Microsoft Corporation develops, licenses, and supports software products and services; and designs and sells hardware worldwide. The companys Windows & Windows Live division offers PC operating system that primarily includes Windows 7 operating system, Windows live suite of applications and Web services, and PC hardware products. Its Server and Tools division provides Windows Server operating systems, Windows Azure; Microsoft SQL Server, SQL Azure, Windows Intune, Windows Embedded, Visual Studio, Silverlight, system center products, Microsoft consulting services, and Premier product support services. This division also offers cloud-based services; and training and certification to developers and information technology professionals, as well as builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. The companys Online Services division provides online information and content, including Bing, MSN, adCenter, and Atlas online tools for advertisers. Its Microsoft Business division offers Microsoft office, Microsoft Exchange, Microsoft SharePoint, Microsoft Lync, Microsoft Office project and office Visio, and Microsoft Dynamics ERP and CRM, as well as Microsoft Office Web Apps and Microsoft Office 365, which are online service offerings. The companys Entertainment and Devices Division segment provides Xbox 360 entertainment platform, which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, and Xbox 360 accessories; Xbox LIVE; Skype; and Windows Phone. Microsoft Corporation markets and distributes its products and services primarily through original equipment manufacturers, distributors, and resellers, as well as through online. The company has strategic alliances with Nokia, and NIIT Ltd., as well as a strategic relationship Dominion Enterprises, Inc.
Analysts expect Microsoft to grow earnings 8.38% per year for the next five years and I've assumed they can continue to grow at 3.50% per year thereafter. Running these numbers through a two stage DCF analysis with a 10% discount rate yields a fair value price of $54.10. This means that at $27.26 the shares are undervalued by 48.7%.
Over the last 12 months, Microsoft's EPS were $1.82 and it's latest book value per share was $8.67. The Graham Number is calculated to be $18.84, which means it is currently overvalued by 47.3%.
Average High Dividend Yield:
Microsoft's average high dividend yield for the past 5 years is 2.97% and for the past 10 years is 2.17%. This gives target prices of $30.99 and $42.39 respectively based on the current annual dividend of $0.92. MSFT is undervalued by 10.4% and 34.5%, respectively. The 10 year average is a little skewed due to Microsoft initiating the dividend in 2003, so the yield was very small. I'll use the 5 year average in my fair value calculation. Microsoft is currently trading at a 10.4% discount to the valuation based on the historical 5 year high dividend yield.
MSFT's average low PE ratio for the past 5 years is 9.12 and for the past 10 years is 14.85. This corresponds to a price per share of $25.99 and $42.32 respectively based off the analyst estimate of $2.85 per share for fiscal year 2013 ending in June. The 5 year and 10 year low PE price targets are overvalued by 6.8% and undervalued by 34.4%, respectively. The 10 year average is a little elevated due to the high PE ratios that Microsoft traded for during the early part of the 2000's. I'll use the 5 year PE to be conservative.
Average Low P/S Ratio:
Microsoft's average low PS ratio for the past 5 years is 2.75 and for the past 10 years is 4.07. This corresponds to a price per share of $26.15 and $38.70 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013. Their current PS ratio is 3.16 over the last 12 months. For the sake of being conservative I'll use the 5 year average. MSFT is currently trading at a 6.2% premium.
Dividend Discount Model:
For the DDM, I assumed that Microsoft will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5 or 10 year growth rates. In this case that would be 15%. After that I assumed they can continue to raise dividends for 3 years at 75% of 15% or 11.25% and in perpetuity at 3.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on this, MSFT is worth $28.88 meaning it's undervalued by 3.9%.
Microsoft's trailing PE is 15.25 and it's forward PE is 8.81. The PE3 based on the average earnings for the last 3 years is 12.27. I like to see the PE3 be less than 15 which MSFT is well under. Compared to it's industry, MSFT seems to be overvalued versus AAPL (10.22) and undervalued versus GOOG (24.82) and ORCL (16.34). Against the industry as a whole, MSFT is undervalued with the industry carrying a PE of 22.64. All industry comparisons are on a TTM EPS basis. Microsoft's PEG for the next 5 years is currently at 1.16 while AAPL is at 0.53, GOOG is at 1.27, ORCL is at 1.08, and the industry is at 0.97. A low PEG ratio is better because it means that you're paying less for the growth of the company.
MSFT's gross margin's for FY 2011 and FY 2012 were 81.7% and 80.2% respectively. They have averaged a 84.8% gross profit margin since 2001 with a low of 80.2% in FY 2012. Their net income margin for the same years were 33.1% and 23.0%. Since 2001 their net income margin has averaged 28.2% with a low of 23.0% in FY 2012. FY 2012 saw a big write-off that negatively effected earnings and net income stifling their results for the year. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. Microsoft is killing it on both these fronts so there's nothing to worry about from their margins. Of course each industry is different and allows for different margins, so let's see how MSFT has done when compared to their industry. For FY 2012, MSFT captured 106.6% of the gross margin for the industry and 117.9% of the net income margin. They're able to turn much more of their revenue into profit compared to their competitors which is great to see.
MSFT's shares outstanding have been in an overall downtrend with an average decrease of 2.43% per year since 2001. Over that time they've bought back 23.7% of their shares outstanding. By repurchasing shares, MSFT is able to increase EPS and management can return cash to shareholders this way by increasing the ownership stake of the company for all the outstanding shares. However, if the shares are being bought at overvalued prices this is detrimental to the shareholders,
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
Microsoft is a dividend contender with 10 consecutive years of dividend increases. Their current annual dividend sits at $0.92 for a current yield of 3.31%. MSFT's annual increases for the last 1, 3, 5 and 10 years has been 21.05%, 20.95%, 16.43% and 27.66%. These numbers are different from the actual quarterly increases since they are based off the dividends paid out during each fiscal year. Their payout ratio has averaged 25.4% since initiating their dividend in 2003. This is great news for investors since this gives the company more room to increase the dividend in the future without taxing the operations of the company.
Microsoft's free cash flow per share has been great since FY 2008 with dividends only taking up an average of 22.94% of the available FCF. This is great news for potential investors because it will allow the Board to continue to increase dividends while building up it's cash reserves for another potential buyout or to get them through another tough stretch for the economy.
MSFT's cash flow and free cash flow have been great since 2008. They started taking on debt in FY 2009 but it's not a taxing amount at all since cash on hand can payoff almost 65% of their debt as of the end of FY 2012.
Return on Equity and Return on Capital Invested:
MSFT's ROE has averaged 30.2% since 2001 with a low of 10.9% and a high of 48.7%. Their ROCI has averaged 28.6% since 2001 with a low of 10.9% and a high of 48.7%. From 2001 through 2008, MSFT carried no debt and so their ROE was equal to their ROCI. For both ROE and ROCI I don't necessarily look for any absolute values, rather I like to see stable or increasing levels over the long term.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how MSFT has done on that front. Their revenue growth since 2001 has been solid at 11.3% per year and their net income has been growing at a 7.4% rate. Since their net income has been growing slower than revenue, their net income margin has decreased from 30.5% to 23.0% between FY 2001 and FY 2012. I'm not too concerned about the net income margin dropping in the last fiscal year due to the write-off for a botched acquisition that negatively effected their performance for the year. Revenue has increased every year except for FY 2009. MSFT's fiscal year also caught the brunt of the recession since it goes from July 1 to June 30.
The average of all the valuation models gives a target entry price of $30.82 which means that Microsoft is currently trading at a 9.9% discount to the average.. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and Graham Number valuations are removed and the new average is $28.00. Microsoft is trading at a 0.9% discount to this price as well.
Assuming that Microsoft can grow their earnings and dividends at the rates that I assumed you're looking at solid returns for the next 10 years. In 2023 EPS would be $5.16 and slapping an average PE of 11.98 gives a price of $61.86. Over the next 10 years you'd also receive $20.02 in dividends for a total return of 294.96% which is good for a 11.42% annualized rate. If you purchase at the fair value price of $30.82 your projected 10 year total return is 265.68% for an annualized return of 10.26%.
Overall, I would say that Microsoft is currently undervalued. It's at a solid price to initiate a position and look to average down. With Microsoft you're getting a very solid company that has plenty of free cash flow to continue increasing their dividend. They could be set for elevated growth if the economy can finally start to expand at a normal rate since it would lead to companies needing to spend more on their IT specifically Microsoft's software since the Office suite is pretty much standard operating procedure for business. Microsoft recently rolled out the Surface Tablet and Windows 8 which could be big drivers of growth. I'll be looking at possibly selling a put option to see what combination of premiums and cost basis would be available.
What do you think about Microsoft as a DG investment at today's prices?