Seeking Alpha

The purpose of this article is to analyze Microsoft's (MSFT) share price in relation to its intrinsic value. For those who are not familiar with the term 'value investing', it is a strategy where one chooses stocks that trade below their intrinsic value. Some of the most prominent value investors including Warren Buffett and his mentor Benjamin Graham - who is considered as the father of security analysis and value investing. They have built their tremendous fortunes based on this principle. This strategy will not make you rich overnight; however, it will help the value investor accumulate wealth in the long-run. The value investor is patient and not easily fazed by emotional or external factors.

In calculating the intrinsic value of Microsoft, I used 15% as expected ROI for an investment period of 10 years. Investors who expect a higher or lower return on their investment will be able to use my calculated intrinsic share price as a benchmark to determine if Microsoft's share is over or undervalued with respect to their desired ROI.

 Company Microsoft Year 2012 Current Share Price \$32.26 Average 10 Year EPSGR 20.65% EPS \$2.76 Average P/E (10 Years) 21.76 Average Div. Yield (5 Year) 2%

Based on Microsoft's performance in the past 10 years, I am confident that its EPS will continue to grow at 20.65% per year. I assume that Microsoft will be having the same P/E multiple and dividend payout by the end of 2022 based on its 10 year averages. Below is an illustration of how I calculated Microsoft's EPSGR and price-to-earnings averages.

 Year EPS P/E 2002 0.71 39.1 2003 0.92 27.9 2004 0.75 38.1 2005 1.12 22.2 2006 1.2 19.4 2007 1.44 20.8 2008 1.9 14.7 2009 1.63 14.7 2010 2.13 11 2011 2.73 9.7 Average Growth Rate 20.65% Average P/E Multiple 21.76

Click to enlarge:

Forecasting Share Price @ 2022

As we can see above, the exponential line that passes through 2002 - 2012 illustrates a 20.65% EPS growth rate year-over-year. This will be used to calculate the total expected dividends for the next 10 years.

 Forecast Share Price 2022 2022 = EPS After 10Y * Average P/E \$392.50

First of all, you need to forecast the share price for your desired investment period. In this case, I projected the share price for the next ten years by using the calculated 20.65% EPS growth rate per year, which is then multiplied by the average P/E multiple. As we can see below, this gives us an expected share price of \$392.50 by 2022.

(\$2.76*1.2065^10)* 21.76 = \$392.50

Share Price Forecast @ 2022 = = \$392.50

Forecasting Total Future Value

 Year Projected EPS (EPS * Average EPSGR) 2012 \$3.33 2013 \$4.02 2014 \$4.85 2015 \$5.85 2016 \$7.06 2017 \$8.51 2018 \$10.27 2019 \$12.39 2020 \$14.95 2021 \$18.04 Total EPS (10 Years) \$89.26 Total Dividend = Total EPS * Avg. Div Payout \$1.79 Forecast Share Price @ 2022 \$392.50 Future Value @ 2022 (total div. + 2022 share price) \$394.29

Some investors don't care much about dividend. To them, the dividend is just too small to be considered. In this particular case, total dividend payout per share is only \$1.79. Even though this amount may seem miniscule, it does affect the future value. Therefore, it should be taken into consideration.

Microsoft's Intrinsic Value

In order to calculate the intrinsic value of something, you have to consider the time value of money. In this particular situation, I set my expected ROI to 15%. Therefore, all future cash flows that I expect from Microsoft will be discounted at a 15% rate for an investment period of 10 years.

NPV = Future Value / Expected ROI ^ (# of years)

= \$394.29 / 1.15 ^ (10)

Microsoft's Intrinsic Value = \$97.46

Compare with Current Stock Price

The intrinsic value above is a result of my goal of 15% expected return on investment that I desire per annum. If so, the current stock price, which is \$32.26, is trading at a significant discount. According to my projected inflows for this stock, it seems that Microsoft will be able to provide shareholders a healthy 30% return on investment for the next 10 years if purchased at this price level.

As you can see, intrinsic value may differ from one investor to another depending on expected return. However, if you solely base your forecast - as I did here - on a ten year historical period, you can determine whether this investment satisfies your expectations. Warren Buffett doesn't just settle for any stock that is undervalued, but rather, he patiently looks for stocks that are trading at least at 25% below its intrinsic value. In this case, Microsoft seems to be undervalued by the market by 202%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.