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Company Description (Source: SEC 10-K)

Microsoft Corporation (MSFT), founded in 1975, is engaged in developing, licensing and supporting a range of software products and services. It also designs and sells hardware, and delivers online advertising to the customers. It has five segments: Windows & Windows Live Division (Windows Division), Server and Tools, Online Services Division (OSD), Microsoft Business Division (MBD), and Entertainment and Devices Division (NYSE:EDD). Its products include operating systems for personal computers (PCS), servers, phones, and other intelligent devices; server applications for distributed computing environments; productivity applications; business solution applications; desktop and server management tools; software development tools; video games, and online advertising. Its cloud-based computing services include Bing and Windows Live Essentials suite.

Vital Statistics (Source: Google Finance)

  • Recent Price: $31.43 (as of 02/21/2012)
  • 52-Week Range: $23.65 - $31.55
  • Market Capitalization: $263.74 Billion
  • P/E Ratio: 11.38
  • EPS: $2.76
  • Yield: 2.55%

A 10-year summary of Sales, Earnings Before Interest and Tax ((EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below. Stock prices are adjusted for splits.

Key 10-year data for Microsoft

Year

Sales (in Millions)

EBIT (in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2011

69943

28071

2.69

28.6

23.9

10.6

8.9

9.8

2010

62484

25013

2.1

31

23.2

14.8

11.0

12.9

2009

58437

19821

1.62

31

15.2

19.1

9.4

14.3

2008

60420

23814

1.87

36.1

19.1

19.3

10.2

14.8

2007

51122

20101

1.42

37

27

26.1

19.0

22.5

2006

44282

18262

1.2

30.2

21.9

25.2

18.3

21.7

2005

39788

16628

1.12

28

24

25.0

21.4

23.2

2004

36835

12196

0.75

30

24.6

40.0

32.8

36.4

2003

32187

11054

0.69

30

23.2

43.5

33.6

38.6

2002

28365

7875

0.48

34.4

21.8

71.7

45.4

58.5

Source: MSN Money; SEC 10-Ks.

From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.

Sales (in Millions), EBIT (in Millions), and EPS versus Year for Microsoft, 2002-2011

As evident from the chart above, Microsoft has demonstrated quite predictable sales and earnings over the past 10 years (with R squared greater than 0.9), which allows us to project EPS in the near future, say in five years (i.e. Year 2016), using the logarithmic regression equation for EPS = 4.75E-153 * exp(0.1749*2016) = 6.4303. This projection assumes 17 percent annual EPS growth.

A conservative average P/E estimate for the stock can be obtained as follows:

Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). The very high P/Es from 2002-2004 are outliers, so we average the Average P/Es from the past 7 years to arrive at a signature P/E of 17.

High P/E estimate: A conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest High P/Es from the past 10 years gives 17.8.

Low P/E estimate: A conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest Low P/Es from the past 10 years gives 11.6.

Average P/E estimate: This takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 14.8 and 9 gives us 14.66.

Target Price

Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $6.4303 * 14.66 = $94.28, which represents an annual stock price return of 31.6 percent from the current price = $31.43. When we add in the 2.5 percent dividend yield, the total return expected is 34.1 percent a year, which means an investment in MSFT today is expected to double in about 2-3 years.

Given a beta = 1.00 for MSFT, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 8 percent for the general stock market, we have a discount rate = 2% + 1.00*(8%) = 10%. Applying this discount rate of 10%, our projected price of $94.28 in 5 years translates to a target price = $58.54 in today's dollars. This is about 86% upside from the current price of $31.43, suggesting the stock is undervalued right now. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a buy price of $46.83 or less.

Current P/E Compared with Signature P/E

The stock's current P/E should be compared with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current EPS = 2.76, giving us a current P/E = 11.38. This is about 67% of the stock's signature P/E of 17, suggesting the stock is undervalued right now. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, so Microsoft is currently attractively priced relative to its historic P/E.

Microsoft's P/E Compared with Competitors' P/Es

It is helpful also to compare Microsoft's valuations with those of its competitors. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are Microsoft's main competitors, but Microsoft's various products and services also face competition from many other technology companies. Current P/E and Forward P/E are tabulated below for the company and its competitors mentioned in MSFT's recent SEC 10-K filing.

Stock

Current P/E

Forward P/E

Microsoft (NASDAQ:MSFT)

11.38

10.49

Google

20.62

14.05

Apple

14.6

10.74

Yahoo (NASDAQ:YHOO)

17.82

16.27

International Business Machine (NYSE:IBM)

14.4

11.8

Intel (NASDAQ:INTC)

10.76

10.39

Amazon.com (NASDAQ:AMZN)

132.48

66.24

Hewlett-Packard (NYSE:HPQ)

8.89

6.59

VMWare (NYSE:VMW)

58.65

43.6

Oracle (NYSE:ORCL)

15.76

11.57

Salesforce.com (NYSE:CRM)

12873

321.83

Adobe (NASDAQ:ADBE)

19.93

14.88

Research in Motion (RIMM)

3.58

5.31

Cisco (NASDAQ:CSCO)

16.06

11.61

SAP (NYSE:SAP)

17.13

14.35

Mean

882.34

37.98

Median

16.06

11.80

Source: MSN Money.

Compared to its competitors, Microsoft is trading at a discount. Only Intel, Hewlett-Packard, and Research in Motion offer better valuations. Salesforce.com, Amazon.com, and VMWare appear significantly overpriced.

Historically, for the past 10 years, Microsoft has underperformed significantly all its competitors, with the exception of Intel, which did worst (10-year price data is not available for GOOG and CRM). Microsoft lost 18.8 percent over the past years, while most of its competitors had gains. Note that this underperformance occurred during a period of strong and consistent sales and earnings growth. The problem is Microsoft's valuations were simply too lofty 10 years, with average P/E = 58 in 2002. Even 17 percent annual growth is not good enough if investors were expecting 58 percent annual growth. This is why Salesforce.com, Amazon.com, and VMWare, with their currently lofty valuations, are extremely risky bets.

Source: Google Finance.

Microsoft has also underperformed the Dow, the S&P 500, and the Nasdaq (all of which Microsoft is a part) over the past 10 years. This again illustrates why lofty P/Es are so dangerous, and how it is possible for the stock price to decline even during periods of strong earnings growth.

Source: Google Finance.

Now that investor's expectations have adjusted significantly lower, with a current P/E of 11.38, MSFT is more likely to offer satisfactory future returns.

Risk Index

Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.

The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For MSFT, the forecast low EPS is equal to 1.94, so the Forecast Low Price = 11.6 * 1.94 = $22.42.

The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price in 5 years, should the stock command a high P/E. For MSFT, this equals 17.8 * 6.4303 = $114.25.

Thus, the Risk Index = ($31.43 - $22.42) / ($114.25 - $22.42) = 10%. Since this is below 20%, the stock has a favorable reward to risk ratio at the current price.

Conclusion

Microsoft Corporation, currently selling around 52-week high of $31.43, has a target price of $58.54. Despite the recent run-up in price, the stock is still selling at a discount to its historic P/E and also to its competitors. Upside potential appears to outweigh downside risk. Therefore, I rate the stock a BUY at the current price.

Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.

Source: After A Lost Decade And Now At 52-Week High, Microsoft Is Still A Buy