The first things that strikes us when researching Microsoft (NASDAQ:MSFT) is how stable the business is. For example, it has very low balance sheet risk, with Microsoft's debt to equity ratio being just 26%. This means that interest rate risk also is kept to an absolute minimum, which should mean that the bottom line is not hit hard by interest rate rises over the medium term.
Despite having a low level of financial gearing, Microsoft was able to deliver strong levels of profitability last year. Its return on equity was a very impressive 26.2%, while its return on assets of 11.1% shows that it is utilizing its large asset base very efficiently. With operating margins of 32.1%, Microsoft is clearly a highly profitable business that does not need to expose itself to unnecessary balance sheet risk.
Due to its high levels of profitability, we think that Microsoft could afford to be a whole lot more generous when it comes to dividend payouts. Indeed, its payout ratio stands at just 38%. Of course, we appreciate that Microsoft is keen to reinvest in the business so as to keep the bottom line moving upward, but it is now a relatively mature company and, we feel, could afford to pay out north of 50% of profits as a dividend.
Still, the current payout ratio is not all bad and equates to a forward yield of 2.7%. Although this is 10% below the key 3% level, income seeking investors should still be attracted to Microsoft due to its potential to offer a higher yield over the medium to long term.
Clearly, higher dividend payments would be aided by higher earnings numbers. That's why we're impressed with Microsoft's forecast earnings growth rate for next year. The company is set to increase earnings by 17.2%, which is well ahead of the wider index and shows that, while relatively mature, Microsoft can still compete when it comes to growth numbers.
Indeed, in terms of products and potential future developments that we think could make a positive contribution to Microsoft's bottom line, there are a couple that we're particularly excited about. For example, Bing is forecast to break even by 2016, which would plug a $1 billion per annum hole in the company's accounts, as it has had to invest substantial sums in the search engine business. Bing's market share has grown at an impressive rate in recent years and although Google (NASDAQ:GOOG) (NASDAQ:GOOGL) still dominates the market, Microsoft's share now stands at around 20%. However, when Bing's partnership with Yahoo (YHOO) is taken into account, that number looks more like 30% and shows that Google's position as the lead search engine may not be quite as dominant as it is perceived to be. Therefore, we think that Bing could begin to make a positive contribution to Microsoft's bottom line over the medium term.
In addition, we're impressed with Microsoft's ability to evolve products while keeping core customers happy. We think this could be a key space for the company in future years and a recent example of Microsoft doing this successfully was the launch of Office 365. It has proven to be relatively popular with core customers and has the potential to keep Microsoft's product offering both relevant (in terms of evolution) and familiar to customers. This theme could prove to be a key driver of Microsoft's future earnings as it looks to provide a balance between new offerings and more traditional, well known values.
Despite being highly profitable, having strong growth potential and a decent yield, Microsoft appears to be undervalued. For instance, its forward P/E ratio is just 13.4, versus 16.2 for the S&P 500, while its price to book ratio of 4 also seems low. Furthermore, an EV/EBITDA ratio of 9.1 could also indicate that there is potential upside and so we feel that Microsoft could see its shares go higher as a result of what we feel is a mispricing.
Microsoft offers investors the chance to own a stake in a highly profitable company that has low balance sheet risk. It also has the potential to offer an even higher yield than the current forward yield of 2.7%, via a higher payout ratio, while its growth prospects appear to be highly attractive, with EPS forecast to increase by 17.2% next year.
Despite this, Microsoft appears to be undervalued right now. Indeed, its forward P/E of 13.4 is well behind that of the S&P 500, which has a forward P/E of 16.2. In addition, a price to book ratio of 4 and an EV/EBITDA ratio of 9.1 in our view further highlight the good value on offer at Microsoft. As a result, we're bullish on Microsoft and feel that shares in the company could move higher as the market moves to correct the mispricing.
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