Microsoft: Undervalued With Strong Growth Potential

| About: Microsoft Corporation (MSFT)

I utilize a core investment strategy which focuses on finding undervalued equity with aggressive growth potential. I especially like Microsoft (NASDAQ:MSFT) because it currently fits my core investment strategy from nearly any valuation method. In my analysis of Microsoft, here are the reasons why it's a cheap investment with strong growth potential.

From a valuation approach, Microsoft is currently trading at a multiple of only 11.18, nearly half of the industry's multiple of about 21. Its forward valuation, which I believe understates the importance of Microsoft's Windows 8 release, also points to strong equity performance, with a multiple of just 10.03. Trailing and forward P/E multiples are paramount in value-investing and, when combined with strong future growth, help to create sound investment decisions.

Microsoft has become a leader in creating a highly diversified portfolio of products and services. It doesn't just provide and specialize on one product, which creates a dangerous risk unique to them, but instead, its large array of products and services help create long-term, less risky growth. I believe in a quantitative approach in investing which emphasizes on a corporation's fundamentals and future profitability and have utilized it in my analysis of Microsoft.


Analyzing a company's profitability comes from a two-fold approach: First, in reviewing its historical success in generating profits and second, in its ability to generate future profits. Profit doesn't only come from increasing revenue, but also from mitigating expenses associated to those revenues, which are representative of a strong business plan. By all means, Microsoft is a very well managed corporation which has done well in increasing revenues while maintaining a controlled cost structure.

Microsoft is a leader the industry on margins, which signify strong cost structures that protect its profits in times of economic slowdowns. Its gross margin is at an impressive 76.62% and its profit margin also at a very impressive 31.96%. To note, the difference between gross and profit margin signifies the expenses a corporation incurs not associated to sales; essentially, these are fixed expenses which can create a dangerous risk to profit if revenue growth reversed. However, Microsoft's 44.96% "fixed" expenses are far less than the industry's 56.73%; which, when combined with its steep profit margin of 31.96%, positions Microsoft to remain profitable even through most economic conditions.

Three other metrics which I find incredibly important in analyzing Microsoft's current and future profitability are its ability to generate profits, measured through ROE, ROA and ROI. In all three metrics, Microsoft is also a leader; with a 38.23% Return-on-Equity, 21.44% Return-on-Assets and 27.87% Return-on-Investments. These figures represent both the past and paint a picture for the future. Microsoft is very profitable in its investments which help me, as an investor, build confidence in them as an investment. These metrics help us analyze where Microsoft will be 3, 5 and 10 years from now.

However, one key piece of information is still missing: Microsoft's investment activity. What's the point in these metrics if Microsoft stops investing, which would result in it eventually be overrun by competitors. This is why I analyzed Microsoft's statement of cash flows and, to my astonishment, investment activities have increased a vast 63.5% in the nine months preceding March 31, 2012, an increase of $6.5 billion compared to the prior year. This substantial increase comes, in part, through its acquisition of Skype, but also as its been preparing for its massive Windows 8 roll out this coming fall.

Lastly, I want to go over Microsoft's revenue, income and equity growth in the last two quarters. In the nine months prior to March 31, 2012, Microsoft experienced 5.9% revenue growth, 1.1% earnings growth, and 9.46% stock equity growth while paying a constant 3% dividend. Much of the reason in Microsoft's mere 1.1% income growth comes from reduced income from none-core components of Microsoft.

Liquidity Risk

Liquidity metrics are measures of how risky debt is to particular companies. On face value, Microsoft's liquidity metrics are beyond outstanding, with a quick ratio of 2.88, current ratio of 2.94, and debt/equity ratio of only 0.17, but these measures are understating Microsoft's true liquidity.

In an analysis of Microsoft's liability account of $49.35 billion, I came across two very interesting accounts which are technically considered a liability, and lumped with debt, but are actually revenue accounts. These are called Microsoft's unearned revenue, which are essentially pre-paid services to Microsoft that have not been used yet. To illustrate how this works, imagine buying a $100 gift card from Best Buy. From Best Buy's perspective, you've given them $100 which will be used to generate future revenue, but hasn't been used for that purpose yet. As a result, they classify this $100 transaction as an unearned revenue account which, from Best Buy's perspective, is a liability. The same applies to Microsoft and has summed to $15.2 billion in unearned revenue, technically classified as a liability.

From both a quantitative and qualitative analysis, Microsoft is positioned for strong growth. Fundamentally, it's leading the industry in its ability to generate profits while maintaining a balanced debt structure. Its current diversified multi-market business strategy makes Microsoft a safer investment, yielding a Beta of only 1.00, but with strong market growth potential. Windows 8 will be crucial in Microsoft's deep and simultaneous market penetration of the mobile, tablet and e-reader markets which have been very lucrative for current market shareholders.

Some investors consider Microsoft a "boring" stock that just pays dividends, but I say that no stock is boring. To classify any stock like that means that you're close minded to potential strong investments and may miss the boat when the "boring" stocks grow tremendously. Historically, Microsoft trades at three-year trailing multiple of 11.98 which, through a historical viewpoint, positions the stock for a 10-20% future growth year, while paying a 2.62% dividend, yielding a total gain of 12.62-22.62%. Everything is currently going right for Microsoft's Windows 8 roll-out on the supply side. Mobile carriers are strongly pushing Microsoft's products and hardware companies, like Dell (NASDAQ:DELL) and Hewlett Packard (NYSE:HPQ), have been quick to adopt the Windows 8 platform for their tablets. Now, all that's left is the consumer-sided demand, which can either spell out huge profits or reap huge losses. Windows 8 provides a very welcomed seamless integration of tablets, computers and phones, which will provide a strong ecosystem while promoting customer loyalty.

I, for one, believe Windows 8 will be adopted on the consumer side and have invested for the long run. At the very least, I'll be enjoying the 2.62% dividend yielding stock which has already grown by 19.19% YTD. I believe that a strong buy-in point may come in the future when settlement talks regarding royalties between Motorola and Microsoft gain headwind, creating volatility in the stock.

Disclosure: I am long MSFT, AAPL, LNG, CHK, AIG.