Borrowing the concept of "new rules" from Bill Maher, I am trying to rechannel the success I had when my rule was to "buy Wal-Mart (NYSE:WMT) under $50." It is now up roughly 50% from that level, and, although I would still love to buy it under $50 and would immediately jump in and do so if possible, it looks like Mr. Market is not going to give me that opportunity. Microsoft (NASDAQ:MSFT) is probably one of the most undervalued large cap stocks left and is a ridiculous bargain at Friday's closing price of $29.85.
Readers may not agree with all of my metrics or with the way that I apply them, but MSFT's value is so compelling that even significant adjustments to the numbers I am going to present would suggest that it is a buy at this level. My methodology tries to replicate the private market value of a stock by developing numbers which could be used by a buyer of the entire company. Readers may protest that MSFT is too big to be bought out by any imaginable purchaser, but I will address this issue a few paragraphs below.
I try to calculate private market value by first calculating net cash (balance sheet cash and investments minus debt). I then determine what price an investor is paying for the actual operating business itself (the Enterprise Price). I then calculate the net after tax interest income (after tax interest income minus after tax interest expense) and subtract it from total income to get the income generated by the business itself (Enterprise Earnings). My next step is to compare the total of depreciation and amortization with the total capital expenditures in the past few years and add the amount by which the first exceeds the second to earnings to get a sense of cash flow available to owners (Enterprise Cash Flow). The ratio between the Enterprise Price and Enterprise Cash Flow gives me a sense of what I am really paying for the business.
In the case of MSFT, I calculate total balance sheet cash and investments at $73 billion and debt at $12 billion for a total net cash balance of $61 billion or $7.20 per 8.5 billion fully diluted shares.(this share count is probably high because it is based on fiscal year 2012 average diluted shares) Thus, the Enterprise Price is $22.65. I will use estimated calendar year 2012 earnings of $2.90. After tax interest expense is close enough to after tax income to come very close to zeroing out(a consequence of low interest rates). In the past several years, depreciation and amortization have been running roughly $500 million per year higher than capex, so I will add 59 cents to earnings to calculate cash flow available to owners at $3.49 a share. MSFT's Enterprise Price of $22.65 is 6.4 times Enterprise Cash Flow. This is a ridiculously low valuation for a company that has steady growth, is becoming less and less dependent upon Windows, and is in an industry with enormous growth potential because of low product saturation levels in Asia and Latin America.
Of course, no investor can actually come along and buy MSFT and capture that stream of cash flow just because he thinks it is cheap at this price. On the other hand, one investor is doing just that; the name of the investor is... Microsoft . MSFT has been steadily buying back stock at a healthy pace. The buybacks slowed down in fiscal 2012 - probably because of a large acquisition - but they had been rolling along at the clip of about $11 billion a year in previous years. MSFT reduces its dividend expense and automatically increases earnings per share through the buy backs at these price levels and they are likely to accelerate in 2013. Share count has been steadily declining year over year.
You can quibble with some of my numbers (maybe the cash should be discounted by repatriation costs, maybe the current year earnings estimate is too high) but that is true of any valuation exercise. The advantage here is that an investor has a HUGE MARGIN OF ERROR - you can afford to be significantly wrong about some of these things and still be right about the market call. MSFT should very conservatively be trading at an EPEE of 10 times cash slow which would produce a price of $34.39 plus 7.20 for the cash or a total of $41.59. It may take a while for MSFT to trade up to this level but the good news is that an investor gets get paid a dividend of more than 3% while you are waiting.