From cloud innovation to low multiples and emerging market growth, software producers offer some of the greatest upside right now. In this article, I will run you through my DCF model on Microsoft (MSFT) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Oracle (ORCL) in order to increase confidence.
First, let's begin with an assumption about revenues. Microsoft ended FY2012 with $69.9B in revenue, which represented a 11.9% increase off of the preceding year. Analysts model a 8.4% per annum growth rate over the next five years, and I view this sentiment as overly conservative. But for the sake of being safe in calculating my price target, I accept the figure. Note that the S&P 500's per annum growth rate is expected to be 10.4% over the the same time period.
Moving onto the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model that cost of goods will eat 21% of revenue over the next few years as SG&A and R&D taper off to 25% and 14.5% of revenue over the same time. These estimates are still roughly around historical 3-year average levels and are assumed to slightly diminish, because that has been the trend. Capex is estimated the same way, so I assume 4% over the next few years. The effective tax rate is estimated at around 27%. We then need to subtract out net increases in working capital: we model accounts receivable as trending towards 22.5% of revenue; inventories as 8.5% of COGS; accounts payable as 9.5% of OPEX; and accrued expenses as 19.5% of SG&A.
Taking a perpetual growth rate of 1.5% and discounting backwards by a WACC of 10% yields a very conservative fair value figure of $37.22. Since Microsoft is a tech firm, a much more realistic estimate for perpetual growth rate would be 3%, which pegs intrinsic value at $48.77. Caution, however, is always advised, so I would go with the conservative case. This is on top of an industry attractive 2.5% dividend yield.
All of this also falls under the context of strong recent quarterly results:
I'm pleased with our performance this quarter. Despite a challenging PC market, we delivered solid financial results. We saw a strong demand for our business products and services and had a record holiday season, driven by the unique entertainment experience we have built with Xbox 360.
This quarter, the strength of our product portfolio enabled us to grow revenue 5% to $20.9 billion. Combined with our ongoing operating expense discipline, even as we prepare for a big launch year, we delivered record earnings per share of $0.78.
From a multiples perspective, Microsoft trades at a respective 11.5x and 10.6x past and forward earnings versus 16.1x and 11.4x for Oracle. Consensus estimates for Microsoft's EPS forecast that it will hit $2.99 in 2013. Assuming a multiple of 13x and a conservative 2013 EPS of $2.90, the rough intrinsic value of the stock is $37.70 - roughly in-line with my conservative DCF calculation.
Consensus estimates for Oracle's EPS forecast that it will grow by 5.4% to $2.34 in 2012 and then by 9.4% and 9.8% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $2.52, the rough intrinsic value of the stock is $37.95, implying 29.7% upside. The company is valued at nearly three-quarters of its historical 5-year average PE multiple while being well positioned to penetrate hardware markets. Often myopic, investors are overly focused on poor recent performance when Oracle stands to gain considerable momentum from improved switching costs and innovation.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.