methods is presented below. It should be noted that the data from the last four financial years was taken in calculating the averages shown below. Adjustments were made to account for outliers present in the dataset.

P/E

Existing P/E – 12.05

Historical P/E – 13.14

Fair Value - $28

**P/S**

Existing P/S – 3.54

Historical P/S – 3.66

Fair Value - $26

**P/FCF**

** **

Existing P/FCF – 12.46

Historical P/E – 15.76

Fair Value - $32

**(P/E) / (P/E – Peers)**

Existing (P/E) / (P/E – Peers) – 0.48

Historical (P/E) / (P/E – Peers) – 0.62

Fair Value - $33

**(P/E) / (P/E – S&P 500)**

Existing (P/E) / (P/E – S&P 500) – 0.65

Historical (P/E) / (P/E – S&P 500) – 0.70

Fair Value - $28

Average Fair Value based on Relative Valuation - $29

*Fair Value*

Combining the estimates obtained from my DCF analysis and relative valuation, the fair value of Microsoft is $32 a share. My 12-month price target of $29 is obtained by applying a P/E of 13 to my 2011 EPS estimate of $2.25. At these levels, MSFT will be trading on par with its historic multiples. As of September 20, 2010, MSFT was trading at $25.4. Therefore, my price target of $29 implies a total return of 15% (including dividends).

(Kindly use this article for information purposes only. Please consult your investment adviser before making any investment decision)* *

**Disclosure: **None. I plan on opening a position in MSFT if and when MSFT trades below $24/share, implying a 25% discount to its fair value.