More Upside Ahead For Microsoft Based On A DCF Analysis

| About: Microsoft Corporation (MSFT)
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Microsoft has been known as a good company that generates strong levels of free cash flow.

However, shares are currently more expensive based on several metrics than they have been in many years.

My DCF sensitivity analysis examines Microsoft to determine whether the shares are currently still undervalued based on forecasting free cash flows.

It is difficult to find a stock that has doubled over the last 5 years that can be considered inexpensive. And, by most traditional metrics, Microsoft (NASDAQ:MSFT) shares are not exactly cheap right now (30x trailing earnings, 20x forward earnings and nearly 17x EV/EBITDA as per Yahoo Finance). However, Microsoft has long been known as a company that generates significant free cash flow, so I decided it would be a good candidate for my DCF sensitivity analysis.

Note: I invite you to read my original article that outlines the DCF sensitivity analysis methodology. The basic idea is that since the results of a DCF analysis can be heavily skewed by making minor changes to the terminal growth rate or WACC (weighted average cost of capital), I have used a range of long-term growth rates and discount (WACC) rates in my analysis below. By using one's own estimate of long-term growth and an appropriate WACC (discount) rate, each individual investor can come up with their own target price for the security in question.

For Microsoft, we can look back at the following data from the past five years:

This allows us to find the average Operating Cash Flow / Revenue (37.44%) and average Capital Expenditures / Revenue (6.21%). Capital expenditures increased meaningfully in 2016, but it is too early to determine whether this will be a new trend or was just a one-year blip. Note that although revenue declined in 2016 (in part due to a $6.6 revenue deferral related to Windows 10), analysts expect the company to post its highest ever annual revenue during the current calendar year.

Using the analyst consensus revenue forecasts for 2017 and 2018 (source: Yahoo Finance) leads to the following pro-forma free cash flow (FCF) projection. For my base case scenario, I have used a long-term growth rate of 2.5%, which I believe to be fairly conservative. The model calls for revenue growth to decline in a linear fashion from 2018 until it reaches 2.5% in 2022.

These free cash flows (along with a terminal free cash flow estimate) are then discounted back to the present time using the WACC. Microsoft is one of two companies to have a AAA credit rating with S&P, so its cost of debt is about as low as it gets (approximately 3% after tax). Assuming a 10% cost of equity, the firm's overall WACC is approximately 9%, which is what has been used in the below analysis. One could certainly argue that a lower discount rate is appropriate - the table at the end of the article shows the results based on a WACC of 7-10%.

Using these variables in the model generate a target price of over $77 per share, which represents nearly 20% upside based on the current share price:

Below, I have summarized the results of 35 different simulations of the model using a range of long-term growth estimates and discount rates. The target prices range from $58.36 to $118.52 - the cell highlighted in red is more than 10% below the current share price, while those highlighted in green are more than 10% above the current share price:

Readers are encouraged to use the comment section below to explain what growth and discount rates they deem to be appropriate.

Microsoft provides an interesting case study into why a DCF sensitivity analysis can be so valuable. I have used this process when analyzing more than two dozen companies so far, and Microsoft has easily the fewest red cells out of any of them. That means that one needs to use fairly pessimistic inputs to get a share price that is meaningfully lower than the $65 Microsoft is currently trading at. Microsoft combines strong cash margins and relatively modest capital expenditures to generate large amounts of free cash flow. Combine that with positive expected future growth and over $33 billion in net cash on the balance sheet and the result is a company that looks favorable from a DCF model perspective.

Disclosure: I/we 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.