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XMFConnor (97.30)

Microsoft: Trading for less than EPV.. a real bargain

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January 18, 2011 – Comments (10) | RELATED TICKERS: MSFT , AAPL , AMZN

Microsoft isn't exactly a sexy pick right now. That can reserved for tech stocks like Amazon or Apple. However, they are a cash cow and have been remarkably consistent in terms of operating results. Here is my very simple look at valuation.

I think the correct way to look at them is in terms of Earnings Power Value using the Bruce Greenwald approach. First, I want to asess the downside. 

To do this, we need to know a few things about MSFT:

1) Despite critics, they are growing. Revenue is up about 20% since 2007, operating is up 50%, and net income is up 46%. While this does not guarantee us that they will not have a slowdown in the future, the trend is clear. Therefore, an EPV of current earnings should be a very conservative valuation because it will not take into account any future growth. Therefore, if we are able to purchase MSFT at a conservative EPV value, then we get any growth for free. I think that given their track record, strong balance sheet, and current initiatives (Kinnect, Windows 7, smartphones, xbox live initiatives, etc..) that purchasing MSFT at EPV value would be a steal.

2) Next, I want to look at the downside. Therefore, I took the lowest cash flow level from the past three years-- their fiscal year ending June 30. They generated FCF of approx. 16 billion (and that's a low year!). For comparison, in their fiscal year ending Sept 2010, they generated approx 24 billion in FCF.

Now, to arrive at an EPV, we would tyically only subtract maintenance capex (rather than using the full capex which was used in the above FCF estimates). Even then, if we take the low FCF figure from the middle of the recession and ignore any growth, that stream of earnings is worth 160 billion with a 10% cost of capital. Then, we can add their 33 billion in net cash to arrive at a very conservative EPV value of 193 billion. This is slightly less than the current enterprise value of MSFT (209.53 B).

Now that calculation used some seriously conservative assumptions.. let's now use the latest FCF number to find an EPV. We will again use the full capex (another conservative assumption) in the FCF calculation. 

They generated approx 24 B in FCF in their fiscal year endind Sept 2010. With 10% cost of capital, its worth about 240 B, then add 33 mm in net cash, we get to 273 B. Dividingby the 8.56B in shares outstanding gives us an EPV value/share of approx $32/share. This is approx. an 11% discount from the current price at time of writing.

Therefore, we are able to purchase a growing business at a historically low valuation at a discount to its EPV-- and get the growth (and more) for free. I like my chances with this investment. I would sell 1/3 when it reaches EPV. From there, it depends on your estimates of future growth (analysts have eps growth over next five years at over 11%).

 

10 Comments – Post Your Own

#1) On January 18, 2011 at 5:15 PM, chk999 (99.98) wrote:

The United States Leather company was a big company at one point, but now it is gone. What technological changes could make MSFT irrelevant?

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#2) On January 18, 2011 at 5:36 PM, XMFConnor (97.30) wrote:

chk999,

That's obviously a tough question to answer. However, MSFT has quite a moat around its core business. I mean just think of things like Excel. Every business uses it... it is incredibly efficient-- and most importantly, the switching costs are very high. Not so much in terms of actual monetary cost, but the learning curve would be very significant. All of the little shortcuts that make huge spreadsheets incredibly easy to analyze... I mean you would have to have a really significant reason to switch. Obviously this is just one example of MSFT's products, but I think it exemplifies the power of MSFT's moat in a pretty good way.

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#3) On January 18, 2011 at 6:58 PM, chk999 (99.98) wrote:

Lotus 123 was once the dominant spreadsheet and Lotus is pretty much gone these days.

Suppose people mostly weren't using PCs, but were using tablets with the Android operating system and spreadsheets located in the cloud. Would MSFT still have a moat? They haven't really made a lot of money in anything except operating system sales and MS Office.

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#4) On January 18, 2011 at 6:59 PM, Mary953 (39.90) wrote:

Connor,

Two thoughts - I came to this forum specifically to write a blog requesting insight into Microsoft this evening.  Apple, Amazon, Netflix, all the other tech stocks that I would normally follow are flying high and MSFT remains - well - cheap, especially when their stock price is stacked against the costs of the others.  I wanted information.  I found your post already waiting for me with all the information I could want presented in a clear logical manner.

Second thought - I just wish I understood more of what you have written.  I am still in the elementary grades of the school of investing here.  I think I have wandered into one of the post-secondary lectures.  I will clutch what knowledge I can understand and rush out with it.

Thanks much - and if you care to dumb any of it down for me, I will be a very happy camper.  I seem to have a mental block where the math of stock evaluation is concerned.   What I have understood from your analysis is that MSFT is a great buy at the moment.  It should be trading at around $32/share.  Instead it is trading at around 28.50 with a 2.3% dividend to boot.  I know enough people who have decades of work on Excel that would cringe at the idea of shifting to a new spreadsheet for me to understand the moat that comes with just that one product.  .You have added Kinnect, Windows 7, smartphones, and xbox live to that mix. 

Revenue is up, operating is up , and net income is up .  Granted, there is no sure thing in the stock market but even I see the trend here. Therefore, if we are able to purchase MSFT at a conservative EPV value, then we get any growth for free. Purchasing MSFT at EPV value would be a steal.  (Now what is EPV value??? - never mind, I will look it up.)

Connor, thanks loads for answering my question before I could even ask it!

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#5) On January 18, 2011 at 7:02 PM, Mary953 (39.90) wrote:

chk999,

Don't burst my bubble.  I like the idea of having the answers I wanted before I even asked for them!  And I absolutely made my son-in-law's Christmas by giving him an Xbox that is Kinect ready.  Besides, as always, you are buying stock in a company, not marrying it til death do you part!

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#6) On January 18, 2011 at 8:10 PM, TheDumbMoney (58.47) wrote:

chk999, the reasons you state are indeed as far as I can tell the reasons MSFT is as cheap as it is.  They are good points.  Against that I have a few thoughts:  1) MSFT has actually experienced a bit of an earnings and revenue and FCF renaissance since 2006, just as Apple and GooG and the cloud were all kicking into gear, which is inconsistent with the thesis that 'they' will destroy MSFT (at least so far); 2) even on the cloud you still have to license every ultimate user from MSFT, unless you switch to another base software platform -- at least as I understand it; 3) even if you're right, I think the worst case scenario is MSFT slowly loses enterprise share, loses PC share, and goes on generating a lot FCF and still growing modestly for at least ten or fifteen years.  If you can essentially buy the company not paying for any of that growth, you're still getting a decent deal even in a bad scenario; 4) the USLC example is not really appropriate, as we are not talking about a whole industry dying -- better to use US leather when talking about how XOM may go the way of the dodo one day.  Lotus is good, but I would suggest Kodak, EK...i.e., will an entirely new way of doing the same thing and building the same essential product destroy MSFT's moat and business?  Ultimately, leaving aside the numbers, all valuation of MSFT boils down to an evaluation of that question, which is, at best, a judgment call, and at worst, a sort of Rorschach test in which the output often seems to depend upon personal emotional feelings about the company.  Personally, I'm long MSFT, and I think the rumors of its demise are greatly exagerrated.  Of course, I thought the same thing about EK in 1999.  Of course, I thought the same thing about MO in 1998.  Etc., etc.  You win some, you lose some....

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#7) On January 18, 2011 at 8:31 PM, throwerw (30.14) wrote:

MSFT stock should do pretty decent over the next decade, with a ton of cash being returned to shareholders through buybacks and dividends.

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#8) On January 18, 2011 at 8:48 PM, checklist34 (99.80) wrote:

chk999,

lotus123 had a massive disadvantage of microsoft having windows, and therefore being able to make a spreadsheet that worke dwith windows alot better than others.

I do not like msft as a company, they haven't ever really innovated anything or created anything, they are theives and copycats.  That was not a well researched statement, but, really, what have they ever invented?  

But I do remember the days when Wordperfect would crash every 2 minutes while MS Word would crash only every 10 or 15 minutes.  Ditto everything else.  

MSFT's moat has always been its OS monopoly and the ability that gives it to ensure that its office suite, etc., work better than anybody elses.  

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#9) On January 18, 2011 at 10:17 PM, XMFConnor (97.30) wrote:

Mary,953,

Glad I could be of help. EPV is one method of valuing a company by only examining the value of its current earnings.

 

The general EPV formula is: After-tax Operating Income (EBIT) + Depreciation and Amortization - Maintenance Capital Expenditures

 

 

This result is then divided by a company's weighted average cost of capital (WACC) to derive the Earnings Power Value. Now all that needs to be done is to add the company's cash balance, subtract the company's total debt and divide by the number of shares outstanding. This will yield the company's theoretical Value/share. But don't forget it excludes the benefits of future growth so it typically will yield a very conservative estimate of a stock's value.

 

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#10) On January 19, 2011 at 12:18 PM, Mary953 (39.90) wrote:

Wow, Just. WOW

I will need to take that in very small parts, figure out what each bit of it means and see if I can translate it into something I can understand,  Then I will have to go do it again and again and again.

On the other hand, I can give you a fairly "easy way" to make some very complicated dishes without having to consult a cookbook, run a 9 generation genealogy, or write a teaching unit with no trouble at all.  It is all in your ability and knowledge.  Part of mine is knowing when to look for help.

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