Microsoft (MSFT) was founded in 1975 as a small tech startup. Headquartered in Redmond, Wash., Microsoft quickly became a technology giant that provides software, services, and solutions to customers worldwide. Its Windows-based operating system was a huge innovation at the time it was developed. Currently, Windows 7, Office, SharePoint, Exchange, Microsoft Dynamics, Windows Server, System Center, and SQL Servers are among the company's most well-known products.
Microsoft has also established a significant presence in the cloud computing revolution. Cloud computing opened a new era for Microsoft, as well as the rest of the world. Everyday millions -- if not billions -- of office documents are uploaded to Microsoft servers. Microsoft's traditional segments have also been huge cash cows. More than 400 million Windows 7 licenses were sold at the end of fiscal year 2011. Office 2010 had a great impact, and the company sold nearly 200 million copies since its first launch. Compared to the previous quarter, Microsoft increased its revenue by 5% and achieved $20.89 billion revenue for the quarter ended December 2011. The stock has been an outperformer so far this year, returning 20% since January.
As of the time of writing, shares of Microsoft were trading at $31.52 with a 52-week range of $23.65-$32.95. Currently, it is trading near the higher end of its trading range for the last 12 months. The company has a market cap of $264.48 billion. Its trailing 12-month P/E ratio is 11.42, and its forward P/E ratio is 10.47. P/B, P/S, and P/CF ratios stand at 4.13, 3.67, and 9.4, respectively. Operating margin is 37.58%, and net profit margin is 32.57%. With a low debt/equity ratio of 0.19, the company seems to have a minor debt issue. Microsoft's dividend yield is 2.54%, supported by a pretty payout ratio of 25.77%.
Microsoft has a three-star rating from Morningstar. The average five-year annualized growth forecast estimate is 8.20%. Among Morningstar's analysts, six have it rated as a buy, one has it as an outperform, and two have hold ratings.
What is the fair value of Microsoft given the forecast estimates? We can estimate the fair value using the discounted earnings plus equity model as follows:
Discounted Earnings Plus Equity 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 growth estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of trailing 12-month EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($2.76 + $3.01) / 2 = $2.88
Average five-year growth forecast is 8.20%. Book value per share is $7.65.
The rest is as follows:
Fair Value Estimator
Fair Value Range
(You can download FED+ Fair Value Estimator here.)
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Microsoft stock is between $40 and $47 per share. At a price of $31.52, MSFT is at least 20% undervalued.
Click to enlarge.
Technology stocks are pretty cheap in general, and Microsoft is no exception. It is trading at a substantial discount to the rest of the market. Shares were trading as high as $50 during the peak of the tech bubble. Since then, it has been tagged as "dead money." While it is true that Microsoft shareholders suffered from substantial losses, the company has been a huge profit booster. In fact, Microsoft was able to boost its earnings at an annualized rate of 18% in the last five years.
Microsoft's strategic alliance with Nokia (NOK) has yet to bear any fruits. Recent reports suggest that Windows-based Nokia Lumia phones are already shaking the smartphone sales. According to the majority of Amazon.com (AMZN) customers, the Lumia 900 4G phone feels better than iOS and Android-based smartphones. Apparently customers are very satisfied with their purchases. I am also planning to order mine in the near future.
Based on my FED+ valuation, Microsoft is trading at least 20% below its fair value range. The company has also been involved in several strategic partnerships with major companies. The cooperation of Yahoo (YHOO) search with Bing search and the Microsoft/Facebook partnership are just a couple examples of the company's recent bold moves. The acquisition of Skype and the Microsoft/Nokia alliance are expected to benefit the company in the long term. I rate Microsoft as a good long-term buy. However, considering the recent upward movement, it might be a good idea to wait for a pullback.