Microsoft: Price Matters

Summary

• Microsoft's WACC is currently about 7% due to a decrease in bond yields.
• However, the DCF valuation does not point to the current undervaluation of the company.
• MSFT becomes even more overvalued even if its price does not change.

The strongest argument that justifies Microsoft's (NASDAQ:MSFT) current price is a decrease in bond yields observed this year. This means a reduction in the discount rate and an increase in the present value of the company's future cash flow. Well, this statement is not difficult to verify by building a DCF model.

Unlike other tech giants, Microsoft's revenue sources are highly differentiated by industry. So, building a separate forecast for each segment is an almost impossible task:

In such circumstances, to forecast MSFT's revenue for the next decade, I used a polynomial model that most closely matches the current average estimates of analysts. I believe that such approach is the least subjective.

Source: Seeking Alpha

Thus, I assume that the CAGR of Microsoft's revenue in the next 10 years will amount to 11.4%. I repeat again, my forecast is based on analysts' estimates, and not on my subjective point of view. And by the way, judging from the history, this forecast cannot be called pessimistic.

Here is the calculation of the weighted average cost of capital (WACC):

Some explanations:

• In order to calculate the market rate of return, I used values of equity risk premium (6.01%) and the current yield of UST10 as a risk-free rate (0.78%). The final indicator amounted to 6.79%.
• I used the current value of the three-year beta coefficient.
• To calculate the Cost of Debt, I used the interest expense for 2018 and 2019 divided by the debt value for the same years.

When building the model, I used the following key assumptions:

• Operating margin for Microsoft for the next 10 years will gradually decline from 34% to 31% in a terminal year. In my opinion, this is an optimistic scenario for the IT industry where competition tends to increase.
• The relative size of CAPEX will decrease from the current abnormal level (11.1%) to a more adequate 9%.
• The average tax rate will amount to 25%.

And, here's the model itself:

The DCF-based target price for Microsoft's shares is $127, offering 31% downwards.

Bottom line

I want to pay attention to three points:

(1) Of course it's just a model. But this model assumes the dynamic development of Microsoft over the next decade. In addition, it takes into account the relatively low discount rate. But at the same time, the model indicates that the company is overvalued...

(2) Judging by the dynamics of the last three months, bond yields are not prone to further decline:

This means a tendency to reduce the present value of the company's future cash flows. In other words, the company becomes even more overvalued even if its price does not change.

(3) I want to remind that I'm a big fan of Microsoft. And as you can see, I do not expect the company to stop growing. This means that the rational price of its shares will necessarily reach the level of $180 and exceed it. Maybe in a year or two. But now, Microsoft's rational stock price is below the current level.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.