Are Investors Undervaluing Microsoft Corporation (NASDAQ:MSFT) By 24%?

By
Simply Wall St
Published
June 03, 2021
NasdaqGS:MSFT
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Microsoft (NASDAQGS:MSFT) is a technology company focused on commercial and industrial applications with software solutions such as Office 365, Azure, Microsoft Teams, Dynamics 365, Linkedin, Windows 10. They also provide platforms for developers via Visual Studio Code and Github. A smaller segment of Microsoft are their devices and their games division powered by Xbox.

You might think that since Microsoft has been around for so long, there is not so much space for them to expand. But upon further inspection, a mix of smart management decisions and projects in high barrier to entry industries might give Microsoft even better footing in new and existing markets. The company is forecasted to grow revenue 11.7% annually, so let's take a deeper look at what possible projects might drive this growth.

Current projects in expansion

These are the current projects Microsoft is working on, that have not realized their full potential and are still expanding. They include:

Microsoft Azure - The backbone of the productivity suite for western corporations.

Azure servers are currently being expanded in China, Indonesia, Malaysia etc. This will also create higher capital expenditures which are a reliable long-term growth investment. 

Microsoft Office - Providing stabilized revenues from essential business tools.

The advantage of MS Office as a cash generator is that they have turned it from an opt-in purchase product to a continuous subscription service which retains more users per year. Currently, MS Office has 300 Million Seats/Paid Users. 

A new app that has seen a large uptake is MS Teams with 145 Million monthly active users is preferred over Skype for businesses, education, conferencing etc. It seems that MS Teams is currently ahead of the competition in large-scale corporate communication apps.

LinkedIn - Well positioned social network with long-term committed users.

Microsoft acquired LinkedIn in 2016 for $26 Billion USD. By integrating LinkedIn, MSFT better positioned MS Office sales and increased its pricing power as it became (at the time) present in front of a half a billion and growing user base. This additionally cut costs for advertising Microsoft products on the platform, made room for more targeted news and educational materials that favor Microsoft products.

Microsoft Dynamics & Viva - A major competitor for Customer Relationship Management (CRM)/ Enterprise Resource Planning (ERP) market-share with potential for innovation.

Microsoft Dynamics is positioned to be a serious competitor to current ERP solutions such as SAP, CRM, ORCL etc. They will keep pressing on the margins of their competitors as they invite more business to switch and adopt Microsoft Dynamics.

Microsoft Viva offers insight into employee activities (such as hours of active work, probability for burnout), and productivity so that teams can communicate efficiently and managers have a better overview of their employees.

PowerApps - The future tool for reducing operating expenses and bureaucracy for companies.

PowerApps are suitable for large corporation clients that seek to cut costs and streamline operations which are already integrated in the Microsoft ecosystem.

Microsoft Gaming - Large but risky potential for growth, reliant on repeated success in development of devices and games.

They are seeing growth in Xbox, the newly acquired Zenimax Games, and Minecraft which allows for a creator economy.

The gaming industry is quite volatile as revenues are dependent on the success of mid to long term projects. If a game fails the whole project is net negative, but if a game is a success they can drag the revenue out with sequels and additions. As long as Microsoft continues to make high quality games and consoles, they will see cumulative benefits in this industry.

Future projects and frontiers

Growth must be justified via reinvestment and good future projects. We see that Microsoft is positioning itself to better serve the advanced needs of large business clients, as well as entering new industries such as healthcare.

Healthcare

The healthcare sector is characterized by massive bureaucracy and opportunities for growth. It is one of the sectors where innovation can unlock substantial future growth. Microsoft has established itself as a corporate and industry suite, but now it seems that they are taking their whole ecosystem and moving on to the healthcare industry.

On 11 April 2021 they entered into an agreement to acquire Nuance Communications for US$56 per share, or US$19.7 Billion. Nuance is a cloud and artificial intelligence (“AI”) software provider with healthcare and enterprise AI experience, and the acquisition will build on industry-specific cloud offerings.

Operations Enhancement via Machine Learning

The company will utilize its large aggregated datasets to help with decision-making processes for businesses. Their capabilities will allow systems such as ERP to better plan target rates and manage working capital (supply chains) more efficiently. The insight from machine learning (ML) can also be used to profile CRM customers, sales-force and recommend optimal moves on the part of the sales representative for a specific customer.

ML can be also used to allocate cloud resources better and further cut costs for their systems. 

In general, while other companies are using big data to drive search results, online sales, targeted advertising etc, Microsoft is leveraging it to improve operations of businesses and reduce the costs for their clients.

Intrinsic Valuation

So how far off is Microsoft Corporation ( NASDAQ:MSFT ) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model .

View our latest analysis for Microsoft

The calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$54.7b US$63.1b US$68.4b US$83.3b US$101.8b US$114.2b US$124.6b US$133.2b US$140.6b US$146.8b
Growth Rate Estimate Source Analyst x16 Analyst x16 Analyst x7 Analyst x4 Analyst x3 Est @ 12.17% Est @ 9.12% Est @ 6.98% Est @ 5.48% Est @ 4.43%
Present Value ($, Millions) Discounted @ 6.5% US$51.3k US$55.7k US$56.7k US$64.8k US$74.4k US$78.3k US$80.3k US$80.7k US$79.9k US$78.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$700b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.5%.

Terminal Value (TV) = FCF 2030 × (1 + g) ÷ (r – g) = US$147b× (1 + 2.0%) ÷ (6.5%– 2.0%) = US$3.3t

Present Value of Terminal Value (PVTV) = TV / (1 + r) 10 = US$3.3t÷ ( 1 + 6.5%) 10 = US$1.8t

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$2.5t. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$252, the company appears a touch undervalued at a 24% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NasdaqGS:MSFT Discounted Cash Flow May 26th 2021

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Microsoft as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 6.5%, which is based on a levered beta of 0.950. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Microsoft, we've compiled three pertinent aspects you should assess:

  1. Risks : Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Microsoft , and understanding these should be part of your investment process.
  2. Future Earnings : How does MSFT's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart .
  3. Other Solid Businesses : Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here .

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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Simply Wall St

Simply Wall St is focused on providing unbiased, high-quality research coverage on every listed company in the world. Our research team consists of data scientists and multiple equity analysts with over two decades worth of financial markets experience between them.