Microsoft Report

11/18/2010

MICROSOFT, CORP. Investments Term Paper

Joshua Berk, Kevin Hylant, & Sarah Noah


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MICROSOFT, CORP.

Investments Term Paper

SUMMARY

COMPANY OVERVIEW

MICROSOFT, Corporation One Microsoft Way Redmond, WA 98052-6399 (United States) Phone: (425) 882-8080 Website: http://www.microsoft.com

Sector/Major Industry Technology/Application Software & Programming Information Date 16 November 2010

Current Stock Price (NASDAQ) $25.57 52-Week Price Range $22.73-$31.58

Current P/E Ratio (12-mo trailing) 11.26 Beta Estimate 1.07

Current Dividend Yield 2.40%

2009 2010 2011 (estimate) EPS 1.62 2.10 2.51 DPS 0.52 0.52 0.64

SUMMARY OF CONCLUSIONS

Microsoft, Corporation is an information technology firm experiencing stagnant stock price growth as the company matures in the industrial life cycle for the technology sector. We preformed comparable analysis, beta comparisons, forecasting EPS and DPS, and valuations models (P/E Ratio Model, Discounted Cash Flow Model, and Dividend Discounting Model) in order to evaluate the financial state and market value of the company. Our results for the valuation models are summarized in the chart below. Model Stock Price Over/Under-Valued? Reliability P/E Model $43.62 Undervalued Poor Discounted Cash Flows Model $33.80 Undervalued Good Dividend Discounting Model $17.89 Overvalued Moderate Through a thorough analysis of Microsoft, Corporation we have concluded that the stock price is undervalued and investors should buy.

http://www.microsoft.com/


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Contents

SUMMARY .......................................................................................................................... 1

COMPANY OVERVIEW .............................................................................................................................. 1

SUMMARY OF CONCLUSIONS ................................................................................................................. 1

I. INTRODUCTION ............................................................................................................. 3

MICROSOFT ................................................................................................................................................ 3

MACROECONOMIC ENVIORNMENT ...................................................................................................... 4

COMPETITORS ........................................................................................................................................... 5

II. COMPANY ANALYSIS ................................................................................................... 7

FINANCIAL RATIO COMPARABLES ........................................................................................................ 7

RISK ANALYSIS & DEBT STRUCTURE .................................................................................................... 8

CALCULATING BETA ................................................................................................................................. 8

BETA COMPARISIONS ............................................................................................................................... 8

FORECASTING EARNINGS PER SHARE ............................................................................................... 10

FORECASTING DIVIDENDS PER SHARE ............................................................................................. 10

III. VALUATION ............................................................................................................... 12

SUMMARY OF STOCK PRICES FROM VALUATION MODELS ........................................................... 12

P/E MODEL ............................................................................................................................................... 12

CAPM – CAPITAL ASSET PRICING MODEL ......................................................................................... 13

SECURITY MARKET LINE (SML) ........................................................................................................... 13

CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC)................................................. 14

DISCOUNTED CASH FLOWS MODEL ................................................................................................... 15

DIVIDEND DISCOUNTING MODEL ....................................................................................................... 17

IV. CONCLUSIONS ........................................................................................................... 18

BIBLIOGRAPHY ............................................................................................................... 19

APPENDIX A ..................................................................................................................... 20

APPENDIX B ..................................................................................................................... 22

APPENDIX C ..................................................................................................................... 24

APPENDIX D..................................................................................................................... 29


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I. INTRODUCTION

MICROSOFT

Microsoft is a public multinational information technology company that received widespread recognition

in the 1990‘s for the development of the user-friendly Windows operating system and Office suites. One

of the most recognizable brand names in the world, Microsoft was founded by two friends who shared a

passion for computer science – specifically program development. The development of DOS, and a smart

partnership with IBM, Bill Gates and Paul Allen soon saw their operating systems on personal computers,

IBM PCs. Now headquartered in Redmond, Washington, this once garage-based business became a

dominant force in the marketplace with the graphical operating system Microsoft Windows. Microsoft

continued to released improved editions of Windows and Office, while ever-expanding its reach into other

technology areas, such as the gaming/entertainment industry with the release of the Xbox gaming console

in 2001 and, more recently partnering with cellular providers with the release of Windows Mobile.

Once a high-growth company, Microsoft has recently reached maturity in the marketplace and is now

fighting to maintain ground in the market as new power-players such as Apple and Google expand. The

main reason for the shift in market share is the national and global driving-force transition from

enterprise demands to a consumer demands. Consumers were once not even considered a variable in the

information technology market, and were instead delegated to membership in the consumer electronics

market. On a daily basis, innovation is being driven and rewarded by the average consumer; therein lies

the information technology market‘s problem. While enterprise contracts wanted efficient products with a

longer lifespan, the consumer demands the newest, the best, and the smartest most innovative product on

the market – and the company that has that product yesterday is the company that stays on top of that

industry sector.

One advantage for Microsoft is sustainability in enterprise contracts; Windows PC‘s may not be the

current fad or cult-favorite, but the Windows OS is reliable, dependable, familiar, and promises consistent

improvements with the release of newer versions every few years. Company contracts make up a majority

of Microsoft‘s revenues, with $4.01 billion in sales of server software alone. At the end of the 2010 fiscal

year, Microsoft announced impressive earnings,

with revenues of $4.55 billion of the anticipated

Windows 7 and $5.25 for the new Office Suite

2010. And yet, despite record earnings and

profits, Microsoft is still not seeing any

movement in stock price.

These stagnant stock prices are a reflection of

investor trends and confidence, and Microsoft‘s

software development has taken a back burner

in light of more trendy and ‗hot‘ products such

as the iPhone 4G and Android mobile. Constant

stock prices reflect that consumers and investors

alike are concerned that Microsoft is not keeping

up with the latest in IT trends. Microsoft may

have leaned too heavily in recent years on the

corporate replacement cycle and not focused on

the IT shift of designing for the consumer. Steve

Ballmer, CEO since 2001, admitted in June, 2010 that Microsoft ―missed a whole cycle‖ in the

smartphone market.

Figure 1.1: No significant stock price movement

indicating stagnant confidence from investors since 2000.

[Note: visible dip in early 2009 after recession &

announcement of failed Yahoo acquisition].

Source: Google Finance


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That being said, Microsoft is working on repositioning itself as a brand in multiple areas of the

information technology industry market. The growth of ―software as a service‖ (SaaS) allows for greater

competition for traditional Microsoft products (e.g. Microsoft Office). Although shareware, open-source,

or low-cost alternative software (e.g. Google Apps) don‘t fulfill the security and functionality that most

businesses mandate, this trend will remain persistent in the foreseeable future. Piracy is also a major

issue, as Microsoft suffers massive losses from the distribution of pirated software. Interestingly enough,

the countries with the highest piracy are those with the largest growth in PC purchases. The software giant

is, thus, unable to tap into these expanding markets. Microsoft, however, is able to leverage control over

its proprietary systems to enable economies of scale and unify its application development across

segments/platforms (Xbox, Windows, and Windows Phone 7), which eases developer access to consumers

(and does not force them to pick one platform over another, which also provides incentives for cross-

development and long-term relationships).

In the competitive realm, Microsoft faces a variety of threats. In operating systems, Oracle is a far greater

threat to Microsoft than Apple (despite popular conception and media attention), since Apple‘s strength is

among consumers (not corporate environments). Oracle is poised to challenge Microsoft, both through its

support of Lintel (Linux OS plus Intel processor chips) and in replacing Microsoft's developer base (with

its own improved Linux-based developer platform). Google outperforms Microsoft by a wide margin in

Internet services and cloud-computing based software offerings. Microsoft recently signed a ten-year

partnership with Yahoo! in February 2010. Under the terms of the revenue-sharing agreement, Yahoo will

receive 78% of the search revenue generated from Microsoft's sites during the first 5 years of the

agreement and 88% of search revenue generated from Yahoo's sites. Microsoft's two primary competitors

in the Entertainment & Devices sector are the Nintendo Wii and the Sony Play Station 3. Following the

announcement of the Kinect peripheral device to the Xbox 360, Sony plans to release Move (similar to

Nintendo‘s Wii peripheral). Other competitors include SAP (servers), Red Hat (Linux software), Symantec

(Internet Security) and Cisco (internet telephony).

Overall Microsoft is still a thriving company facing increased pressure from an increasingly consumer-

driven industry. Microsoft has enough corporate contracts and loyalty for the Windows and Offices

programs to maintain sustainability and continued growth. However, in order to maintain market capital,

Microsoft needs to begin tailoring to the consumer. The possibilities for growth are available; Microsoft

just needs to be one step ahead of its competitors in order to capture the market. Microsoft may have

missed beating the other firms out to the fields of smartphones and home entertainment, but they are

paving the way for the cloud-computing.

MACROECONOMIC ENVIORNMENT

The most recent financial crisis was triggered by a liquidity shortfall in the United States banking system.

Considered by economists to be the worst crisis since the Great Depression of the 1930s, it contributed to

the failure of key businesses (e.g. banking, retail, automotive), declines in consumer wealth estimated in

the hundreds of billions of U.S. dollars, substantial financial commitments incurred by governments, and

a significant decline in economic activity. Many causes have been suggested, with varying weight assigned

by experts. Both market-based and regulatory solutions have been implemented or are under

consideration, while significant risks remain for the world economy in the foreseeable future. The Obama

administration has taken a rhetoric (and passed legislation) that is considered by many corporations to be

hostile. Due to actions by government entities and market fluctuations, interest-rates are at record lows

and should not rise in a substantial manner for quite some time. For this reason, Microsoft recently sold

$1 billion each of 3-, 10- and 30- year bonds and $1.75 billion of 5-year debt. Demand for the securities,


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from one of only four non-financial U.S. companies with the AAA rating (Automatic Data Processing,

Johnson & Johnson, Microsoft, ExxonMobil), was huge across the globe. Proceeds from the bonds will be

used to fund working capital, capital expenditures, stock buybacks and acquisitions. The higher dividend

(increased to $0.16 per share), combined with Microsoft‘s share repurchase program, reflects their

―commitment to returning capital to shareholders and confidence in its long-term growth.‖

COMPETITORS

Apple (Source: Yahoo! Finance)

Sector/Major Industry: Technology, Personal Computers Information Date: 18 November 2010 Current Stock Price: $300.50 (NASDAQ) 52-Week Price Range: $188.68 - $321.30 Current P/E Ratio: 19.83 (trailing twelve months) Beta Estimate: 1.36 Current Divident Yield: 0%

Apple, Incorporated is a multinational information technology firm founded in 1976 that began as a

manufacturer of personal computing devices. It saw a rise and fall in competition with Microsoft in the

early 1990‘s. Microsoft focused on providing affordable at-home computing solutions, while Apple

focused on delivering a much more extensively engineered, and consequentially expensive, at-home

computer experience. Once almost off the charts completely, Apple reinvented the firms image with the

help of Jonathan Ive and the iMac, and the later iPod and iPhone. Now a technology cult-favorite, Apple

designs and markets consumers-oriented products, and is widely considered one of the ‗hottest‘ and most

innovative tech firms of the developing market.

Oracle (Source: Yahoo! Finance)

Sector/Major Industry: Technology, Application Software & Programming Information Date: 18 November 2010 Current Stock Price: $27.91 (NASDAQ) 52-Week Price Range: $21.24 - $29.82 Current P/E Ratio: 22.27 (trailing twelve months) Beta Estimate: 1.07 Current Divident Yield: 0.7%

Oracle Corporation is an enterprise software company. It develops, manufactures, markets, distributes

and services database and middleware software, applications software and hardware systems, consisting

primarily of computer server and storage products. Oracle has leveraged its dominance of the database

software industry to become a major provider of enterprise software solutions. The recent acquisition of

Sun will enable the firm to further its strategy of providing complete IT solutions to its clients. Microsoft

and Oracle compete fiercely in the space of operating systems, primarily for servers in the corporate

sector. Oracle's claims that it offers excellent system availability, scalability, energy efficiency, powerful

performance, and low total cost of ownership relative to its competitors (e.g. Microsoft). Oracle was

founded in 1977 and is headquartered in Redwood City, California.


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Google (Source: Yahoo! Finance)

Sector/Major Industry: Technology, Internet Information Providers Information Date: 18 November 2010 Current Stock Price: $583.55 (NASDAQ) 52-Week Price Range: $433.63 - $630.85 Current P/E Ratio: 23.71 (trailing twelve months) Beta Estimate: 1.13 Current Divident Yield: 0%

Google Inc. maintains index of Web sites and other online content, which helps users to obtain instant

access to relevant information. Further, the company provides Android, a mobile software platform

(which rivals the Apple iPhone and Microsoft‘s Windows Phone 7). The firm‘s main source of revenue is

derived from its advertising offerings, primarily AdWords (auction-based), but also AdSense (for content

owners), and various forms of Display advertising. The company also offers Google Enterprise product

line comprising Google Apps that provides hosted communication and collaboration tools, which are

intended to compete with Microsoft‘s Office Suite. Due to the creative versatility and intellectual aptitude

of technology companies, each will continually converge on competitor‘s offerings within the market. An

example of this is Microsoft‘s Bing search engine and complementary advertising platform, which are a

direct response to Google‘s dominance and incredible profitability.


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II. COMPANY ANALYSIS

FINANCIAL RATIO COMPARABLES

Quarterly revenue growth (YoY) is in line with the industry. EBITDA (ttm), operating margin, and net

income are significantly higher than competitors and the industry. ROE is much higher than competition

and the industry average, at roughly 43%. Debt/Equity is also lower than the industry, but higher than

Apple (AAPL) and Google (GOOG), since neither carry any debt. Given the conditions of this model (an

unknown Enterprise Value), we took the average of multiples for the three comparable firms (AAPL,

GOOG, ORCL) and multiplied them by Revenue and EBITDA (respectively) to get values of $306.9B and

$378.2B for a mean value of $342.55B. Obviously, since we know that Microsoft's enterprise value outside

of this model was calculated to be $299.151B, this model (or the given comparable firms) is extremely

inaccurate. When comparing other multiples (e.g. ROE, PE, Dividend Yield), Microsoft is significantly

undervalued by the market given its consistent performance over investor expectations. Although we

believe that this model should be considered in other situations in which less information is provided, it

does not appear to be appropriate for our purposes.

In $Billions MICROSOFT - Comparable MICROSOFT -Actual

Enterprise Value Average $342.55B

$299.151B Revenue Multiple $306.9

EBITDA Multiple $378.2

Figure 2.1: Comparable Analysis (used financial ratio comparable analysis) Source of Ratios: Yahoo! Finance

Figure 2.2: Results of comparables in estimating the enterprise value (all of which are higher than the enterprise

value calculated from the DCF)


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RISK ANALYSIS & DEBT STRUCTURE

The threat to Microsoft‘s core businesses of Windows and Office (via cloud computing) is the primary risk

of concern. Google is intent on disrupting Microsoft‘s ―cash cows‖ in a proactive move to restrict

Microsoft‘s ability (with Bing) to encroach on Google‘s primary revenue-stream. Regulatory and antitrust

issues are also an issue. Given the disruption of cloud-computing, Windows OS and Office will be nearly

irrelevant to MSFT and contribute immaterial amounts to revenue in no less than ten years. The vast

majority of Microsoft‘s revenue will eventually derive from Azure, which should eventually become a very

profitable business. Due to the implicit barriers to establishing a cloud platform (technical expertise, high

fixed costs, massive returns to scale), it is expected that the industry will resemble a mature one very

quickly, comprised of a few (very large) participants. This opportunity could become an enormous risk if

investment is not planned and/or implemented properly. (See Appendix A: Item 1 for complete

breakdown of Microsoft business components).

Financially, even after buying back $60 billion of stock during the last five years, Microsoft‘s fortress-like

balance sheet still boasts $40 billion of cash and long-term investments against only $39 billion in total

liabilities. With a growing pile of cash and an AAA debt rating, Microsoft is one of a select few firms with

such financial resources at its disposal. A quick glance at its capital structure indicates that it has little

incentive to take on extra debt aside from tax purposes and to time the market for financing future growth

or distributing further capital to shareholders. Simply put, Microsoft is in excellent financial position.

CALCULATING BETA

In order to get an idea of the risk associated with Microsoft‘s stocks, and the volatility of the share in

market climates, we calculated Microsoft‘s beta.

The entire calculations for Microsoft‘s beta over the past 5 years are displayed in Appendix A: Item 2,

which calculated out the per-month percentage change in Microsoft‘s stock and the per-month percentage

change in the S&P 500. Calculating covariance and variance yielded

Beta is a measure of a stock‘s systematic risk (non-diversifiable) in relation to the stock market, and can

be and indicator of future stock performance. However, beta is determined based on historical data and

therefore is no guarantee for future performance or volatility of Microsoft‘s stock. How Microsoft has

done in the past 5 years may be no indicator of future performance.

BETA COMPARISIONS

Beta comparison can be a useful method of evaluating a company relative to other companies based on

the potential risk o. Figure 2.3 – displayed on the next page - compiles 3 collected beta estimates from

various financial monitoring websites, alongside our Beta estimate (value determined in the precious

section Calculating Beta).


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Figure 2.4: Beta values of comparables from multiple sources

SOURCE BETA Expected Return Risk Relative to S&P 500 Google Finance 1.07 11.91% Slightly more risky than market Calculated Beta 1.04 11.58% Slightly more risky than market Yahoo! Finance 1.01 11.24% Stock price fluctuates almost identical to rate of

market S&P 500 1.00 11.13% Stable, index benchmark NASDAQ 0.88 9.79% Less volatile, less risky than market

Across the board there are slight variations in the beta estimation. The NASDAQ lists Microsoft as

significantly less risky than the market, which if used in the DCF would have a negative impact on

shareholder value by increasing the cost of capital and decreasing the present value of future cash flows.

Google, Yahoo!, and our own estimations vary over a spread of about 6%, and seem more probable than

the NASDAQ average. While in a state of slow growth and low stock prices, Microsoft is still a technology

firm and appears to have more risk associated with it than Starbucks Corporation (12-m0 trailing

NASDAQ beta of 1.22).

While the beta may not be the best average of the actual future movement of stock prices in the market for

Microsoft, it does shed some light on investor attitude towards the stock when compared to its

competitors. Figure 2.4 displays the beta values for Microsoft‘s main competitors.

FIRM Google Finance Beta Yahoo! Finance Beta NASDAQ Beta Apple 1.36 1.36 1.04 Google 1.13 1.13 1.08 Microsoft 1.07 1.01 0.88 Oracle 1.07 1.07 0.60 Benchmark 1.00 1.00 1.00

Across the board there are slight variations between the financial indexes, however it is possible to see the

difference in betas between the comparables. Google and Apple are considered to be high-growth tech

firms right now, and are experiencing record high stock prices and sales as they coast along the frontiers

of technology innovation driven by consumer trends. Microsoft and Apple, considerably older firms, have

lower betas as the majority of their clients are enterprise contracted for business solutions. As discussed

in the opening introduction, investors and consumers alike are more concerned with what is hot, new, and

trendy.

While Microsoft and Oracle may be experiencing sound revenue growth, they are not meeting investor

expectations for innovation and future growth. This seeming disadvantage is what protects Microsoft

against the volatility of the market; consumer trends are temporary, and demand fluctuates much more

drastically and quickly than enterprise demands. Therefore, even though all four companies are in the

information technology sector, Microsoft is currently estimated to be a mature, less-risky firm when

compared to its high-growth competitors.

Therefore we decided that Microsoft, as a mature tech firm in between extreme stages of cyclic growth in

the technology industry, should have a beta fairly close to our calculation of 1.04 (which is consequentially

the average of the Google Finance and Yahoo! Finance beta estimations). Some risk is associated with the

industry, and Microsoft will yield returns slightly above the market rate, but overall a lower-risk

Figure 2.3: Beta values for Microsoft from multiple sources


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Figure 2.5: forecasted earnings per share

Figure 2.7: forecasted dividends per share

technology firm. Because of this analysis, we decided to use a beta of 1.04 for all of our following cash flow

models.

FORECASTING EARNINGS PER SHARE

HISTORICAL FORECAST 2010 2011 2012 2013 2014 2015 2.10 2.25 2.45 2.65 2.85 3.05

The future earnings per share for Microsoft were estimated using linear regression. When graphing the

previous 5 years-worth of EPS, we see a linear, consistent growth (graphed in Figure 2.6). This visual

assumption is validated by a correlation coefficient of R2 = 0.9332, which indicates a very close fit. We

used the linear regression trend-line equation to calculate future earnings per share, displayed on in

Figure 2.5.

Because of the linear

relationship, it is safe to

estimate that in the coming few

years, with no major business

restructuring, Microsoft will

continue to see growth in EPS.

This is supported by the

business model of enterprise

solutions that Microsoft has

focused on, creating product

sustainability through corporate

contracts. Windows/Office

software is cyclically

repositioned as a leader in the

marketplace upon the release of

new versions, updates, and add-

ons. While Microsoft is trying to

reposition itself and reinvent

the Microsoft image to keep 'in

the game' with younger, 'hotter' consumer-based companies such as Apple and Google, the very nature of

corporate clients provides more reliable consumption, less prone to profit fluctuations due to consumer

trends and fashions, and therefore more reliable earnings.

FORECASTING DIVIDENDS PER SHARE

HISTORICAL FORECAST 2010 *2011 2012 2013 2014 2015 0.52 0.64 2.45 2.65 2.85 3.05 *Special forecast for 2011 DPS, explained in following analysis

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MICROSOFT - EPS Annual, Forecast

EPS

Linear (EPS)

Figure 2.6: graph of EPS included forecasted data points


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The future earnings per share for Microsoft were estimated using linear regression. We plotted the

previous 5 years-worth of annual dividends per share. Based on historic trend, we were able to create a

graph similar to that of EPS. Noting a similar linear trend (displayed in Figure 2.7) we plotted the linear

trend-line which had a correlation-coefficient of R2 = 0.9573, indicating strong correlation. Therefore, we

used the equation for the trend-line in order to predict future DPS values, displayed in Figure 2.6.

As noted in Figure 2.6, the forecast for the fiscal year of 2011 for Microsoft was actually determined

based on historical trend. For the previous 5 years, with only one exception, dividend increases were

announced in Q1 and that dividend remained constant through Q4. Instead of following the linear

regression line for 2011, we simply took the latest dividend, for Q1 2011 DPS = $0.16, and carried it

through the year, resulting in an annual DPS of $0.64 for 2011. Because of some variation in previous

years from this pattern, we chose to continue the linear regression out from 2011 due to a lack of

uncertainty in Microsoft‘s dividend payout decisions.

Dividends are hard to compare and analyze in the technology industry as many high-growth and maturing

technology firms chose not to pay dividends. Microsoft started inconsistent dividends in 2003, and

consistent dividends in 2006. The choice to pay dividends was made in late 2002, when the cash-machine

Microsoft started to realize it was maturing as a company and – despite the effort to remain cool and

innovative – needed to keep investors interested. If Microsoft continues on its current path with dividend

payouts, the company will most likely begin to face financial trouble in light of high dividend yields.

Already having a dividend yield of 2.40% (much higher than any other tech firm, many of which sport a

dividend yield of 0.00%), and encountering slow but steady growth in the years following the recession,

Microsoft cannot sustain having such a high dividend growth rate. After 2015, Microsoft may find need to

drastically decrease the growth rate of dividends, or potentially even off their dividend payouts altogether.


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Figure 3.0: table summarizing valuation modeling results

III. VALUATION

SUMMARY OF STOCK PRICES FROM VALUATION MODELS

Model Stock Price Over/Under-Valued? Reliability P/E Model $43.62 Undervalued Poor Discounted Cash Flows Model $33.80 Undervalued Good Dividend Discounting Model $17.89 Overvalued Moderate

P/E MODEL

The Price-to-Earnings model is a quick and easy way to value a company, especially privates companies

that do not pay dividends. The value of the stock is expressed in the following equation:

For Microsoft, we projected the EPS for 2011 through linear regression trend-lines (see Figure 2.5),

discussed in the previous section Earnings and Dividend Analysis. Through research, we obtained the

P/E ratio for the technology sector from Yahoo! Finance. The expected stock value was calculated using

the aforementioned equation;

For the current stock price, as of November 16, 2010, this would imply that Microsoft stock is drastically

undervalued, by $18.05. However, the P/E Model of forecasting stock price leverages the industry average

of price-to-earnings in the calculation, which may not be and accurate representation of Microsoft. A high

P/E ratio indicates that investors are expecting high returns in the future from the firm, however recent

historical stock price trends indicate that investors have much lower expectations from Microsoft than

that of other technology firms.

Another factor that affects the P/E ratio of a firm compared to that of the industry is the cyclical nature of

the industry. Microsoft is currently in the midst of an upswing in revenues, with significant revenue

increases in certain business segments with the renewal of enterprise contracts due to the release of

Windows 7 and Office 2010. Knowing that Microsoft relies heavily on enterprise contracting, it is possible

to determine that these large increases in revenues raise earnings per share correlate to a lowered P/E

ratio.

Microsoft‘s current 12-month trailing P/E ratio is 11.26; a lower P/E ratio is also indicative of a larger,

more mature firm with less room for growth. For a mature company such as Microsoft, stocks are

purchased for consistent earnings and dividends, and not for growth potential. Other competitors, such as

Apple and Google, are expecting record high P/E ratios as a result of consumer attention and investor

optimism for market growth. The market is expecting significant innovation and growth from technology

firms, and is focused on the production of products and services that cater to the new consumer-driven


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technology industry. Therefore, we concluded that the P/E Model is not an accurate method of forecasting

stock price for Microsoft because it misrepresents shareholder‘s expectations of the company by

determining the price based off of shareholder‘s expectations of the industry as a whole.

CAPM – CAPITAL ASSET PRICING MODEL

We calculated the CAPM for use in the Discounted Cash Flow (DCF) Model and the Dividend Discounting

Model (DDM). The CAPM is a measure of theoretical rate of return on an asset, and is defined by the

following equation:

( )

We decided to use base our calculation of the risk-free rate off of the 10-year Treasury notes as opposed to

the 20-year or 30-year bond because the 10-year bond is more liquid, and the investments are traded

much more frequently. Therefore there is less risk associated with the holding of the security. The risk-

free rate was then calculated by taking the average of the monthly yields on 10-year Treasury notes over

the past 5 years, where rf = 3.902% (see Appendix B: Item 1).

We already determined that Microsoft‘s beta = 1.04 in the previous section.

The expected rate of return for the market determined by averaging the daily year-over-year yield for the

past five years (see Appendix B: Item 2). This gave a yield of rm = 10.902%.

When plugged into the CAPM

( )

SECURITY MARKET LINE (SML)

The CAPM enables us to see the effect of beta on stockholder expectations. Calculating expected return

with variable beta values using the CAPM formula provides a linear trend-line of expected returns. When

compared with different beta-return combinations, it is possible to determine whether a stock is over- or

under-valued. Figure 3.1 is a graph with the plotted CAPM security market line, and labeled points

indicating where Microsoft sits on the expected return line for varying beta values (values from the

previous section Beta Comparisons). From this plot, we can see that Microsoft stock is currently

undervalued, because an investor could be expecting a greater return (which would be reflected in high

stock prices) for the same amount of risk.


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pe

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A B C D

Figure 3.1: SML trend-line using Microsoft CAPM

CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The first step taken in creating the DCF for Microsoft was the calculation of the weighted average cost of

capital (WACC), using the following equation:

(

) (

)

Re Cost of Equity 11.18% Determined in ―CAPM – Capital Asset Pricing Model‖

Rd After-Tax Cost of Debt 2.03% =(interest)*(1-tax rate)

i Interest Rate 3.12% See ―INTEREST RATE‖ below

Tc Tax Rate 35% See ―TAX RATE‖ below

E Market Value of Equity $218,879.2m (Share Price)*(Shares Outstanding)=($25.57)*(8,560B)

D Market Value of Debt $9,817.25 See Appendix C: Item 1

V Total Value $228,696.5m V = E + D

INTERST RATE

The interest rate for the company is determined by the quality of the debt issued. In the 2010 10K

in the ―Credit-Risk-Related Contingent Features‖, Microsoft stated that they received a AAA

bond rating as of June 30, 2010 for long-term unsecured debt. Using the Standard & Poor‘s

index, the AAA bond rating of 10-yr Corporate Bonds yielded an interest of 3.12%.

TAX RATE

The tax rate for Microsoft was determined in two ways. One was by dividing the taxes paid into

the EBIT values for a few years, which averaged at about 36%. The other was to take Microsoft‘s

2010 annual taxable income, approximately $24billion, and see what federal tax bracket the

company fell into. Taxable income over $18million is in the 35% tax bracket, and therefore

Microsoft‘s tax rate is 35%.

Point Estimated MSFT Beta

A 0.88 B 1.01 C 1.04 D 1.07


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Figure 3.2: Growth Assumptions

Using the above data, Microsoft‘s weighted average cost of capital is

(

) (

) [ ]

DISCOUNTED CASH FLOWS MODEL

Companies that have fallen out of investing favor are good news for the value-investor, and Microsoft is

no exception. A company that is always late to be dominant in an industry (Microsoft is rarely the first to

enter a market), Microsoft is experiencing low stock prices indicating decreased shareholder expectations

and value from the previous decade, as well as relatively low expectations when compared to industry

comparables.

Figure 3.2 shows the ‗assumptions‘ for growth as determined by the percentage of each value to

revenues, or the growth percentage of that value on itself. The percentage-change and percentage-of-

revenue calculations, and the averages, are compiled into Appendix C: Item 2.

Sales Assume 8.0% growth until 2019, then 4% after that

COGS Assume constant 16.26% of revenues

Gross Profit Margin Sales-COGS

SG&A Assume constant 41.85% of revenues

EBITDA GP-SG&A

Depreciation Assume growth of 0.5% of previous years percent of revenue

EBIT EBITDA-Depreciation

EBIT*(1-tax rate)

Depreciation Assume growth of 0.5% of previous years percent of revenue

Capital Expenses Assume constant 4.36% of revenues

ΔNWC 0.51% growth of average NWC (taken from historical data)

A complete DCF – which utilizes these growth percentages – is in Appendix C: Item 3.

REVENUE (SALES) GROWTH ESTIMATE

A complete analysis of how we obtained an 8% growth rate for the first 10 years, followed by a 4%

growth rate indefinitely is located in Appendix C: Item 4.

Following the projection of sales, using these growth assumptions from Figure 3.2, were we able to

compute the projects of sales for Microsoft and therefore calculate all of the Pro-Forma Income Statement

values in order to find the Future Free Cash Flows.


16

In order to evaluate stock price, we determined Microsoft‘s terminal value to be $474.35 billion.

Discounted back to today and added to the present value of all future cash flows from DCF

gives the value of the firm. From the value of the firm, it is possible to determine the share price for

Microsoft stock by solving for equity and dividing by the current number of shares outstanding

Figure 3.3 is a table summation of these

calculations for the share price using DCF.

A share price of $33.80 indicated that the

current value of stock for Microsoft is

undervalued at its current price of $25.57

by $8.23. This is our best estimation of

intrinsic stock value and it avoids falling

into the trap of making bad comparisons.

However, because of the difference

between what Microsoft has done and how

the firm would like to be preforming, it is

hard to predict if there will be a major

reconstruction of the business model in order to maintain market cap and regain a position in the

spotlight with Apple and Google. While pointing out the more poignant issues Microsoft is facing with low

capital growth, and potentially uncertain sales as other firms rise to the top, our DCF for Microsoft

definitely displays the firm to be a sustainable success for years to come.

Terminal Value (of DFC) Value 2019 and

beyond $ 474,347.94

Value of Firm

PV Cash Flows 2011-18 $ 110,485.72

+ Terminal Value $ 188,665.78

VALUE OF FIRM $ 299,151.50

Value of Equity = val of firm - mkt val of debt

Value of firm $ 299,151.50

Market Value of debt $ 9,817.250

VALUE OF EQUITY $ 289,334.25

Value per Share = val of equity / # of shares out

Number shares out. 8560

Value of equity $ 289,334.25

VALUE PER SHARE $ 33.80

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚

𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚

𝑆 𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

# 𝑆 𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑚

𝑏

𝑺𝒉𝒂𝒓𝒆 𝑷𝒓𝒊𝒄𝒆 𝟑𝟑 𝟖𝟎

Figure 3.3: Table of calculation of share price for DCF


17

DIVIDEND DISCOUNTING MODEL

Our final model for valuing Microsoft stock is the Dividend Discount Model which is a relatively simple

measure to determine stock price. The trouble comes from estimating and calculating the values for

growth and expected return.

In order to estimate the future growth in dividends, we used 5 years-worth of quarterly dividends

payments. Appendix C: Item 5 consists of a table that shows the calculated dividend growth. Also

included is a table, Appendix C: Item 6, which displays the two calculated averages – geometric and

arithmetic. We chose to use the geometric average for the Dividend Discounting Model for Microsoft

because it was both downwardly conservative and also because we were looking at historical data, and the

geometric average accounts for compounding. The geometric average of dividend growth was 10.20%.

The constant model was chosen for Microsoft because they are a firm experiencing long-term stable

growth. Microsoft is no longer in a period of supernormal growth, and is not expected to be a high-growth

firm. This is reflected in the relatively stable stock prices over the past decade, indicating that investors do

not see innovation necessary to invest in the firm. We assumed constant growth for Microsoft because it is

currently in a stage of maturity, and we predict that over the course of the next 8-10 years, the company

will remain in a steady state of slow growth as it maintains a certain market cap but struggles to introduce

itself into new, emerging markets faster than its younger competitors.

The DDM for constant growth is Gordon‘s Growth Model, and is expressed by the following equation

Calculating next period‘s dividend is a naïve calculation, based solely upon the current dividend payout

and the projected growth rate of dividends. Therefore, by using the growth rate as determined by

historical dividends, we get a dividend of $0.1763.

This implies that Microsoft will pay a dividend of approximately 18 cents in the second quarter of the 2011

fiscal year. We already calculated the CAPM (see ―CAPM – Capital Asset Pricing Model‖) for previous

valuation models. Plugging all the variables in, we get a stock price of $17.89.

This model suggests that Microsoft‘s stock is overvalued by $7.89. The Gordon Growth model is best

suited for firms that are growing at a rate comparable or lower than the nominal growth in the economy,

and have established dividend payouts that they intend to continue with in the future. Overvalued stocks

are usually indicative of an inflated market price or deterioration in financial strength. Microsoft is not

suffering for inflated market prices like its high-growth competitors, and after careful analysis through

this report, is not experiencing a period of financial weakness either. Therefore, it appears that the DDM

is not a very accurate model for forecasting Microsoft‘s future stock price.


18

IV. CONCLUSIONS

Given the provided analysis, our group believes strongly that Microsoft is extremely undervalued and

should be considered a buy. Qualitatively speaking, the firm's ability to pursue opportunities are being

underestimated by the market (Bing, Mobile, Xbox) and its potential downfalls are exaggerated (the

eventual downfall of Windows OS + Office). With Windows Azure, which will leverage the enormous set of

developers, and the cross-pollination of product divisions, Microsoft is uniquely positioned to leverage its

core competencies in the market.

Quantitatively, we proved through comparables, DCF, and P/E that the underlying financials are not

correctly valued by investors. The P/E model was determined to be a poor indicator of Microsoft‘s stock

price because the P/E ratio of the industry is weighed too heavily towards the high-growth firms, and the

maturing Microsoft stocks are not providing the same yield. However, the P/E model did show that

Microsoft stock was heavily undervalued, which is in congruence with our DCF. The DCF also showed

heavily undervalued stock prices, indicating that future growth exceeds the expectations of the market

and investors. This is backed up by the security market line, which showed that the market‘s betas for

Microsoft place it way below our calculated CAPM trend-line. Finally, the DDM model was dismissed as

an accurate methodology for determining Microsoft‘s stock price because Microsoft is not showing any

signs that would lead to overvaluation.

The macroeconomic landscape is one that favors debt issuance, which is the reasoning behind Microsoft's

recent move to capture low lending rates; this move should not be interpreted as one of desperation (in

fact, Microsoft's balance sheet is excellent; the overall firm is one of four non-financial U.S. companies

with a AAA credit rating). See Appendix D: Item 1 for multiple charts and tables breaking-down

Microsoft‘s debt structure. In the immediate future, Microsoft should aggressively pursue growth

opportunities even more (mobile) and further embrace industry trends (collective shift to the "cloud").


19

BIBLIOGRAPHY

"About Microsoft: Your Potential. Our Passion.."Microsoft.com. Microsoft Corporation, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.microsoft.com/about/en/us/default.aspx>

"Historical Dividend Data for Microsoft (MSFT)."Dividend.com. Dividend.com LLC, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.dividend.com/historical/stock.php?symbol=MSFT>.

"Investor Relations." Microsoft.com. Microsoft Corporation, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.microsoft.com/investor/default.aspx>.

Maheshwari, Sapna, and Tim Catts. "Microsoft Plans $4.75 Billion, 4-Part Bond Sale."BusinessWeek.com. Bloomberg L.P., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.businessweek.com/news/2010-09-22/microsoft-plans-4-75-billion-4-part-bond-sale.html>.

"Microsoft Corporation, NASDAQ:MSFT News & Quotes." Google Finance. Google, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.google.com/finance?q=microsoft>.

"MSFT Microsoft Corporation." Morningstar.com. Morningstar, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://quote.morningstar.com/stock/s.aspx?t=msft>.

"MSFT: Microsoft Corporation." Yahoo Finance. Yahoo, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://finance.yahoo.com/q?s=MSFT>.

"MSFT Stock Quote - Microsoft Corporation."NASDAQ.com. NASDAQ Stock Market, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://quotes.nasdaq.com/asp/SummaryQuote.asp?symbol=MSFT&selected=MSFT>.

"Microsoft (MSFT) Stock Research, Investment News, & SWOT Analysis." WikiWealth.com. Guerilla Investments LLC, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.wikiwealth.com/research:msft>.

"S&P 500 Equity Indeces." StandardAndPoors.com. Standard & Poor‘s Financial Services LLC., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline;+filename%3DFactsheet_SP_500.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application/pdf&blobkey=id&blobheadername1=content-type&blobwhere=1243765720036&blobheadervalue3=UTF-8>.

Siegler, MG. "That‘s Ballmer With A ―B‖ — For ―Billions‖." TechCrunch.com. AOL, Inc., 5 Nov. 2010. Web. 18 Nov 2010. <http://techcrunch.com/2010/11/05/ballmer-stock-sale/>.

Wilcox, Joe. "Why won't Wall Street give Microsoft a break?." BetaNews.com. Betanews, Inc., 7 Nov. 2010. Web. 18 Nov 2010. <http://www.betanews.com/joewilcox/article/Why-wont-Wall-Street-give-Microsoft-a-break/1289152037>.

http://www.microsoft.com/about/en/us/default.aspx

http://www.dividend.com/historical/stock.php?symbol=MSFT

http://www.microsoft.com/investor/default.aspx

http://www.businessweek.com/news/2010-09-22/microsoft-plans-4-75-billion-4-part-bond-sale.html

http://www.businessweek.com/news/2010-09-22/microsoft-plans-4-75-billion-4-part-bond-sale.html

http://www.google.com/finance?q=microsoft

http://quote.morningstar.com/stock/s.aspx?t=msft

http://finance.yahoo.com/q?s=MSFT

http://quotes.nasdaq.com/asp/SummaryQuote.asp?symbol=MSFT&selected=MSFT

http://www.wikiwealth.com/research:msft

http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline;+filename%3DFactsheet_SP_500.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application/pdf&blobkey=id&blobheadername1=content-type&blobwhere=1243765720036&blobheadervalue3=UTF-8





http://techcrunch.com/2010/11/05/ballmer-stock-sale/

http://www.betanews.com/joewilcox/article/Why-wont-Wall-Street-give-Microsoft-a-break/1289152037

http://www.betanews.com/joewilcox/article/Why-wont-Wall-Street-give-Microsoft-a-break/1289152037


20

APPENDIX A

ITEM 1: breakdown of sales and market share for various Microsoft departments

Microsoft Corporation is the world's largest software maker by revenue, with $58.43 billion of revenue in

FY2009. It develops, manufactures, licenses, and supports a range of software products and services for

various computing devices worldwide. Full-time employees in 2009 exceeded 90,000 worldwide. While

the bulk of Microsoft‘s profits derive from corporate contracts, a significant amount of its profits result

from consumers. Despite the prevalence of other operating systems (OSX, Linux), Windows is growing in

market share. With the release of Windows 7 in December 2009, Windows finished the year with roughly

a 92% market share. Microsoft reported a record revenue of roughly $19 billion for 2Q10, a 14% increase

(YoY) from 2Q09. Growth was primarily driven by the well-received release of Windows 7, which was

launched globally in October 2009 and sold more than 60 million copies in 2Q10 (the fastest selling OS in

history). It was also boosted by a 15-17% YoY increase in unit PC sales, as well as the sale of 5.2 million

XBOX 360 consoles. Its Online Services Division experienced a 5% YoY decline, hurt by a 2% decline in

online advertising revenue. However, MSFT's ability to simultaneously cut costs resulted in a net income

of $6.66 billion for the quarter, a 60% increase over 2Q09. The company also managed to generate $5.0

billion in operating cash flow, $4.8 billion of which it returned to investors. Microsoft‘s products and

service offerings fall into five divisions or business sectors: Client - Windows/Windows Live Division,

(28% of revenue, 45% of net income in FY2009), Server and Tools - Products for IT Professionals (22% of

revenue, 16% of net income), Business (32% of revenue, 42% of net income), Online Services (5% of

revenue, -4% of net income), Entertainment and Devices (13% of revenue, 1% of net income).


21

ITEM 2: Calculation of Beta from monthly changes in return on Microsoft and the S&P 500


22

APPENDIX B

ITEM 1: Table of Monthly Yields on 10-yr Treasury Notes: used to calculate Risk-Free Return for CAPM

Risk-Free Return = 3.902%


23

Item 2: Daily year-over-year yield of the S&P 500


24

APPENDIX C

ITEM 1: Table for Market Value of Debt: used to calculate WACC

ITEM 2: Calculations to determine growth of sales and subsequent growth of margins

Calculating Growth 2006 2007 2008 2009 2010 AVERAGES ASSUMPTIONS

COGS 15.04% 18.10% 15.79% 16.42% 15.95% 16.26%

assume constant 16.26% revenues

DEP

2.24% 2.82% 3.40% 4.38% 4.04% 3.38% ave dep change %revenue per year

- 0.58% 0.59% 0.98% -0.34% 0.45% ave difference per year as % revenue

- 45.45% 42.78% 24.61% -2.15% 27.67% ave dep change % of previous year growth

SG&A 42.55% 41.85% 40.60% 43.30% 40.97% 41.85% assume constant 41.85% of revenues

Cap.Ex 3.56% 4.43% 5.27% 5.34% 3.19% 4.36% assume constant 4.36% of revenues

ΔNWC - -19.86% -5.06% 15.21% 11.75% 0.51% growth of ave NWC (taken from historical data)


25

ITEM 3: DCF Model

Calculating WACC

COST OF CAPITAL 10.79%

CAPM (Cost of Equity) 11.18%

Rf 3.902%

Rm 10.90%

Market Risk Premium 7.00%

Beta 1.04

After-Tax Cost of Debt 2.03%

interest* 3.12%

tax rate (from bracket) 35%

Book Value of Debt 9817.250

Market Value Equity 218879.2

Share Price 25.57

# Shares outstanding 8,560

Total Value 228696.450

Calculating NWC

Current Assets 49,010.00 40,168.00 43,242.00 49,280.00 55,676.00

Current Liabilities 22,442.00 23,754.00 29,886.00 27,034.00 26,147.00

NWC 26,568.00 16,414.00 13,356.00 22,246.00 29,529.00

ΔNWC -10,154.00 -3,058.00 8,890.00 7,283.00

Terminal Value (of DFC)

Value 2019 and beyond $ 474,347.94

Value of Firm

PV Cash Flows 2011-18 $ 110,485.72

+ Terminal Value $ 188,665.78

VALUE OF FIRM $ 299,151.50

Val of equity = val of firm - mkt val of debt

Value of firm $ 299,151.50

Market Value of debt $ 9,817.250

VALUE OF EQUITY $ 289,334.25

Val per share = val of equity / # of shares out

Number shares out. 8560

Value of equity $ 289,334.25

VALUE PER SHARE $ 33.80

Revenue Growth Rate Estimate* 8.00%

Terminal Growth Rate Estimate* 4.00%

*from Appendix C: Item 4


26


27

ITEM 4: Revenues (Sales) Growth Predication Explanations


28

ITEM 5: DDM Growth Calculations Per DPS

ITEM 6: Table outlining DDM Calculations for Stock Price


29

APPENDIX D

Item 1: capital structure and debt structure (from Morningstar)

Microsoft Report

Documents