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With a market cap of $217.57 billion as of June 28, Microsoft (NASDAQ:MSFT) is one of the largest information technology companies. Microsoft is an immensely profitable company with a gross margin of 78% and net profit margin of 31.76%. For some reason, the Street does not appreciate Microsoft's profitability. The year-to-date return is -6.42%. The company has a beta value of 1.04 with a 14-day average true range of 0.49. As of June 28 close, Microsoft was trading at $25.8 with a ttm [trailing 12 month] P/E ratio of 10.24 and a forward P/E ratio of 9.31.

Microsoft has a 4-star rating from Morningstar. Wall Street has diversified opinion on Microsoft's future. The bottom line is 0.4% growth, whereas the top-line growth estimate is 16.3% for the next year. Average five-year annualized growth forecast is 11%.

What is the fair value of Microsoft given the analyst estimates? In this article, the fifth in the series, I will show a step-by-step calculation of Microsoft's fair value using FED+ (Future Earnings Discounted plus Equity) Model.

FED+ MODEL

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Microsoft's Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $2.58 along with the mean estimate of $2.77 for the next year.

E0 = EPS = ($2.58 +2.77) / 2 = $2.675

Wall Street holds diversified opinions on Microsoft's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five year growth forecast is 11%. Book value per share is $6.17.

The rest is as follows:

V0

E0

$2.68

V1

E0 (1+g)/(1+r)

$2.68

V2

E0((1+g)/(1+r))2

$2.68

V3

E0((1+g)/(1+r))3

$2.68

V4

E0((1+g)/(1+r))4

$2.68

V5

E0((1+g)/(1+r))5

$2.68

D

E0(1+g)5/[r(1+r)5]

$24.38

BV

Equals

$6.17

Fair Value

Equals

$46

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. According to my 5 year discounted-earnings-plus-book-value model, the fair-value estimate for Microsoft is $46 per share. As of June 28, Microsoft was trading at a price of $25.8. Microsoft is undervalued by almost $20. While I do not expect this gap to be closed by this year, I think Microsoft will beat the market returns for the next 5 years.

O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.

EPS Growth: Higher is better.

P/E Ratio: Lower is better.

The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors and the formula works very well so far.

What is the O-Metrix Score of Microsoft?

  • Microsoft offers a dividend yield of 2.48%. That is a bonus for shareholders.
  • Growth estimate is the same as the discounted earnings model and is equal to 11%.
  • Since we are at the middle of the year, taking the average of ttm [10.24] and forward [9.31] P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 9.77.

O-Metrix = [(2.48 + 11) / (9.77)] * 5 = 6.9

Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. Microsoft's O-Metrix score of 6.9 is way above the market score. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. With a positive dividend yield, Microsoft is under-priced with a B-Grade, above average-return zone.



Summary

As of June 28, Microsoft was trading at $25.8, which is almost 44% lower than my fair value estimate. Thus, I believe Microsoft has almost 80% upside potential to reach its fair-value. While I do not expect this gap to be closed in a short period of time, I think Microsoft will be an outperformer. If the analysts' estimates hold, Microsoft will provide a better return than the market average. The stock was going down since February, but it recently crossed its upward resistance boundary with a high volume. The next target will be the February peak value of $29. Mr. Gates have been performing automated stock sales for a long time. That is one of the primary reasons that the stock is cheap. While many shareholders see that as a negative event, I think it offers an opportunity to buy cheap shares of a highly profitable company that pays regular dividends.

Source: Microsoft Has Almost 80% Upside Potential