Recently a fellow contributor, Jason Russ, published an article arguing that Microsoft (NASDAQ:MSFT) is overvalued by about 11%. This piece will serve as a counter-argument to that article. While the aforementioned article made some valid points, there are a few things in that article I do not agree with. This is why I decided to offer my perspective on it.
How should Microsoft be valued based on discounted cash flow?
The article argues that Microsoft's growth is coming to a slowdown, which will affect the company's valuation in the future. This is valid, since companies can only grow so much and all companies will experience a slowdown in their growth sooner or later. The article states that Microsoft's earnings grew at an annual average of 13.1% for the last 10 years, 9.2% for the last five-years, and it is expected to grow at 6.78% for the next five-years and at 5.0% for the next 15 years after that. The author plugs a 10% discount rate per year and arrives to the conclusion that the stock is worth $35.27 according to this calculation.
Here is the problem with this calculation. This calculation makes almost every stock in the market, as well as the market itself, appear to be very expensive. Currently the average P/E in S&P 500 index is 19.59. If we assume 5% average annual growth and a 10% discount rate with reasonable P/E of 15 with 10-year horizon, the fair value of the S&P 500 appears to be well below 1,300. This calculation would mean that the market is overvalued big time.
There are three issues with this type of calculation. First, the discount rate is pretty high. One of the greatest teachers in the world of investment, Benjamin Graham, suggests that investors should expect a return of 7% from their conservative stock investments after inflation and dividends. In fact, he suggests that a 4% compounded annual growth rate coupled with a 3% dividend yield on top (after inflation) would be a very reasonable return on investment. Between 1913 and 2013, the average annualized return of the stock market was 9.95% before adjusting for inflation and 6.54% after adjusting for inflation. So, if we apply a 6% discount rate before dividends and inflation, Microsoft's fair value would jump to about $49.
This is not the only issue I have though. The second issue I have is that Microsoft currently sits on $88 billion in cash and short-term investments in addition to $15 billion in long-term investments. In comparison, the company's debt is as little as $22 billion. When valuing a company, it is always important to keep that company's cash position in mind. For example, if you are buying a local barber shop for $20,000 and the barber shop has $4,000 in cash reserves, you are actually paying $16,000 for the barber shop. The exact same principle also applies to companies that trade publicly. Currently, Microsoft is worth $344 billion and the company's cash reserve is worth about $103 billion. This leaves us with a net value of $241 billion, which is roughly 11 times Microsoft's net income last year. When we include Microsoft's ever-growing and massive cash reserve in the above calculation, the company's fair value is closer to $60-65 per share.
The third issue I have is somewhat related to the first two issues. The discounted cash flow assumes no buybacks even though it is very typical for mature companies to buy their shares back in order to reduce the float. Microsoft's current share count is 8.26 billion and the company bought back nearly 3 billion shares in the last 10 years. Last year, the company approved a large buyback of $40 billion and this shows the company's commitment to reduce its share count. As companies buy their shares back to retire those shares, their earnings-per-share increase even if their net incomes stay flat. This is why it is important to incorporate this into discounted cash flow analyses. This can be incorporated into calculations in two ways, either by adding to EPS growth estimates or reducing discount rate.
How about dividends?
When computing a company's future dividends, it is also important to look at that company's cash reserves as well as its commitment to buy shares back. Many times, companies can grow their dividend-per-share by buying their shares back. If Microsoft plans on paying $1 billion in dividends and there are 1 billion shares, the company will have to pay $1 per share. If the company bought some shares back and reduced the share count to 900 million, it can now pay $1.11 per share even if it will still spend $1 billion. This is why Microsoft can grow its dividend rate for a very long time at a reliable pace.
Last year, Microsoft earned $2.67 per share and paid $1.07 in dividends. Since the company has a pretty large cash reserve, it can spend this cash on either raising dividend payments or buying its shares back. At the end of the day, either move would increase the dividend payment per share even if the company's overall dividend budget stayed flat. If Microsoft were to spend a third of its earnings on dividends and a third on stock buybacks, this would increase the company's dividend payment by roughly 10% every year assuming a 5% annual growth rate in the company's net income.
Currently, the average yield in the market is 1.85% and Microsoft's yield of 2.69% is considerably higher than that. Based on past and future dividend expectations, Microsoft appears to be undervalued.
Are Microsoft's margins at risk?
The article also compares Microsoft's current margins with the company's margins in 2010 to say that there is a downtrend. A company's margins can move in any direction for any reason, and it is important to diagnose why a company's margins might be headed down. In the last few years, Microsoft saw its margins decline for two reasons. One, the company's product mix has changed considerably in the last several years. In the past, Microsoft used to be a software company and software comes with high margins. In recent years, the company started to increase its portfolio of hardware products, which adds lower margins to the mix. This is nothing to worry about. Two, Microsoft has been investing heavily for future growth as the company wants to capture market share in the consumer market. The company bought Nokia's (NYSE:NOK) handset division and launched a new Xbox in the last year. These things cost money.
Even with slightly declining margins, Microsoft is still taking home a lot of money. Last year, operating margin was 49.40% in the Windows Division, 40.25% in Server and Tools, and 65.48% in the Microsoft Business Division. Excluding the newly emerging consumer products and hardware businesses, Microsoft's margins are as healthy as they have ever been.
There are many different ways one can value a company. Microsoft is one rare company that looks cheap no matter which method one uses to value it. The company is highly profitable and it sits on a giant pile of cash that keeps growing. Any valuation method should make sure to keep these facts in account. Apart from everything else, why should Microsoft trade for a single-digit P/E while the overall market's average P/E is so close to 20?
Disclosure: The author is long MSFT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.