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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.