Microsoft Is Significantly Undervalued

| About: Microsoft Corporation (MSFT)

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.


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

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Operating Margin 41.1% 24.5% 36.6% 37.2% 36.2% 37.2% 34.1% 38.6% 38.8% 29.5%
Net Margin 31.1% 22.2% 30.8% 28.5% 27.5% 29.3% 24.9% 30.0% 33.1% 23.0%
ROA 13.6% 9.5% 15.0% 18.0% 21.2% 26.0% 19.3% 22.9% 23.8% 14.8%
Financial Leverage 1.3 1.2 1.5 1.7 2.0 2.0 2.0 1.9 1.9 1.8
ROE 17.7% 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.

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
14,906 13,517 15,793 12,836 15,532 18,430 15,918 22,096 24,639 29,321

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:

2007-2011 2008-2012 2007-2010 2008-2011 2009-2012 2007-2009 2008-2010 2009-2011 2010-2012 Average
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:

2003-2010 2004-2011 2005-2012 2003-2008 2004-2009 2005-2010 2006-2011 2007-2012 2003-2012 Average
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.


Current 10 Yr Avg
P/E 15.7 30
P/S 3.4 6.3
P/B 3.6 6.2

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.


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.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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