Running the Numbers: A Five-Minute Valuation of Microsoft

Sep.19.08 | About: Microsoft Corporation (MSFT)

In our experience, most private investors don’t complete fundamental financial analysis on prospective investments.  They often recognise this and say they would like to do more – but “it is hard work”.  They are right – but running financial analysis on prospective investments, even at a high-level, is a vital step in making quality decisions.  The professionals don’t pull the trigger without running the numbers.

One of the aims of our Valuecruncher interactive tool is to make it easier for people to complete fundamental valuation analysis using a discounted cash flow valuation methodology.  Here is our quick guide to completing a high-level discounted cash flow valuation analysis in five-minutes.  We have chosen Microsoft (NASDAQ:MSFT) as the example company.

The default Valuecruncher interactive tool is a starting point for the valuation of companies in our database.  Instead of having to build a discounted cash flow model and source the various company projections – Valuecruncher gives you the valuation model and starting inputs.  We start on the MSFT company page.

Valuecruncher MSFT Company Page

To get started – hit the “Create Your Valuation” button.  This takes you to the default Valuecruncher valuation for MSFT.  This default valuation isn’t a recommendation it is a starting point to create your own valuation.

Profitability

The profitability tab covers the company’s anticipated revenues and profitability (at the EBITDA level).  The starting numbers in the default valuation are based on estimates of the company’s prospects moving forward.  To complete a high-level valuation of MSFT we round the revenues to three significant figures – US$67.5 billion in 2009, US$74.5 billion in 2010 and US$79.4 billion in 2011.  We have used a flat EBITDA margin of 40% to 2011.

Key Valuation Assumptions

Discount Rate – reflects the required rate of return on an investment. The discount rate consists of two key components, the time value of money and risk.  The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital [WACC].  The higher the discount rate the more variable (greater risk) the cash flows generated by the company.  For US companies we would expect to see discount rates in the 8-12% range – 8% being stable utility style businesses and 12+% being riskier technology-based companies.  For MSFT we have used a 10% discount rate.

Terminal Growth Rate – is an approximation of the growth rate beyond the next three years into perpetuity (i.e. forever) of the company’s cash flows. The company’s growth rate will fluctuate with economic and industry cycles with the terminal growth rate representing an average growth rate.  The long-run expectation for economy wide growth is approximately 2-3% (nominal).  We have a blog post with a table showing how to estimate terminal growth.  But the place to start is 2-3% + a factor for near term growth.  We have completed a valuation for Google (NASDAQ:GOOG) that used a 6.5% terminal growth estimate – that is pretty high.  You would expect to typically see terminal growth in a 2-4% range.  For MSFT we have used 3%.

Tax – The tax rate entered is used to calculate the tax payable for the first three years. Beyond that the marginal tax rate of the country of domicile is used.  For MSFT we have used 35%.

Capital Expenditure / Depreciation

How much does the company have to spend to generate the revenues and profits for the business?  Capital expenditure is a cost that is not included in the revenue or EBITDA margin assumptions.  This covers: the acquisition or disposal of operating assets, research and development costs not included in the EBITDA margin and changes in net working capital.  The terminal capital expenditure represents an estimate of the ongoing investment required to facilitate the forecast long term growth. The terminal capital expenditure value should be viewed as a simplified estimate of a more complex series of expenses.  For MSFT we have assumed capital expenditure of US$3.25 billion in 2009, US$3.75 billion in 2010 and 2011 then terminal capital expenditure of US$4.0 billion.  We have assumed depreciation of US$2.75 billion in 2009, US$3.0 billion in 2010 and US$3.25 billion in 2011.

That is it – 16 variables with default numbers provided.  Other inputs from the balance sheet that form part of a net debt calculation (long-term borrowings and cash) are calculated automatically by Valuecruncher based on the latest balance sheet numbers.

This gives us a valuation for MSFT of US$30.86 – 25.6% above the current share price of US$24.57.  Based on this high-level analysis MSFT looks cheap.

Valuecruncher valuation model of MSFT with interactive assumptions

Stock position: None.