Microsoft Corporation (MSFT) which is said to be as one of the best companies in America distinguished themselves as high quality.
MSFT Value Investing Approach
This model is prepared in a very simple and easy way to value a company, it adopts the investment style of the Father of Value Investing Benjamin Graham. The essence is that any investment should be purchased at a discount, meaning the true value should be more than the market value. Graham believed in fundamental analysis and was looking for companies with a sound balance sheet and with little debt. The basis for this valuation is the company’s five years of historical financial records, the balance sheet, income statement, and cash flow statement. We calculated first the enterprise value as our first step. We believed this is important because it measures the total value of the company.
MSFT Discounted Cash Flow (DCF) Model
This model will show us how to calculate the value. I will walk you through every step of the calculation. The table below shows the historical value of Microsoft. With the formula, here’s how:
- Vo is the value of the equity of a business today.
- CF1 to CFn represent the expected cash flows (or benefits) to be derived for periods 1 to n. The discounted cash flow model is based on time periods of time of equal length. Because forecasts are often made on an annual basis in practice, we use the terms “periods” and “years” almost interchangeably for purposes of this theoretical discussion.
- r is the discount rate that converts future dollars of CF into present dollars of value.
The equation above is the basic discounted cash flow (DCF) model.
Discounted Cash Flow Spreadsheet
This model shows the historical equity, net income and the retained earnings per share together with the projected equity, net income, and the retained earnings. Return on investment, growth and the price to earnings were also calculated and can be seen in the table.
The above cash flow spreadsheet was based on the ten-year historical data of income and expense as well as the equity and dividends of Microsoft Corporation. The capitalization rate that used was 15 percent and the return on investment was 38.46 percent, which is the average ROI from the period 2008. The price to earnings that was used was $13, which is the average from the period 2008. The computed present value of MSFT was $64.60 per share for a total amount of $549 million. For the calculated 5th year income, the result was $11.40 per share for a total amount of $96,974 (in million), discounted at present value. On the other hand, the present value of net income was $42 million.
The calculated present value of equity was $9.00 per share at the rate of 26.92 percent, while the future value at year 6 was $29.64 per share which is equal to the present value of $9.00 per share. You could have taken the money today at $29.64 per share instead of waiting six periods to have it. You would have a chance to reinvest the money today, at the same rate and will have a chance to double the amount, In addition, the future value of equity was $1.3 billion.
MSFT Investment in Enterprise Value
The concept of enterprise value is to calculate what it would cost to purchase an entire business.
The market capitalization of MSFT was trending up and down at a rate of 5 percent average. The total debt represents 4 percent of the enterprise value, while the cash and cash equivalent represent 25 percent average of the enterprise value, therefore the enterprise value was lesser of 21 percent of the market capitalization. Purchasing the entire business of Microsoft, the investor will be paying 100 percent of its equity and zero debt because the debt has offset by cash and cash equivalent.
The purchase price of the entire business of Microsoft to date, March 15, 2013, will be $181.5 billion at $21.36 per share. The market price to date was at $28.14 per share.
Net Current Asset Value (NCAV) Method
Net Current Asset Value (NCAV) method is well-known in the value investing community. Studies have all shown that the Net Current Asset Value (NCAV) method of selecting stocks has outperformed the market significantly.
When a stock is trading below the Net Current Asset Value per Share, they are essentially trading below the company’s liquidation value and therefore, the stock was trading at a bargain, and it is worth buying.
The concept of this method is to identify stocks trading at a discount to the company’s Net Current Asset Value per Share, specifically two-thirds or 66 percent of net current asset value.
The net current asset value valuation indicates that the stock price of MSFT was overvalued from the period 2008 to the trailing twelve months of 2013 because the 66 percent ratio represents only 11 percent of the market price. This means that the stock of Microsoft Corporation was trading above the liquidation value of the company.
Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation
Showing the results of MC/NCAV valuation for MSFT, the stock was trading at overvalued prices from 2008 up to the trailing twelve months of 2013 because the result of the ratios exceeded the 1.2 ratios. Further, the 1.2 ratio represents only 16 percent of the average computed ratios.
The Margin of Safety (MOS)
The Margin of Safety requires knowing when the buying price is low in absolute terms, rather than merely relative to the market as a whole. This formula is used to identify the difference between company value and price. The enterprise value was used because it takes into account the balance sheet since it is a much more accurate measure of the company’s true market value than market capitalization.
The margin of safety for MSFT was an 80 percent average at $111 average. The enterprise value was at $22 average which represents 17 percent of the intrinsic value, while on the other hand, the intrinsic value was at $132.33 average.
Let us find out how to calculate the intrinsic value of MSFT. The formula was:
Intrinsic Value = Current Earnings x (9 + 2 x Sustainable Growth Rate)
The explanation in the calculation of intrinsic value was as follows:
EPS or the company’s last 12-month earnings per share; G as the company’s long- term (five years) sustainable growth estimate; 9 is the constant represents the appropriate P-E ratio for a no-growth company as proposed; and 2 for the average yield on high-grade corporate bonds.
Now, that we have learned the formula and the explanation of the calculation, let us now see the results by looking at the table below.
The earnings per share (EPS) and the sustainable growth rate (SGR) factor the calculation of the intrinsic value. The Earnings Per Share was $2 average from 2008, while the annual growth rate was $64 average and calculated through:
Sustainable Growth Rate (SGR)
To calculate the sustainable growth rate for a company, you need to know how profitable the company is as measured by its return on equity (ROE). You also need to know what percentage of a company’s earnings per share is paid out in dividends, which is called the dividend payout ratio. From there, multiply the company’s ROE by its plow back ratio, which is equal to 1 minus the dividend payout ratio.
To simplify, the formula would be: Sustainable growth rate = ROE x (1 – dividend-payout ratio)
Return on Equity (ROE)
Return on Equity (ROE) is an indicator of a company’s profitability by measuring how much profit the company generates with the money invested by common stock owners. In other words, ROE shows how many dollars of earnings result from each dollar of equity.
The return on equity was average 39 percent and the payout ratio was 30 percent average from the period 2008. Sustainable growth rate resulted in 28 percent. The other way of calculating the sustainable growth rate was the average approach, using the average ROE. The table below will show us the difference between the two approaches.
As seen in the table, the average approach produced a higher result because it takes into consideration the previous period’s performance. In addition, the margin of safety in an average approach was 82 percent.
The Intrinsic Value Graph
The graph above shows that the enterprise value line was stable at $21 average and was trending at 10 percent average, while the intrinsic value has an erratic movement of ups and down. As we can see, in the period of 2010 and 2011, the intrinsic value line soared up at 57 and 34 percent, respectively. For the reason, during those periods, the growth went up high which resulted in a higher intrinsic value.
Now, the question is “Where is the margin of safety?” The margin of safety is the space in between the two lines, which is the true value line and the price line. To calculate for the margin of safety, simply get the difference of the intrinsic value and the enterprise value and that is your margin of safety. The average margin of safety was 80 percent.
Price to Earnings/Earning Per Share (P/E*EPS)
This valuation will determine the status of the stock price because stocks may be undervalued or overvalued. One way to do this is by simply multiplying the Price to Earnings (P/E) ratio with the company’s relative Earning per Share (EPS) and comparing it to the enterprise value per share.
The P/E*EPS valuation shows that the price was undervalued because the enterprise value was lesser by 18 percent against the P/E*EPS ratio. The price represents 82 percent of the P/E*EPS ratio.
It tells us that the stock price of Microsoft Corporation was cheap using this valuation. Another way of calculating this valuation is by the use of the average approach. Below is the difference between the two approaches.
The average approach marked a higher result because it takes into consideration past performance.
The Enterprise value (EV)/Earning Per Share (EPS) or (EV/EPS)
The use of this ratio is to separate price and earnings in the enterprise value. By dividing the enterprise value of projected earnings (EPS), the result represents the price (P/E) and the difference represents the earnings (EPS).
The EV/EPS valuation, tells us that the price (P/E) that was 51 percent, while the earnings (EPS) was 49 percent. This might indicate that the stock is trading at an almost fair price.
Enterprise Value (EV)/ Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) or (EV/EBITDA).
This metric is used in estimating business valuation. It compares the value of the company inclusive of debt and other liabilities to the actual cash earnings exclusive of non-cash expenses. This metric is useful for analyzing and comparing profitability between companies and industries. It gives us an idea of how long it would take the earnings of the company to pay off the price of buying the entire business, including debt.
The EV/EBITDA valuation tells us that it will take 7 years to cover the cost of buying the entire business of Microsoft Corporation. In other words, it will take 7 times of the cash earnings of the company to cover the purchase price.
This valuation also shows the profitability of the company. The EBITDA represents only 14 percent of the enterprise value; therefore it will take a long period of waiting to cover the purchase price of the entire company. The gross margin and the net margin of Microsoft were 78 and 27 percent average, respectively.
The present value of MSFT was $64.60 per share for a total amount of $549 million. The calculated present value of equity was $9.00 per share at the rate of 26.92 percent, while the future value at year 6 was $29.64 per share which is equal to the present value of $9.00 per share. You could have taken the money today at $29.64 per share instead of waiting six periods to have it. You would have a chance to reinvest the money today, at the same rate and will have a chance to double the amount. In addition, the future value of equity was $1.3 billion.
Enterprise Value Approach
The total debt was 4 percent while the cash and cash equivalent were 25 percent. Thus the enterprise value was lesser of 21 percent of the market capitalization. Buying the entire business is paying 100 percent of its equity. Meanwhile, the purchase price of the entire business to date, March 15, 2013, was $181.5 billion at $21.36 per share. The market price to date was at $28.14 per share.
Current Asset Value
The net current asset value approach shows that the stock of MSFT was trading at overvalued prices from 2008. The stock price was expensive because it was trading above the liquidation value of the company. The price was overvalued since the results exceeded the 1.2 ratios.
Margin of Safety
The margin of safety shows that there was a margin of safety at an 80 percent average at $111. The enterprise value was at $22 average which represents 17 percent of the intrinsic value. While the intrinsic value was at $132.33 average. The Earnings Per Share was $2 average from the period 2008, while the annual growth rate was $64 average. In addition, the return on equity was average 39 percent and the payout ratio was 30 percent average. The sustainable growth rate was 28 percent.
The Relative Valuation Approach
Furthermore, the relative valuation method shows that the stock was trading at an undervalued price. The enterprise value represents 82 percent of the P/E*EPS ratio. The EV/EPS valuation shows that the price (P/E) was 51 percent and the earnings (EPS) was 49 percent. This might indicate that the stock is trading at a fair value.
EV/EBITDA tells us that it will take 7 years to cover the cost of buying the entire business of MSFT. The gross and net margins were 78 and 27 percent average, respectively.
Overall, the stock of MSFT was trading at fair value, although there was a margin of safety of 80 percent. Therefore, I recommend a BUY in the stock of Microsoft Corporation (MSFT).
Research and Written by Cris