With the S&P down 19.0% from 52-week highs, the correction in the market is starting to get me excited about stock valuations again and putting fresh savings to work in my investment portfolio. Technology companies have taken a particularly hard hit with the Nasdaq down 31.5% over the past year.
Microsoft has a strong economic moat and business model, as this article will discuss, and has now seen its stock price fall 32.4% over the past year to sit at $235.87. At the right price, Microsoft could be a great long-term addition to a portfolio and the company’s valuation is starting to look attractive at 14% below its average valuation of $268.93 across six different techniques.
In this article we will run Microsoft through the IFB Equity Model spreadsheet to get a sense of its valuation and we’ll play around with important growth rates in a sensitivity analysis. This model is one of the courses and spreadsheets available on the IFB products page and allows users to easy value a company in a fully customizable model using six different techniques which grab data automatically from forecasted 10-year financial statements.
Microsoft’s Growing as a Core Backbone of the Economy
Microsoft’s products have become critical to everyday life and productivity in the workplace. Whether a multi-national company uses SAP, Oracle, or Microsoft Dynamics (formerly Great Plains) as their enterprise resource planning system (ERP system), I would bet money that nearly all of these companies are also using Microsoft Word and Excel as their workhorse at the individual contributor level.
Over the years, Microsoft has used their Windows operating system and core software products as a cash cow to grow and expand into numerous business from LinkedIn to Azure cloud solutions. The company segments itself into Productivity and Business Processes (32% of 2021 revenue), Intelligent Cloud (36%), and More Personal Computing (think xBox and gaming, 32% of sales). All segments have strong operating margins in the 36 – 45% range and contributed 35%, 37%, and 28%, respectively, toward operating income as can be seen in the graphs below.
In the latest fiscal year, Microsoft’s revenue increased $25.1 billion (18%), driven by Office 365 Commercial, LinkedIn, and gaming. The company’s adjusted diluted EPS increased 38% driven by operating income growth of 32% combined with share repurchases. In Microsoft’s latest first quarter results for their 2023 fiscal year, the company reported revenue increases of 16% in constant currency driven by cloud revenue which increased 31% in constant currency.
The functionality, transferability, and history of company files/systems make Microsoft’s products quite sticky for their clients with high switching costs. This global use and stickiness has great implications for long-term growth. When combined with the margins of a software product, this makes Microsoft a very attractive company to investors.
Strong Economic Moat
Microsoft’s global brand and leading products have allowed it to achieve an average return on equity (ROE) and return on invested capital (ROIC) of 32.0% and 21.2%, respectively, over the past decade. This level of profitability is well above my rule of thumb of 15% ROE and 9% ROIC, allowing me to be confident that, in my opinion, the company is able to maintain and continue to increase its intrinsic value over a business cycle.
In 2021 and 2020, Microsoft repurchased 101 million shares ($23.0 billion) and 126 million ($19.7 billion), respectively. Given the amount of shares outstanding, the IFB Equity Model automatically calculates the repurchase rate and plugs it into the valuations. Combined with the current dividend yield of 1.1%, this share buyback rate of 1.2% means a total shareholder yield of 2.3%. According to the IFB Equity Model, over the past 3 years, the company has spent on average 34.8% of cash flow from operations on share repurchases. We are forecasting this rate of share repurchases to continue to be the case. I always like to see share repurchases from a company as it is a tax-efficient way to return cash to shareholders and shows faith by management in the long-term prospects of the business.
Microsoft’s strong moat provides long-term growth opportunities that are very hard to find in a business. In a 2-stage valuation, our model assumes a short-term 10% growth rate over the next ten years and then applies a terminal growth rate of 6%. For my value investing background, these are aggressive growth rates but Microsoft’s historical growth discussed earlier along with a calculated sustainable growth rate of 26.6%, give me confidence in using the higher rates in a growth at a reasonable price (GARP) style investment thesis for Microsoft. For a terminal growth rate, I do not often go beyond a conservative 3%, but Microsoft’s results seem to historically support the growth premium.
In the IFB Equity Model, the company’s historical financials are input, which drive the operating and profitability ratios that automatically build the financials. Investors can then make a few critical assumptions such as the cost of equity of 8.8%, and short and long-term growth rates of 10% and 6%, respectively. The same forward inputs are used for each different calculation methodology to be discussed in detail next. Later, we will run through a sensitivity analysis where we change the key growth assumptions in this GARP style investment thesis.
In addition to the below valuation highlights, looking out at the forecasted financial statements in the IFB Equity Model, we can get a sense of what the business needs to look like in the future in order for our valuation to hold. In the case of Microsoft, they have to continue to grow their asset base through capital expenditures and acquisitions of $84.1 billion over the next 10 years. This is needed to get the company’s revenues to $436 billion in 10 years’ time. Luckily, Microsoft’s free cash flows can handle this investment and still have enough cash to return lots to shareholders.
Discounted Cash Flow: Valuing the free cash flows of Microsoft in a discounted cash flow (DCF) approach indicates a $285.09 price per share, which creates a 20.9% margin of safety. In such a valuation we are taking the cash flow from operations and adjusting for capital expenditures. The growth rates feeding into this are the 10% short-term revenue growth and then 6% for long-term terminal value discussed earlier.
Gordon Growth Model: With an implied price of $321.53, the Gordon Growth Model (GGM) is the highest valuation in our model, showing a 36.3% discount to the current share price. This is driven by the GGM using the dividend which has a higher growth rate of 20% being input into the model. The GGM valuation is a spin on the classic dividend discount model (DDM), taking the dividend from the models forecast and then valuing the company based on the discounted cost of capital and growth rates. Because the model is using a short-term 10% growth rate combined with a 6% long-term growth rate, this type of DDM is also referred to as a two-stage growth model or H-Model.
Trailing P/E Multiple: Stepping into the “Justified” multiples valuation approach, we start with the trailing P/E multiple which takes the latest earnings and then multiplies it by a “justified” P/E ratio, which calculates out to 29.4x for Microsoft. The justified P/E ratio is calculated by taking Microsoft’s 78% payout ratio put forward for a year’s worth of growth at our 6% long-term growth rate, then divides this by the 8.8% cost of equity less the 6% growth rate.
Leading P/E Multiple: The justified leading P/E valuation is very similar to the trailing but instead multiplies next year’s forwards earnings by the justified leading P/E, which in turn does not add growth as it is already taken into account by using next year’s earnings. Microsoft’s justified leading P/E ratio is 27.8x that next year’s forecasted earnings will be multiplied by.
Price-to-Book: The justified price-to-book valuation is one of my favorites due to the fundamental comparisons between return on equity (ROE) and the cost of equity (also referred to as the required return on equity). Microsoft deserves to trade at 12.8x price-to-book because their return on equity of 42% is far higher than their 8.8% cost of capital. Given Microsoft’s forecasted $158.5 billion book value of equity, this 12.8x justified P/B implies a valuation of $266.92 per share.
Residual Income Valuation: Microsoft’s valuation using the residual income method comes out to $251.28 per share. This valuation method is done by taking the forecasted earnings of the company in any given year and then subtracting an “equity charge” based on the book value of equity and the cost of capital. After subtracting this equity charge off earnings, investors are then left with the residual income, which can be discounted back and added to the current book value of equity.
There are numerous ways we can change the IFB Equity Model. From changing discount rates, to growth rates, or overriding the historical averages being used in various margin and turnover figures, there are almost countless combinations of scenario’s that could be priced out. Given the GARP style of investment Microsoft falls under, one of the most sensitive variables to its valuation will be growth.
Let’s explore what happens to our valuation if we drop the long-term growth rate down to 3%. As mentioned earlier, this is my usual long-term growth rate but for a company with the economic moat of Microsoft, I was making an exception. As can be seen below, under the first more conservative long-term growth rate drop to 3%, Microsoft’s valuation drops to $149.08, leaving it looking 36.8% overvalued.
In our second sensitivity scenario, we will look to the upside and see what happens if short-term growth is 20% instead of 10%. This higher growth rate is actually in line with Microsoft’s historic results, so it could be argued the 10% was a little conservative. With a 20% short-term growth rate in this more aggressive scenario, the 6% long-term terminal value has been supported. This more aggressive growth scenario results in a $369.09 average valuation and 56.5% margin of safety. With the IFB Equity Model, investors can build in their own assumptions and conduct their own sensitivity analysis.
Sensitivity analysis is always important to understand the drivers of the valuation and how things can change. In our third sensitivity analysis, we keep growth the same but take the average cost of sales from 32.5% to 40%, reducing Microsoft’s gross margin by 7.5%. This takes Microsoft’s valuation to $252.03 and shows what an increase in competition and lower pricing power could look like.
While Microsoft has a leading market with many of its consumer and business products solutions today, that may not always be the case. Much of Microsoft’s valuation is due to the long-term growth rates being applied in the valuation and changes in market dominance could have a large impact on these long-term figures. Google is already nipping at the heels of Microsoft in some of its historic products with its Google Sheets and Android-based laptops beginning to be used by some businesses and consumers.
From my personal experiences, the one company where I used Google Sheets (which was mainly for upload and sharing purposes), we still had Excel running in the background. This same company was also moving employee email over to Gmail which I must say I rather enjoyed. For the average consumer, some of this heavy functionality of Microsoft products is not always necessary and Google sheets will work just fine.
Microsoft looks like a compelling buy for long-term investors at this valuation having fallen 32.4% from 52-week highs. The company’s historic strong profitability and dominant product offerings support the growth rates being applied in the GARP style investment thesis. Microsoft’s intrinsic value of $268.93 yields a decent 14% discount to the current share price of $235.87. Investors might want to keep an eye on Microsoft in the current market environment and think about getting ready to cross the company off their wish list.
The IFB Equity Model is one of the many courses and files available on our products page. The model allows users to easily value a company in a fully customizable model using six different techniques which grab data automatically from forecasted 10-year financial statements being built within the 3-statement financial model.