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I'm not writing this article to argue whether the PC is dead or not. I'm writing this article to argue why you should consider investing in Microsoft (NASDAQ:MSFT). Microsoft has consistently been able to adapt to consumers' needs, as well as revolutionize products. No matter how they decide to move forward, I am confident that the company will continue to produce healthy returns and margins. Since the beginning of the year, the company has been trading in the $28-$32 range. I think that the stock is due for a breakout, and that there is a great opportunity here.

Profitability

The table below shows how profitable Microsoft has been during the past ten years.

2003200420052006200720082009201020112012
Operating Margin41.1%24.5%36.6%37.2%36.2%37.2%34.1%38.6%38.8%29.5%
Net Margin31.1%22.2%30.8%28.5%27.5%29.3%24.9%30.0%33.1%23.0%
ROA13.6%9.5%15.0%18.0%21.2%26.0%19.3%22.9%23.8%14.8%
Financial Leverage1.31.21.51.72.02.02.01.91.91.8
ROE17.7%12.0%19.9%28.6%39.5%52.5%38.4%43.8%44.8%27.5%

When you shift focus to EPS growth, Microsoft has seen healthy growth. Earnings per share have increased on average of 12.4% over the past five years. When looking forward to the next five years, analysts have a projected growth rate of 10.3%. This shows a promising future for the company. Even though the growth rate is predicted to decline by a small margin, which is to be expected as a company progresses, it shows that analysts are still confident in the ability of Microsoft to generate revenue moving forward.

Intrinsic Value

When valuing Microsoft, I used a discounted free-cash-flow model. The table below has the FCF in millions from the past ten years.

2003200420052006200720082009201020112012
14,90613,51715,79312,83615,53218,43015,91822,09624,63929,321

The following two tables show the average growth rate that Microsoft has seen over the past ten years. Since just taking the average from 2002 to 2011 could be a bit misleading, I used five and ten year multi-year growth performances. I've found that this gives a more accurate growth rate.

5 Year Multi-Year Growth:

2007-20112008-20122007-20102008-20112009-20122007-20092008-20102009-20112010-2012Average
11.73%11.82%10.57%8.42%21.05%0.83%6.63%18.26%10.90%11.13%

10 Year Multi-Year Growth:

2003-20102004-20112005-20122003-20082004-20092005-20102006-20112007-20122003-2012Average
6.03%10.29%10.71%3.94%2.96%6.65%15.33%29.59%9.67%10.57%

The average of the two tables gives an average growth rate of 10.85%, a pretty solid number from a cash cow like Microsoft. For a conservative valuation, I cut the average growth rate in half, making it 5.43%.

For the discount rate, I used the CAPM. With an expected rate of 10.5%, risk free rate of 1.68%, and a beta of 1.17, the discount rate came out to be 12.0%. I use an expected rate of 10.5% in order to get a fairly conservative discount rate.

The intrinsic value for Microsoft based off the calculations above is $43.97. With Microsoft closing at 29.07 at the writing of this article, it is obvious that there is significant upside. When including a margin of safety of 25%-50%, we have a target buy window between $21.98 and $32.98. Since the current price falls within this window, I'll turn to price multiple valuations to either confirm or deny the buy.

Valuation

Current10 Yr Avg
P/E15.730
P/S3.46.3
P/B3.66.2

When the current multiples of Microsoft are compared to the ten year averages of the company, it confirms that the company could be perceived as undervalued.

Conclusion

Many investors have been hesitant to invest in Microsoft just because they have always viewed the company as overvalued. However, I believe that based on the above research, Microsoft is now undervalued. It seems that Microsoft is selling at a significant discount when compared to its intrinsic value of $43.97. With ten years of healthy growth and profitable numbers and a promising future, I recommend a buy for Microsoft.

Source: Microsoft Is Significantly Undervalued