Microsoft: Overvalued By Opinions, Undervalued By Mathematics – Seeking Alpha
Microsoft’s (NASDAQ:MSFT) stock has risen by 130% in the past four years, it is currently trading at an all-time high stock price, and has a P/E of 30. Naturally, people will assume such companies are overvalued, and these opinions are not of the minority as of late. But such assumptions are unjustified when the company’s financials and outlooks are analyzed mathematically.
Before going into any in-depth analysis, it’s important to first perform a conservative DCF analysis on the company to see what it should at least be worth. The following briefly explains the DCF assumptions used in the valuation which will be presented afterward (all historical numbers are trailing 12 months, year 0 = sum of the previous 4 quarters).
When analyzing Microsoft’s revenue, it is important to include any unearned revenue together with the reported revenue to arrive at the actual cash revenue received by the company (for in-depth explanation, see my previous article). For the sake of simplicity and conservatism, we will assume that Microsoft’s adjusted revenue (including unearned revenue) will only grow at the terminal growth rate (see explanation on terminal growth below) of 2.5%.
2) Operating Margin
Integration and restructuring costs are excluded in the analysis of operating expense (which includes both COGS and OPEX) as they are one-time items. For valuation purposes, we will assume the operating margins for the future will be consistent with the past few years.
3) Share-based Compensation
SBC will also be assumed to be consistent with prior years.
4) Capital Expenditure And Depreciation
For analytical purposes, capex is offset by D&A to arrive at net capital expenditures, which represents the additional capital expenditures the company must make beyond maintenance capital expenditures (replacing its depreciated PP&E).
Because Microsoft is investing heavily into its cloud business, we will assume that net capital expenditure margin (net capex/adjusted revenue) will increase to 2% before it slowly declines to 1% in perpetuity (note that this is still high for a mature company and assumes the business to be capital intensive).
5) Tax Rate
Tax rate is gradually adjusted upward from Microsoft’s recent effective tax rate towards the marginal federal corporate income tax rate of 35%. (See Aswath Damodaran’s explanations on forecasting tax rate.)
6) Deferred Tax
Deferred tax is not added back to FCF (in contrast to standard DCF models) as it represents mandatory future cash outflows.
7) Working Capital
Net change in working capital is not added back to FCF as Microsoft consistently generates positive cash flow from working capital, and this source of cash flow is not sustainable and represents necessary future cash outflows. (See Aswath Damodaran’s explanations on forecasting working capital.)
8) Terminal Growth Rate
The terminal growth rate assumes the current 10-year treasury rate (2.5%). (For explanation on why the long-term treasury rate should be used, see Aswath Damodaran’s explanations on terminal value.)
9) Discount Rate
The discount rate is calculated as a 10-year treasury rate plus equity risk premium. The assumed equity risk premium in this model is 4.5%, which is 0.31% higher than the average (geometric) equity risk premium of the past 20 years. (For the reason why a constant discount rate is applied instead of a beta-calculated discount rate, see Warren Buffett’s comments on discount rate and beta.)
10) Other Debt/Equity Components
Net cash (cash/marketable securities – debt) is added to the company’s firm value. The company has no preferred shares or NCI.
Based on this valuation, it can be seen that the implied price is almost identical to the current market price. What this means is that, despite the extremely conservative assumptions used in the valuation (2.5% revenue growth rate and no improvements on operating margins), the stock is still worth more than its current traded value.
The assumptions used are what’s used for highly mature companies with no growth potential or potential for improvements in operating efficiency. These assumptions might have been accurate for Microsoft before Satya Nadella became CEO, but it is 100% incorrect for the current Microsoft.
The following is a snapshot of Microsoft’s products and services growth in the most recent three quarters:
Despite some of Microsoft’s revenue streams slowing or declining, the majority of its business line is growing at a healthy rate, especially those related to the cloud business. Furthermore, the change in the company’s net unearned revenue also shows that growth is accelerating, consistent with the growth seen in products and services.
Also let’s not ignore Microsoft’s potential for improvements on operating efficiency. In the past few years, the company had been focusing on restructuring and investments, which have hurt the company’s margins on a short-term basis. But as the new Microsoft grows and matures, it’s reasonable to assume the company will improve on its operating margins (especially for cloud computing as it’s inherently an economies of scale business). Microsoft’s strong moat (almost monopolistic) in software guarantees that the company will be able to maintain excess returns over the long run.
In my previous article which attempted to value Amazon (NASDAQ:AMZN) Web Services as a standalone business, I explained the potential for the cloud computing business. The same reasoning and assumptions used for AWS can also be used for Azure. Even though Azure is still a distant second in the cloud market, the sheer size of the potential market ensures that there will be sufficient revenue growth potential for Microsoft in the future, which seems to be underemphasized in its valuation.
Now if we take a slightly less pessimistic view of Microsoft’s future and assume that its revenue will grow 3% faster than the terminal growth rate in the next 10 years, and that its operating margins will improve slightly to 33%, this would be its implied value:
There seems to be a highly asymmetrical upside for Microsoft: If the company grows slightly faster and operates a bit more efficiently than currently priced, there is a potential 30% upside – if the company has no excess growth beyond its terminal growth rate and doesn’t improve on its operating margins, its current price is still justified.
Microsoft vs. Amazon
Given that cloud computing will be the big secular growth trend of the future, the question in many investors’ minds would be whether to invest in Microsoft or Amazon. The candid answer would be Microsoft, and it has nothing to do with the actual cloud business of either companies.
When a company’s stock is bought, you are buying all the businesses of that company, not just the segment that’s favorable. If AWS were a standalone company, it could make the case that it’s the best cloud computing stock in the market given its first-mover advantage and tremendous lead in market share.
But its valuable cloud business is tied up with the much less lucrative retail business. Only one example needs to be given to show why it’s the wrong industry to invest in. Wal-Mart’s (NYSE:WMT) recent decision to provide free two-day shipping for orders greater than $35 with no annual fee, and Amazon’s immediately lowering of its free shipping minimum to $35.
The former demonstrated that participants in the retail industry are desperate and are willing to capture market share with no regards for profits, and the latter demonstrated that Amazon must continue to participate in price wars in order to defend its market lead. It’s possible that someday Amazon’s retail business will reach a scale and market dominance that it no longer has to participate in price wars with other retailers, but such a possibility is not guaranteed.
On the contrary, Microsoft’s other business is its perennial cash cow, the software business. Even though its growth potential might be limited, it still commands a monopolistic position in areas such as computer operating systems and office software. And as long as there are no viable replacements (and there isn’t in the foreseeable future), Microsoft’s software business will continue to earn excess profits which can then be used to grow its cloud business or be returned to shareholders.
Because of the different competitive dynamics faced by the two companies, it’s wiser to invest in Microsoft if the goal is to solely benefit from the growth of cloud computing. This article will end with a graph showing the narrowing gap between AWS and Azure.