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Founded in 1975, Microsoft (NASDAQ:MSFT) is a technology behemoth, with a market capitalization of $276 billion and a debt to equity ratio of 19%. It operates in five principal segments: Windows & Windows Live Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division.

Windows and Servers are together responsible for approximately 50% of total revenues and 70% of the total operating profits. The Online Services division continues to lose money and lost $2.7 billion last year. The stock is up 28% over the last year compared to the 13% returns of the tech-heavy NASDAQ index. The company offers a respectable dividend yield of 2.4%.

In this article, I conduct a valuation analysis to determine the fair value and 12-month price target for the company.

Historical Growth

MSFT grew its revenues at an annual rate of 6% and income at an annual rate of 12% during the last five years. These growth rates accelerated during the last year, with revenues up 12% and income up 23%. Comparing the quarterly performance with the same quarter of the previous year, the earnings were flat, while revenues were up by 5%.

Future Growth

MSFT has generated strong returns on equity, averaging 42% during the last three years. Last year, the company's trailing twelve-month ROE matched the historical ROE of 42%, down from last financial year's ROE of 45%. I project a 40% return of equity for the next five years. During the last three years, the company has returned approximately 75% of its earnings back to shareholders via dividends and share repurchase programs. Applying a retention ratio of 25% to the future ROE of 40%, I obtain my projected long-term growth rate of 10%. This is higher than the consensus long-term growth rate estimate of 8%.

Margins and Profitability

MSFT's gross margins have decreased over the last three years. While the three-year average gross margins were 79%, the company reported TTM margins of 76%. The operating margins were steady at 38% over the last three years. The net margins, however, showed a positive trend, with net margins increasing from 29% to 33% during this time period. The return on assets has also improved marginally from 22% to 23%.

To compare MSFT's performance to that of its peers, I evaluated the margins and operational aspects of some of the other companies in the computer services industry. The peers selected for analysis included Oracle (NYSE:ORCL), IBM (NYSE:IBM), Adobe (NASDAQ:ADBE), and Google (NASDAQ:GOOG). The table below presents the peer analysis.

Ticker

Market Cap

P/E

P/S

Lt D/E

ROA

ROI

GM

OM

MSFT

275.64B

11.9

3.9

20.9

23.8

33.1

77.7

38.8

ORCL

151.08B

16.5

4.3

37.1

12.7

16.2

76.4

33.8

IBM

238.68B

15.8

2.2

113.5

13.8

21.6

46.9

19.6

ADBE

16.87B

20.7

4.0

26.0

9.7

11.2

89.6

26.1

GOOG

201.95B

20.9

5.3

5.1

14.9

17.5

65.2

30.7

Average

17.1

3.9

40.5

15.0

19.9

71.2

29.8

As seen in the table above, among the companies listed, MSFT boasts of the highest return on assets and return on investments. MSFT has higher margins and lower P/E than every company on the list. IBM has the lowest P/S ratio, while GOOG has the highest.

Valuation

Valuation analysis was performed using residual income analysis. The starting point for this analysis was consensus 2012 and 2013 EPS estimates. Next, I applied my projected growth rate of 10% to obtain the EPS estimate for the following three years. The cost of equity was calculated using bottom-up beta of 1.33, risk free rate of 2% and a risk premium of 5.64%. Finally, a stable growth rate of 3% was used as part of this analysis. The analysis results are as below:

Analysis results

EPS 2012 - $2.7

EPS 2016 - $4.0

Long-Term Growth Rate - 10%

PV of Residual Income = $8.9

PV of Terminal Value = $22.7

Existing Book Value = $7.6

Intrinsic Value = $39

As shown in the above, MSFT trades at a discount of 19%. The stock is cheap in my opinion and makes a good investment candidate at current levels, offering a potential return of 21% (including dividends).

Disclaimer: Please use this article for information purposes only. Please consult your investment advisor before making any investment decision.

Source: Microsoft: Return Potential Of 21%