Microsoft - A Fundamental and Historical Valuation

☁️💻 Business Overview

Total: 12/17

• +2 ✅✅ Projected Operating Margin: 50.69%
• +1 ✅ Projected 5-Year Revenue CAGR: 14.64%
• +2 ✅✅ Last 5-Year ROIC: 28.78%
• +1 ✅ Estimated Cost of Capital: 10.35% (lower than ROIC)
• +1 ✅ Last 5-Year Shares Outstanding CAGR: -0.50%
• +1 ✅ Projected 5-Year EPS CAGR: 18.36%
• +0 ⚠️ Projected 5-Year Dividend CAGR: 6.32%
• +2 ✅✅ Estimated Debt Rating: Aaa
• +2 ✅✅ Morningstar Moat: Wide
• +0 ⚠️ Morningstar Uncertainty: Medium

Microsoft show its competitive advantages and pricing power through its stellar margins and higher revenue and EPS growth. This is reflected in its Morningstar Wide Moat rating. Also the fact that its ROIC 5 year average is almost triple its estimated cost of capital shows that management can earn higher returns on its capital allocation.

Below, during the next sections, we'll value Microsoft and try to estimate its fair value while comparing it to today's price.

📈Business Valuation

To calculate the intrinsic value of the company I'll use multiple methods:

• Discounted Cash Flows (DCF) - Intrinsic value is estimated by projecting its free cash flows over the next 10 years and discounting them to present value using the estimated cost of capital;
• EPS Growth - the fair value is estimated by projected the Earnings Per Share CAGR for the next 5 Years and then, given its current and historic values of PE, come up with a PE for the 5th Year. This will give us its price 5 Years from now using the formula: Price = EPS x PE that we then discount using the estimated cost of capital;
• Historical P/E - we assume mean reversion to the historical P/E values;
• Historical EV/EBITDA - we assume mean reversion to the historical EV/EBITDA values;
• Historical P/CF - we assume mean reversion to the historical P/CF values;
• Historical P/S - we assume mean reversion to the historical P/S values;
• Historical P/B - we assume mean reversion to the historical P/B values.

Cost of Capital

I've used the latest annual and Q2 financial statements of the company, the 10-Year US bonds as the risk free rate and revenue geographic exposure to come up with its cost of capital, cost of debt and cost of equity. Also, given the fact that Moody's provided a rating for the company I used it as the debt rating.

Cost of Capital: 10.35%.

This value will be used later as a discount rate in the valuation methods.

Please feel free to come up with your own values by using the tool I've used: Cost of Capital - The Fair Value Journal. It is and will ever be completely free :)

Discounted Cash Flows (Weight: 40%)

I've used the latest annual and Q2 financial statements of the company, the analyst estimates for both revenue and margins and the cost of capital calculated previously.

Some notes on the inputs above:

• Terminal Revenue Growth - I'm using the risk-free rate (10-Yr bonds of the US), because long term the company should not grow more than the rate of the economy. I'm using the risk-free rate as a proxy to it, so the terminal growth becomes it;
• Terminal Cost of Capital - I'm assuming its Cost of Capital begins at its current estimated value and then gradually converges to the industry average;
• Initial and Terminal Tax Rate - Given the fact that its recent averages are around ~17-18% I'm assuming the same value as the industry average for both;
• Terminal ROIC - By default this value is equal to its terminal cost of capital. However, here, I'm being a little more optimistic and saying Microsoft will maintain its good capital allocation and still be able to return on its capital almost double its cost of capital. Its still below its historical averages of ~20-30%, but will reflect this optimism in the valuation.

All the other inputs were taken from the financial statement or from analyst projections.

The DCF gives us an estimated fair value of 408.72 dollars for Microsoft.

Something that we can also do now is to play around with Monte Carlo simulations. What this will allow us to do is to simulate multiple DCF valuations with pre-defined ranges for each of the inputs. Each simulation will randomize the inputs between these pre-defined values. For this I also used analysts estimates.

As you can see from the above Microsoft seems to be fairly valued or even a little overvalued given that its current price of 430.29 dollars is around or a little below P80. From these simulations we can extrapolate that there's between ~50-80% probability of Microsoft being overvalued.

Please be free, as before, to fill in your own values. Make the valuation your own and do yourself a DCF valuation using your own assumptions: DCF - The Fair Value Journal

EPS Growth (Weight: 25%)

For this valuation method, I've used the current EPS and the analysts estimates of EPS growth. I also assumed a 25 PE for the company.

Then again used the Monte Carlo simulations to check what happens when the input values change within a specified range:

Using this valuation method, Microsoft that is currently priced at 430.29 dollars seems to be undervalued being currently valued below P10. From this we can extrapolate that there's more than 90% probability that the stock is undervalued.

As before, feel free to try this yourself: EPS Growth - The Fair Value Journal

Historical P/E (Weight: 15%)

The current P/E (Price / Earnings) ratio is below its 7-8 Year average. This means that the company is undervalued by this metric. Assuming a mean reversion to its historical average of 33.08 we can assume a fair value of 507.78 dollars.

For every type of historical and relative valuation you can use the same free tool: Historical / Relative Valuation - The Fair Value Journal

Historical EV/EBITDA (Weight: 10%)

The current EV/EBITDA (Enterprise Value / Earnings Before Interests, Taxes, Depreciation and Amortization) ratio is below its 7-8 Year average. This means that the company is undervalued by this metric. Assuming a mean reversion to its historical average of 22.50 we can assume a fair value of 523.87 dollars.

Historical P/CF (Weight: 5%)

The current P/CF (Price / Free Cash Flow) ratio is below its 7-8 Year average. This means that the company is undervalued by this metric. Assuming a mean reversion to its historical average of 25.54 we can assume a fair value of 521.06 dollars.

Historical P/S (Weight: 3%)

The current P/S (Price / Sales) ratio is below its 7-8 Year average. This means that the company is a little undervalued or even fairly valued by this metric. Assuming a mean reversion to its historical average of 11.44 we can assume a fair value of 462.11 dollars.

Historical P/B (Weight: 2%)

The current P/B (Price / Book) ratio is below its 7-8 Year average. This means that the company is undervalued by this metric. Assuming a mean reversion to its historical average of 12.04 we can assume a fair value of 566.20 dollars.

✍️Summary

Now that we did all the heavy work, let's take the above and come up with the company weighted average fair value.

I basically take each valuation method used and given my confidence on the company apply a 20% or 10% discount (when to buy) and addition (when to sell) or use the Monte Carlo P10, P20, P80 and P90 values:

Feel free to choose your own values, but for me I will pick a fair value of 437.17 dollars given the overall moat of the business and the potential opportunities this company may create for itself in the future.

Overall it seems Microsoft is fairly valued or at maximum a little undervalued at the current prices.

Fair Value: 437.17 dollars