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Important disclosures appear on the last page of this report.
Krause Fund Research
Spring 2011
Technology Recommendation: Buy
Analysts
Nick Petersen
[email protected]
Adam Lewis
[email protected]
Brian Shea
[email protected]
Company Overview
Microsoft Corporation (MSFT) is a global leader in the
diversified software industry, with 2010 revenue of $62.4
billion. Microsoft divides operations into five business
segments: Windows & Windows Live division, server and
tools, online services division, Microsoft business division,
and entertainment and devices division. The Windows &
Windows Live division and Microsoft business division are
the primary drivers of revenue, accounting for 28.5% and
30.3% of total revenue for 2010.
Stock Performance Highlights 52 week High $31.58
52 week Low $22.73
Beta Value .77
Average Daily Volume (3 Month) 59.06 m
Share Highlights Market Capitalization $213.17 b
Shares Outstanding 8.4 b
Book Value per share $5.77
EPS (last fiscal year) $2.13
P/E Ratio 11.91
Dividend Yield 2.05%
Dividend Payout Ratio 24.4%
Company Performance Highlights ROA 21.79%
ROE 40.63%
Sales $62.4 b
Financial Ratios Current Ratio 2.13
Debt to Equity .86
Microsoft Corporation (NYSE:
MSFT)
April 17, 2011
Current Price $25.37
Target Price $35-37
90’s Golden Stock Still Performs
Microsoft Window’s user-friendly interface and easy
navigation have allowed the software to capture 90% of the
operating systems market. The nearest competitor, Apple,
competes with only 5% market share. Microsoft’s strong and
trusted brand image gives the company a sustainable and long-
term competitive advantage.
Cloud computing is expected to grow at 21.6% per year
until 2014, when revenue is expected to reach $29.5 billion.
With Microsoft’s recent investment in the industry, the company
will use this technology to drive future growth.
Microsoft consistently invests 15% of annual revenue into
R&D. This investment will help Microsoft remain a top
innovator in software.
Microsoft’s expansion into the Smartphone market through
a partnership with Nokia allows Microsoft’s Windows Phone 7
to compete with established competitors like Google’s Android
and RIM’s Blackberry.
One Year Stock Performance
Source: Yahoo!Finance
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Macroeconomic Factors
Macroeconomic factors such as GDP and
unemployment are highly correlated with
demand for computer software. During the
2008-2009 economic crises, individuals and
organizations reduced spending in the software
industry. Recently, the economy has been
improving; real GDP is expected to rise by 2.4%
in 2011. Assuming the economic rebound
continues, we expect growth in the software
industry to return the normal mid-to-high single-
digit range in 2011 (S&P).
Going Lean
Following the credit crisis and resulting
recession, companies are treading cautiously.
Even with an improving economy, companies
hesitate to reinvest in human capital at their pre-
recession levels. The current U.S.
unemployment rate is 9.0%; the Obama
administration projects an 8.6% unemployment
rate for 2012 (Huffington Post). This data
suggests that while the economy is growing,
companies are reluctant to hire more workers.
At the same time, corporate after-tax profits are
increasing, as shown below: g g g g g g g g g g
Rising corporate profits, combined with a steady
and high unemployment rate, means that
companies are “going leaner”. This approach
means that companies are implementing
growth-strategies without hiring workers, which
suggests that companies are becoming more
efficient.
This trend is important to Microsoft because
profits drive corporate technology spending,
which gives Microsoft a strong growth
opportunity (WSJ). We expect the “lean” trend
to continue, driving corporations to invest extra
cash in capital, such as information technology.
On a macroeconomic level, this change could
potentially raise structural unemployment levels
as companies choose to invest in technology
over workers.
Consumer Spending on Technology
From the individual perspective, consumer tech
spending is highly dependent on income and
discretionary spending. The two biggest threats
that we foresee to consumer spending are rising
oil prices and rising inflation; both threats
reduce consumer’s discretionary income. The
demand for oil will be inelastic in the short to
medium term, as our economy continues to
search for a renewable and sustainable
substitute. Likewise, inflation, especially in food
prices, will impact consumer discretionary
income detrimentally. Although inflation hurts
consumer spending, we do not foresee rising
prices as a serious economic issue in the United
States over the next two to three years. We
expect domestic inflation to rise at a 2-3%
annual rate.
U.S Inflation – Percentage Change in CPI
(Forcasts.org)
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Energy Prices
Rising energy costs could potentially slow the
current economic recovery. The U.S. Energy
Information Administration forecasts the
average retail gasoline price to increase to $3.70
per gallon for the current year, and $3.80 per
gallon in 2012. This increased cost will decrease
consumer discretionary spending as well as
increase transportation and production costs. As
fuel supply remains relatively stable, increased
fuel demand in developing countries will drive
oil prices upward. We expect oil prices to reach
prices as high as $140 per barrel in the next two
to three years, compared to current prices of
$108 per barrel.
Crude Oil Prices – Dollars per Barrel
(Forecasts.org)
Government and Tech Spending
Despite budget cuts, the United States is
increasing its total information technology by
3.6% for the current year (FY2011). The
Department of Defense, Department of
Homeland Security, and Department of Health
and Human Services primarily drive this
increase in spending (USAspending.gov). This
is pertinent to Microsoft because the spending
will contribute to future revenue growth.
The Software Industry
The Main Players: Operating Systems
Market Share:
Microsoft – 90%
Apple – 5%
Linux (& others) – 5%
(S&P)
What Drives Software Sales?
Since computer hardware companies depend on
software companies to produce operating
systems and programs to run hardware, software
companies must rely on sales of hardware
manufacturers. For example, a consumer will
likely purchase a new computer equipped with
the most recent Windows operating software
rather than purchasing the software
independently. 75% of Windows sales are
directly to hardware producers.
Innovation drives demand for computer
software. In the early 2000’s, Windows XP was
the dominant operating system software. By
2007, Windows Vista became the new, up-to-
date operating system. Today, Windows 7 is the
latest and most advanced operating system for
computers. We can expect new versions in the
coming years because technology becomes
obsolete quickly.
Two of the main opportunities for future growth
in software are cloud computing and
smartphones. Both technologies will demand
innovative, user-friendly, and efficient operating
systems. If the current operating systems market
is indicative of which systems consumers and
businesses will choose for smart phones and
cloud platforms, we see upside to investors of
Microsoft.
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Future Opportunities – Cloud Computing
Microsoft originally impacted the software
industry with BASIC, followed by MS-DOS,
and now Windows. Microsoft sees its next wave
in cloud computing, which is a technology that
improves the ability to distribute software and
information over the Internet. Users are able to
access tasks and programs from nearly
anywhere with this technology; we expect the
“internet cloud” to drastically improve the
accessibility and distribution of information,
which will increase corporate and individual
efficiency. Estimated revenue from cloud
computing was $11.1 billion in 2009 and is
forecasted to grow at 21.6% annually until
2014, when expected revenue will reach $29.5
billion (IDC).
Cloud computing software is an operating
system that runs on a server from a remote
location. The programs and information on this
operating system connect servers and data
centers to consumers and businesses. The
advantage of using a cloud platform is that a
user does not need to hassle with updates to the
operating system or the storage of files.
Microsoft’s significant investment in research
and development, the company’s market
capitalization, and the company’s experience as
an innovator lead us to see Microsoft as the
market leader in this emerging industry. Since
businesses and consumers have been using
Windows for years, they have a disposition to
choose Windows Azure as a cloud platform.
Microsoft has a three-year partnership with Dell
to deploy and manage virtualization and private
cloud technologies. The deal involves applying
Microsoft’s cloud computing platform, Azure,
to Dell’s hardware. This partnership should
secure Microsoft’s Azure platform as a major
market player in cloud services.
Future Opportunities: Smart Phones
Another significant opportunity for software
companies is the smartphone market. These
phones have evolved into handheld computers
that can perform many of the same tasks as a
personal computer. Like a computer, these
smartphones need easy-to-use operating systems
to appeal to consumers. Worldwide smartphone
use grew by 75 percent in 2010 and is expected
to grow by 49.2% in 2011 (IDC). Apple and
Google currently control most of the
smartphone operating systems, but Windows
recently released software that is expected to
capture significant market share by 2015,
putting the Windows 7 phone second only to
Google’s Android (IDC).
Microsoft
Microsoft is the world’s leader in development
and innovation in the software industry. The
company was founded by Bill Gates in 1975 and
began as a developer of the BASIC computer
program and MS-DOS. The company followed
these programs with Windows, a program that
currently dominates the operating systems
market. In the past ten years, Microsoft has
diversified its operations by producing computer
hardware and consumer electronics such as the
XBOX gaming system and Zune mp3 player,
while continuing the advancement of its
operating systems and desktop software.
Corporate Strategy
Microsoft is in the mature stage of its business
cycle, but has the resources to capture growth
opportunities in the technology sector. While
the company will probably never revisit the
growth rates of the 90’s, Microsoft’s innovative
products and services will create steady long-
term growth for the company. Microsoft
allocates about 15% of its annual revenue to
research and development (MSFT 10K). This
reinvestment leads to newer, better, and more
efficient products and services that individuals
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and organizations continue to purchase. Few
could deny that Windows operating systems and
Microsoft Office software have significantly
increased efficiency. Consumers have learned
that Microsoft develops high-quality and useful
products. We expect this trust to carry forward,
giving the company a sustained competitive
advantage in creating new products. As the
company invests in the “internet cloud,” this
competitive advantage will set the company
apart from competitors in the new industry.
Products and Services
Microsoft reported record revenue of $62.48
billion for its fiscal year ending June 30, 2010,
an increase of 7% from fiscal year 2009.
Microsoft divides its products and services into
five different segments: Windows and Windows
Live, Microsoft Business, Server and Tools,
Online Services, and Entertainment and
Devices. Although Microsoft is primarily a
software developer, the company has recently
begun to create forms of computer hardware and
consumer electronics. This distribution of their
revenue over the past three years is as follows:
Year Ended
June 30,
Revenue (in
millions)
2010 2009 2008
Windows &
Windows Live
$17,788 $14,690 $16,815
Server and
Tools
$14,878 $14,276 $13,217
Online
Services
$2,198 $2,110 $2,164
Microsoft
Business
$18,909 $18,864 $18,904
Entertainment
and Devices
$8,114 $8,035 $8,502
Unallocated /
Other
$597 $462 $818
Consolidated $62,484 $58,437 $60,420
(MSFT 10-K)
The “Windows & Windows Live” division is
typically Microsoft’s largest revenue-generator,
driven by the Windows operating system.
Seventy-five percent of this division’s revenue
stems from operating system software that is
pre-installed by original equipment
manufacturers (OEMs) that produce computers,
such as Dell and Hewlett-Packard. The other
25% of revenues are derived from commercial
retail sales of Windows without included
hardware.
The “Microsoft Business” division develops
productivity-increasing software and services
for businesses and individuals. The primary
products of this division are Microsoft Office,
SharePoint, Exchange, and Lync. These
products generate 90% of the division’s
revenue.
The “Server and Tools” division develops
software and services for information
technology professionals. Products and services
in this division include Windows Server,
Microsoft SQL, Server, Windows Azure,
Windows Embedded device platforms, and
Enterprise Services.
The Online Services division controls
Microsoft’s search engines: Bing and MSN.
These search engines generate revenue by
selling search and display advertising.
The Entertainment and Devices division is
Microsoft’s newest segment. The division
develops hardware, software, and services to
entertain individuals such as the Xbox 360
gaming console, Xbox Games, Xbox live
subscription and accessories, Zunes, and the
Windows Phone.
Research and Development
Microsoft spent $8.7 billion, $9.0 billion, and
$8.2 billion on research and development
expenses during fiscal years 2010, 2009, and
2008, respectively. These expenditures comprise
14%, 15%, and 14% of revenue each year,
respectively (MSFT 10K). Microsoft plans to
continue making these expenditures to create
growth opportunities. Outside the already
discussed opportunities in cloud computing,
Microsoft sees opportunity in natural user
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interfaces, which allow users to control devices
using touch, gestures, handwriting, and speech
recognition.
Major Customers
According to Microsoft’s 2010 10-K, no
individual customer accounted for more than
10% of revenue in any of the past three years.
The most significant type of customer is original
equipment manufacturers (OEMs) that produce
hardware that depends on Microsoft’s software
to operate. This means that the demand for
Windows operating software is derived from the
demand for personal computers.
International Trends
Microsoft has a domestic and international
market. International revenues produce a large
portion of total revenue each year, as seen in the
graph below:
(MSFT 10-K)
We expect that international sales will continue
to steadily increase, driven by sales in emerging
markets.
Partnership with Nokia
The mobile and smartphone markets are
contributing to Microsoft’s international growth.
Between the third quarter of 2009 and the third
quarter of 2010, worldwide mobile phone sales
grew by 35% while smartphone sales grew by
96% (Gartner). Microsoft and Nokia, the current
world market leader in mobile phones with 35%
market share, jointly created a partnership
where Nokia will adopt the Windows Phone as
its primary smartphone. This alliance with
Nokia will drive future sales of the Windows
Phone in a mutually beneficial relationship for
both companies; Nokia’s dominance in the
mobile phone market will be supported by
Microsoft’s dominance in the application
software and operating systems market.
(Microsoft.com).
Competition
Mac vs. PC
Consumers have been led to believe that Apple
will soon dominate the software industry with
the Mac operating system; however, the Mac vs.
PC battle is less a threat to Microsoft than many
consumers would suspect. As of August 2010,
Windows-based PCs encompassed 91% of the
PC market. At the same time, Apple composed
only 5% of this market (S&P NetAdvantage).
Linux also captures about 5% of the market.
(S&P NetAdvantage). We expect that Windows
will remain as the dominant operating system in
the future, based on its user-friendly interface
and widely-used status. Much of Apple’s
revenue growth comes from strong performance
in the hardware and consumer electronics
industries.
Oracle vs. Access
Microsoft maintains a commanding presence in
desktop software. Microsoft Word and Excel
dominate the word processor and spreadsheet
software markets (S&P). Microsoft Access is a
major player in the database market; however,
Oracle poses a threat with its database program.
Although Oracle’s database has more features
and capabilities, Microsoft Access is a cheaper,
easier-to-use program.
Google vs. Microsoft
Google competes with Microsoft’s Bing and
MSN search engines. Google has historically
been the market’s dominant search engine.
0
10,000
20,000
30,000
40,000
2008 2009 2010
Mill
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f D
olla
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U.S.
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However, in the past year, Bing searches have
increased by 6% while Google searches have
decreased by 2% (Hitwise.com). Since
Microsoft’s search engines are not a large
portion of its operations, Microsoft is more a
threat to Google than Google to Microsoft.
Google focuses its operations on the Internet,
while Microsoft focuses on computer software.
Microsoft’s earnings are the highest of its
competitors; this profit leverages extra research
and development investment to maintain a
dominant position in the industry.
A larger battle between Google and Microsoft
concerns smart phones, which was discussed
above.
The following table compares Microsoft to
several of its main competitors:
(Yahoo Finance)
Valuation Analysis
Revenue Forecasting
We project that Microsoft’s biggest increases in
revenue will come from their server and tools
division, which includes their Azure cloud
platform, and the company’s entertainment and
devices division, which includes the Windows 7
phone. This is based on the projected growth for
cloud computing and smart phones through the
continuing value year. We also expect steady
growth in the Microsoft Business division,
fueled by Microsoft office, and growth in the
Windows and Windows Live division as more
companies upgrade to Windows 7.
CV Growth Rate
We chose 3 percent as our continuing value
growth rate to match the average growth in
GDP. The continuing value year represents the
end of a high growth period based on cloud
computing and smart phone markets.
Cost of Revenue
We expect slight increases in costs of revenue as
inflation affects inputs.
Research and Development
Microsoft consistently dedicates approximately
15 percent of their revenue into research and
development. The company believes that the
foundation of their innovation and technological
advancement comes through R&D spending.
Plant Property and Equipment
Microsoft will spend more on PPE in the future
as they open more data centers to store
information in their servers related to their cloud
computing activities.
WACC
CAPM:
Beta: 0.77 based on Bloomberg’s 3-year,
weekly raw beta.
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Risk Free Rate: 4.43% as the YTM on a 30-
year Treasury Bond.
Market Risk Premium: 4.34%
Cost of Equity: 7.77%
After-tax Cost of Debt: 1.92%. Microsoft has
rarely issued debt. We believe that the company
will pay off all the debt within the short-run as
they increase their cash balances with growth.
Invested Capital and Return on Invested
Capital
Microsoft invests majorly in human capital.
Since human capital does not appear on the
balance sheet, ROIC appears unnaturally high.
We believe that as Microsoft invests more in
PPE for data centers, they will reach a more
stable ROIC in the 100-150% range by their
continuing value year.
Share Repurchases
Microsoft often repurchases shares of common
stock with their excess cash. In recent years, the
company issued debt to make large share
repurchases. We expect Microsoft to return to
historic repurchases of around $6 billion
annually.
Dividend Policy
Since 2004, Microsoft has paid a dividend to its
shareholders. In the most recent years, the
dividend has been approximately 27 percent of
its earnings per share. We make the assumption
to hold this constant through the continuing
value year.
Relative P/E Analysis
Microsoft is a very unique company in which
the products and services they provide have
very few companies that have the same
offerings. Due to the nature of this analysis, we
find it hard to achieve a legitimate projection
based on the inputs.
Sensitivity Analysis
We conducted a series of sensitivity analysis
scenarios to provide a reasonable range of stock
prices based on our key assumptions. The first
scenario, shown in the table below, compares
the impact of our beta and continuing value
growth estimates. The reasonable ranges for
these inputs generated a valuation above
Microsoft’s current stock price, reinforcing or
“Buy” rating.
Beta
$42.77 0.70 0.75 0.80 0.85
2.50% 45.34 43.35 41.55 39.90
CV 2.75% 45.42 43.44 41.63 39.97
Growth 3.00% 45.51 43.52 41.70 40.05
3.25% 45.60 43.60 41.78 40.12
3.50% 45.69 43.68 41.86 40.20
The second scenario contrasts the risk free rate
and the market risk premium, generating a
reasonable range of values shown below. Once
again, this sensitivity analysis produced
valuations above the current stock price.
Beta
$42.77 0.70 0.75 0.80 0.85
4.00% 50.11 47.67 45.48 43.49
Risk- 4.25% 47.32 45.16 43.20 41.41
Free 4.50% 44.85 42.91 41.15 39.54
Rate 4.75% 42.64 40.90 39.31 37.85
5.00% 40.65 39.08 37.63 36.30
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Finally, we tested our Beta against our estimated
market risk premium. The beta is perhaps the
most subjective piece of data, while the market
risk premium is based on over 80 years of data.
Even with variation in each, the stock price does
not fall below the current price, which gives
investors a wide margin of safety.
Beta
$42.77 0.70 0.75 0.80 0.85
4.00% 47.94 45.88 44.01 42.29
Market 4.25% 46.13 44.12 42.29 40.61
Risk 4.50% 44.46 42.49 40.71 39.08
Premium 4.75% 42.91 41.00 39.25 37.67
5.00% 41.48 39.61 37.91 36.36
Investment Outlook
Technological innovation is the foundation of
Microsoft’s success. Microsoft plans to continue
investing in research and development to create
new growth opportunities. The most recent
financial crisis has forced many companies to
re-evaluate expenditures and operations, which
we predict will benefit Microsoft as companies
focus on improved efficiency through
technology. We think Microsoft holds a
sustainable competitive advantage in operating
systems by offering the most widely-used and
trusted software in the industry. We think that
attempts to chisel away significant Windows
market share will be futile. An investor cannot
expect that Microsoft will recreate multi-
thousand percent returns as it did in the 1990’s,
but the company has matured into a healthy and
dominant player in software that we see offering
investors market returns, or slightly above
market returns, over the medium to long-term.
This optimistic outlook, combined with our
valuation models, make Microsoft an attractive
investment.
Important Disclaimer
This report was created by students enrolled in
the Security Analysis (6F:112) class at the
University of Iowa. The report was originally
created to offer an internal investment
recommendation for the University of Iowa
Krause Fund and its advisory board. The report
also provides potential employers and other
interested parties an example of the students’
skills, knowledge and abilities. Members of the
Krause Fund are not registered investment
advisors, brokers or officially licensed financial
professionals. The investment advice contained
in this report does not represent an offer or
solicitation to buy or sell any of the securities
mentioned. Unless otherwise noted, facts and
figures included in this report are from publicly
available sources. This report is not a complete
compilation of data, and its accuracy is not
guaranteed. From time to time, the University of
Iowa, its faculty, staff, students, or the Krause
Fund may hold a financial interest in the
companies mentioned in this report.
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Citations http://www.netadvantage.standardandpoors.com
.proxy.lib.uiowa.edu/NASApp/NetAdvantage/sh
owIndustrySurvey.do?code=cos
http://www.huffingtonpost.com/2011/02/14/oba
ma-2012-budget-unemployment-
growth_n_822928.html
http://seekingalpha.com/article/252544-
corporate-profit-margins-likely-to-fall-here-s-
why
http://online.wsj.com/article/SB1000142405274
8703439504576116400253142750.html
http://it.usaspending.gov/?q=content/current-
year-fy2011-continuing-resolution
http://www.idc.com/about/viewpressrelease.jsp?
containerId=prUS22692511§ionId=null&el
ementId=null&pageType=SYNOPSIS
http://www.gartner.com/it/page.jsp?id=1466313
http://www.microsoft.com/presspass/press/2011
/feb11/02-11partnership.mspx
http://www.hitwise.com/us/press-center/press-
releases/bing-searches-increase-twenty-one-
percent/
Microsoft 10-K (SEC.gov)
http://www.idc.com/getdoc.jsp?containerId=prU
S22762811
http://www.computerworld.com/s/article/92084
78/Android_drives_big_smartphone_growth_in
_2010_IDC_says
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Business Segments: 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVWindows and Windows Live Division 16,815 14,690 17,788 19,567 21,132 22,823 24,649 26,127 26,911 Growth per year -12.6% 21.1% 10.0% 8.0% 8.0% 8.0% 6.0% 3.0% Percentage of Revenue 27.8% 25.1% 28.5% 29.2% 29.3% 29.4% 29.7% 29.9% 29.9%
Server and Tools Division 13,217 14,276 14,878 17,110 19,505 22,041 24,245 25,699 26,470 Growth per year 8.0% 4.2% 15.0% 14.0% 13.0% 10.0% 6.0% 3.0% Percentage of Revenue 21.9% 24.4% 23.8% 25.6% 27.1% 28.4% 29.2% 29.5% 29.5%
Online Services Division 2,164 2,110 2,198 2,308 2,423 2,544 2,646 2,752 2,835 Growth per year -2.5% 4.2% 5.0% 5.0% 5.0% 4.0% 4.0% 3.0% Percentage of Revenue 3.6% 3.6% 3.5% 3.4% 3.4% 3.3% 3.2% 3.2% 3.2%
Microsoft Business Division 18,904 18,864 18,909 19,476 20,061 20,662 21,282 21,921 22,578 Growth per year -0.2% 0.2% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% Percentage of Revenue 31.3% 32.3% 30.3% 29.1% 27.8% 26.6% 25.6% 25.1% 25.1%
Entertainment and Devices Division 8,502 8,035 8,114 8,439 8,945 9,660 10,240 10,752 11,075 Growth per year -5.5% 1.0% 4.0% 6.0% 8.0% 6.0% 5.0% 3.0% Percentage of Revenue 14.1% 13.7% 13.0% 12.6% 12.4% 12.4% 12.3% 12.3% 12.3%
Unallocated and other 818 462 597 - - - - - - Growth per year -44% 29% - - - - - - Percentage of Revenue 1.4% 0.8% 1.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Consolidated Revenues 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869
REVENUE DECOMPOSITION
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Microsoft Inc.Income StatementFiscal Years Ending June 30(numbers in millions)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVRevenue 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869Operating expenses:Cost of Revenue 11,598 12,155 12,395 13,380 15,134 17,101 19,104 20,068 20,670Research and Development 8,164 9,010 8,714 10,035 10,810 11,660 12,459 13,088 13,480Sales and marketing 13,039 12,879 13,214 14,718 15,855 17,101 18,274 19,195 19,771General and administrative 5,127 3,700 4,004 5,017 5,405 5,830 6,230 6,544 6,740Employee severence 0 330 59 0 0 0 0 0 0Total operating expenses 37,928 38,074 38,386 43,150 47,203 51,691 56,067 58,895 60,662
Operating Income 22,492 20,363 24,098 23,749 24,863 26,040 26,995 28,357 29,208Interest Expense 0 0 (151) 0 0 0 0 0 0Dividend/Interest Income 888 706 843 1,254 1,351 1,457 1,557 1,636 1,685Gain/Loss on Investment 434 (683) 208 418 450 486 519 545 562Gain/Loss on Foreign Currency 0 (509) 1 0 0 0 0 0 0Other Income (Expense) 0 (56) 14 0 0 0 0 0 0Total Other Income (Expense) 1,322 (542) 915 1,672 1,802 1,943 2,077 2,181 2,247
Income Before Taxes 23,814 19,821 25,013 25,422 26,664 27,983 29,072 30,538 31,454Provision for income taxes 6,133 5,252 6,253 10,035 10,810 11,660 12,459 13,088 13,480
Net Income 17,681 14,569 18,760 15,387 15,855 16,323 16,612 17,450 17,974
Earnings per share:Basic 1.9 1.63 2.13 1.77 1.84 1.91 1.96 2.07 2.14
Weighted avg. shares outstanding:Basic 9,328 8,945 8,813 8,705 8,613 8,538 8,477 8,430 8,395
Cash div. declared per common sh. 0.44 0.52 0.52 0.48 0.50 0.52 0.53 0.56 0.58
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Microsoft Inc.Balance SheetFiscal Years Ending June 30(numbers in millions)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVAssetsCurrent assets:Cash and cash equivalents 10,339 6,076 5,505 9,090 26,296 43,734 61,236 79,314 97,778Short-term investments 13,323 25,371 31,283 32,221 33,188 34,184 35,209 36,266 37,354Total cash, cash equivalents, and ST investments 23,662 31,447 36,788 41,312 59,484 77,918 96,445 115,579 135,131Accounts receivable, net 13,589 11,192 13,014 13,380 14,413 15,546 16,612 17,450 17,974Inventories 985 717 740 1,338 1,441 1,555 1,661 1,745 1,797Deferred income taxes 2,017 2,213 2,184 1,820 1,456 1,092 728 364 0Other current assets 2,989 3,711 2,950 3,345 3,603 3,887 4,153 4,363 4,493Total current assets 43,242 49,280 55,676 61,195 80,398 99,998 119,600 139,501 159,396Property and equipment, net of accumulated depreciation 6,242 7,535 7,630 8,028 8,648 9,328 9,967 10,470 10,784Equity and other investments 6,588 4,933 7,754 7,987 8,226 8,473 8,727 8,989 9,259Goodwill 12,108 12,503 12,394 12,394 12,394 12,394 12,394 12,394 12,394Intangible assets, net 1,973 1,759 1,158 1,338 1,441 1,555 1,661 1,745 1,797Deferred income taxes 949 279 0 0 0 0 0 0 0Other long-term assets 1,691 1,599 1,501 2,007 2,162 2,332 2,492 2,618 2,696Total assets 72,793 77,888 86,113 92,948 113,270 134,079 154,842 175,717 196,326
Liabilities and stockholders' equityCurrent liabilities:Accounts payable 4,034 3,324 4,025 4,014 4,324 4,664 4,984 5,235 5,392Short-term debt 0 2,000 1,000 0 0 0 0 0 0Accrued compensation 2,934 3,156 3,283 3,261 3,513 3,789 4,049 4,254 4,381Income taxe payable 3,248 725 1,074 2,509 2,702 2,915 3,115 3,272 3,370Short-term unearned revenue 13,397 13,003 13,652 13,380 14,413 15,546 16,612 17,450 17,974Securities lending payable 2,614 1,684 182 0 0 0 0 0 0Other current liabilities 3,659 3,142 2,931 3,718 4,531 5,363 6,194 7,029 7,853Total current liabilities 29,886 27,034 26,147 26,882 29,484 32,277 34,954 37,240 38,970Long-term debt 0 3,746 4,939 4,116 3,293 2,470 1,646 823 0Long-term unearned revenue 1,900 1,281 1,178 1,338 1,297 1,244 1,246 1,309 1,348Deferred income taxes 0 0 229 0 0 0 0 0 0Other long-term liabilities 4,721 6,269 7,445 7,436 9,062 10,726 12,387 14,057 15,706Total liabilities 36,507 38,330 39,938 39,771 43,135 46,717 50,233 53,429 56,024
Stockholder's equity:Common stock and PIC - 24,000 shares authorized 62,849 62,382 62,856 60,017 57,424 55,095 53,052 51,317 49,912Retained Earnings (Deficit) -26,563 -22,824 -16,681 -6,840 12,711 32,267 51,556 70,972 90,390Total stockholder's equity 36,286 39,558 46,175 53,177 70,135 87,362 104,608 122,288 140,302
Total liabilities and stockholder's equity 72,793 77,888 86,113 92,948 113,270 134,079 154,842 175,717 196,326
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Microsoft Inc.Cash Flow StatementFiscal Years Ending June 30(numbers in millions)
2008 2009 2010OperationsNet income 17,681 14,569 18,760Adjustments to reconcile net income to net cash from operations:Depreciation, amortization, and other noncash items 2,056 2,562 2,673Stock-based compensation 1,479 1,708 1,891Net recognized losses (gains) on investments and derivatives (572) 683 (208)Excess tax benefits from stock-based compensation (120) (52) (45)Deferred income taxes 935 762 (220)Deferral of unearned revenue 24,532 24,409 29,374Recognition of unearned revenue (21,944) (25,426) (28,813)Changes in operating assets and liabilities:Accounts receivable (1,569) 2,215 (2,238)Other current assets 153 (422) 420Other long-term assets (98) (273) (223)Other current liabilities (748) (3,371) 1,295Other long-term liabilities (173) 1,673 1,407Net cash from operations 21,612 19,037 24,073
FinancingShort-term borrowings (repayments), maturities of 90 days or less, net 0 1,178 (991)Proceeds from issuance of debt, maturities longer than 90 days 0 4,796 4,167Repayments of debt, maturities longer than 90 days 0 (228) (2,986)Common stock issued 3,494 579 2,311Common stock repurchased (12,533) (9,353) (11,269)Common stock cash dividends paid (4,015) (4,468) (4,578)Excess tax benefits from stock-based compensation 120 52 45Other 0 (19) 10Net cash used in financing (12,934) (7,463) (13,291)
InvestingAdditions to property and equipment (3,182) (3,119) (1,977)Acquisitions of companies, net of cash acquired (8,053) (868) (245)Purchases of investments (20,954) (36,850) (30,168)Maturities of investments 2,597 6,191 7,453Sales of investments 25,132 19,806 15,125Securities lending payable (127) (930) (1,502)Net cash used in investing (4,587) (15,770) (11,314)Effect of exchange rates on cash and cash equivalents 137 (67) (39)
Net change in cash and cash equivalents 4,228 (4,263) (571)
Cash and cash equivalents, beg. of period 6,111 10,339 6,076Cash and cash equivalents, end of period 10,339 6,076 5,505
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Microsoft Inc.Cash Flow StatementFiscal Years Ending June 30(numbers in millions)
2011E 2012E 2013E 2014E 2015E 2016CVCash Flows from Operating ActivitiesNet Income 15,387 15,855 16,323 16,612 17,450 17,974 Increase in accounts receivable (366) (1,033) (1,133) (1,066) (838) (524) Increase in inventories (598) (103) (113) (107) (84) (52) Increase in accounts payable (11) 310 340 320 251 157 Increased in accrued compensation (22) 252 276 260 204 128 Increase in short-term unearned revenue (272) 1,033 1,133 1,066 838 524 Increase in long-term unearned revenue 160 (41) (53) 2 63 39 Increase in income taxes payable 1,435 194 212 200 157 98
Net cash provided by operating activities 15,713 16,466 16,985 17,288 18,042 18,344
Cash Flows from Investing Activities Increase in short-term investments 0 0 0 0 0 0 Increase in long-term investments (233) (240) (247) (254) (262) (270) Increase in PPE (398) (620) (680) (640) (503) (314) Increase in Intangibles (180) (103) (113) (107) (84) (52)
Net Cash used for Investing Activities (811) (963) (1,040) (1,001) (848) (636)
Cash Flows from Financing Activities Increase (decrease) in LT debt (823) (823) (823) (823) (823) (823) Increase (decrease) in ST debt (1,000) 0 0 0 0 0 Payment of Dividends (4,154) (4,281) (4,407) (4,485) (4,712) (4,853) Common Stock Repurchases (6,000) (6,000) (6,000) (6,000) (6,000) (6,000)
Net Cash provided by Financing Activities (11,978) 896 770 691 465 324
Net Increase (Decrease) in Cash 2,925 16,399 16,715 16,979 17,659 18,031
Cash, Beginning of Year 5,505 8,430 24,829 41,544 58,522 76,181
Cash, End of Year 8,430 24,829 41,544 58,522 76,181 94,213
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Microsoft Inc.Common Size Income StatementFiscal Years Ending June 30(percentage of sales)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVRevenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%Operating expenses:Cost of Revenue 19.20% 20.80% 19.84% 20.00% 21.00% 22.00% 23.00% 23.00% 23.00%Research and Development 13.51% 15.42% 13.95% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%Sales and marketing 21.58% 22.04% 21.15% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00%General and administrative 8.49% 6.33% 6.41% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%Employee severence 0.00% 0.56% 0.09% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Total operating expenses 62.77% 65.15% 61.43% 64.50% 65.50% 66.50% 67.50% 67.50% 67.50%
Operating Income 37.23% 34.85% 38.57% 35.50% 34.50% 33.50% 32.50% 32.50% 32.50%Other Income (Expense) 2.19% -0.93% 1.46% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%
Income Before Taxes 39.41% 33.92% 40.03% 38.00% 37.00% 36.00% 35.00% 35.00% 35.00%Provision for income taxes 10.15% 8.99% 10.01% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Net Income 29.26% 24.93% 30.02% 23.00% 22.00% 21.00% 20.00% 20.00% 20.00%
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Microsoft Inc.Common Size Balance SheetFiscal Years Ending June 30(percentage of total assets)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVAssetsCurrent assets:Cash and cash equivalents 17.11% 10.40% 8.81% 14.55% 42.08% 69.99% 98.00% 126.93% 156.48%Short-term investments 22.05% 43.42% 50.07% 51.57% 53.11% 54.71% 56.35% 58.04% 59.78%Total cash, cash equivalents, and short-term investments 39.16% 53.81% 58.88% 66.12% 95.20% 124.70% 154.35% 184.97% 216.27%Accounts receivable, net 22.49% 19.15% 20.83% 21.41% 23.07% 24.88% 26.59% 27.93% 28.77%Inventories 1.63% 1.23% 1.18% 2.14% 2.31% 2.49% 2.66% 2.79% 2.88%Deferred income taxes 3.34% 3.79% 3.50% 2.91% 2.33% 1.75% 1.17% 0.58% 0.00%Other 4.95% 6.35% 4.72% 5.35% 5.77% 6.22% 6.65% 6.98% 7.19%Total current assets 71.57% 84.33% 89.10% 97.94% 128.67% 160.04% 191.41% 223.26% 255.10%Property and equipment, net of accumulated depreciation 10.33% 12.89% 12.21% 12.85% 13.84% 14.93% 15.95% 16.76% 17.26%Equity and other investments 10.90% 8.44% 12.41% 12.78% 13.17% 13.56% 13.97% 14.39% 14.82%Goodwill 20.04% 21.40% 19.84% 19.84% 19.84% 19.84% 19.84% 19.84% 19.84%Intangible assets, net 3.27% 3.01% 1.85% 2.14% 2.31% 2.49% 2.66% 2.79% 2.88%Deferred income taxes 1.57% 0.48% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other long-term assets 2.80% 2.74% 2.40% 3.21% 3.46% 3.73% 3.99% 4.19% 4.31%
Total assets 120.48% 133.29% 137.82% 138.94% 157.18% 172.49% 186.42% 201.39% 218.46%
Liabilities and stockholders' equityCurrent liabilities:Accounts payable 6.68% 5.69% 6.44% 6.42% 6.92% 7.46% 7.98% 8.38% 8.63%Short-term debt 0.00% 3.42% 1.60% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Accrued compensation 4.86% 5.40% 5.25% 5.22% 5.62% 6.06% 6.48% 6.81% 7.01%Income taxes 5.38% 1.24% 1.72% 4.01% 4.33% 4.67% 4.98% 5.24% 5.39%Short-term unearned revenue 22.17% 22.25% 21.85% 21.41% 23.07% 24.88% 26.59% 27.93% 28.77%Securities lending payable 4.33% 2.88% 0.29% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other 6.06% 5.38% 4.69% 5.95% 7.25% 8.58% 9.91% 11.25% 12.57%Total current liabilities 49.46% 46.26% 41.85% 43.02% 47.19% 51.66% 55.94% 59.60% 62.37%Long-term debt 0.00% 6.41% 7.90% 6.59% 5.27% 3.95% 2.63% 1.32% 0.00%Long-term unearned revenue 3.14% 2.19% 1.89% 2.14% 2.08% 1.99% 1.99% 2.09% 2.16%Deferred income taxes 0.00% 0.00% 0.37% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Other long-term liabilities 7.81% 10.73% 11.92% 11.90% 14.50% 17.17% 19.82% 22.50% 25.14%Total liabilities 60.42% 65.59% 63.92% 63.65% 69.03% 74.77% 80.39% 85.51% 89.66%
Stockholder's equity:Common stock and PIC - 24,000 shares authorized 104.02% 106.75% 100.60% 89.71% 79.68% 70.88% 63.87% 58.81% 55.54%Retained deficit -43.96% -39.06% -26.70% -10.22% 17.64% 41.51% 62.07% 81.34% 100.58%Total stockholder's equity 60.06% 67.69% 73.90% 79.49% 97.32% 112.39% 125.94% 140.16% 156.12%
Total liabilities and stockholder's equity 120.48% 133.29% 137.82% 138.94% 157.18% 172.49% 186.42% 201.39% 218.46%
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Microsoft Inc.Value Driver EstimationFiscal Years Ending June 30(numbers in millions)
2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016CVNOPLATEBITA: Revenue 60,420 58,437 62,484 66,899 72,066 77,731 83,062 87,252 89,869 Total operating expenses 37,928 38,074 38,386 43,150 47,203 51,691 56,067 58,895 60,662EBITA 22,492 20,363 24,098 23,749 24,863 26,040 26,995 28,357 29,208 Less Adjusted Taxes:Income Tax Provision 6,133 5,252 6,253 10,035 10,810 11,660 12,459 13,088 13,480Tax Shield on Interest Expense 0 0 53 0 0 0 0 0 0Tax on Interest and Investment Income 463 (190) 320 585 631 680 727 763 786Adjusted Taxes 5,670 5,442 5,986 9,450 10,179 10,979 11,732 12,324 12,694Net Deferred Tax (2,966) (2,492) (1,955) (1,820) (1,456) (1,092) (728) (364) 0Change in Deferred Tax 322 474 537 135 364 364 364 364 364NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877
Invested CapitalOperating Current Assets: Normal Cash (10% of sales) 6,042 5,844 6,248 6,690 7,207 7,773 8,306 8,725 8,987 Accounts Recievable 13,589 11,192 13,014 13,380 14,413 15,546 16,612 17,450 17,974 Inventory 985 717 740 1,338 1,441 1,555 1,661 1,745 1,797 Other Current Operating Assets 2,989 3,711 2,950 3,345 3,603 3,887 4,153 4,363 4,493Total operating current assets 23,605 21,464 22,952 24,753 26,664 28,760 30,733 32,283 33,252 Minus operating current liabilities: Accounts Payable 4,034 3,324 4,025 4,014 4,324 4,664 4,984 5,235 5,392 Income Tax Payable 3,248 725 1,074 2,509 2,702 2,915 3,115 3,272 3,370 Accrued Compensation 2,934 3,156 3,283 3,261 3,513 3,789 4,049 4,254 4,381 ST Unearned Revenue 13,397 13,003 13,652 13,380 14,413 15,546 16,612 17,450 17,974 Other current Liabilities 3,659 3,142 2,931 3,718 4,531 5,363 6,194 7,029 7,853 Total operating current liabilities 27,272 23,350 24,965 26,882 29,484 32,277 34,954 37,240 38,970
Net Working Capital (3,667) (1,886) (2,013) (2,129) (2,819) (3,517) (4,221) (4,956) (5,719) Plus Net PPE 6,242 7,535 7,630 8,028 8,648 9,328 9,967 10,470 10,784 Plus PV of operating leases 1,807 1,954 1,579 1,768 1,981 2,218 2,485 2,783 3,117 Plus Net intangible assets 1,973 1,759 1,158 1,338 1,441 1,555 1,661 1,745 1,797 Plus Other LT Assets 1,691 1,599 1,501 2,007 2,162 2,332 2,492 2,618 2,696 Minus long term unearned revenue 1,900 1,281 1,178 1,338 1,297 1,244 1,246 1,309 1,348 Minus Warrenty liabilities 278 132 69 - - - - - - Minus other liabilities 4,721 6,269 7,445 - - - - - - Invested Capital 1,147 3,279 1,163 9,674 10,115 10,672 11,138 11,350 11,328
ROIC NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 Divided by beginning invested capital (1,306) 1,147 3,279 1,163 9,674 10,115 10,672 11,138 11,350 ROIC -1313% 1342% 569% 1241% 156% 152% 146% 147% 149%
FCF NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 Minus change in Invested Capital 2,453 2,132 (2,115) 8,511 441 556 466 212 (23) FCF 14,691 13,264 20,765 5,924 14,606 14,868 15,160 16,184 16,900
EP NOPLAT 17,144 15,395 18,649 14,435 15,047 15,424 15,627 16,397 16,877 ROIC -1313% 1342% 569% 1241% 156% 152% 146% 147% 149% WACC 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39% 7.39%EP 17,240 15,311 18,407 14,349 14,333 14,677 14,838 15,574 16,039
Non Operating AssetsCash on Hand 10,339 6,076 5,505 9,090 26,296 43,734 61,236 79,314 97,778"Normal Cash" 6,042 5,844 6,248 6,690 7,207 7,773 8,306 8,725 8,987Excess Cash 4,297 232 (743) 2,400 19,090 35,961 52,930 70,589 88,791 Short-term Investments 13,323 25,371 31,283 32,221 33,188 34,184 35,209 36,266 37,354Long-term Investments 6,588 4,933 7,754 7,987 8,226 8,473 8,727 8,989 9,259Non Operating Assets 24,208 30,536 38,294 42,609 60,504 78,618 96,866 115,843 135,403
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Microsoft Inc.Weighted Average Cost of Capital (WACC) Estimation
Beta 0.77 Bloomberg (3 year weekly)CAPM:Rf Rate 4.43%Risk Premium 4.34%Cost of Equity 7.77%After-tax Cost of Debt 1.92% Using Marginal Tax Rate = 35%
Current Price 25.37Shares 8,400,000,000
Market Value of Equity 213,108Market Value of Debt/Leases 14,963Market Value of Firm 228,071
WACC 7.39%
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Microsoft Inc.Discounted Cash Flow (DCF) and Economic Profit (EP) Model ValuationFiscal Years Ending June 30
Assumptions: CV growth 3.00%CV ROIC 149%WACC 7.38%Cost of Equity 7.77%
2011E 2012E 2013E 2014E 2015E 2016CV
DCF ModelFCF 5,924 14,606 14,868 15,160 16,184 377,249 PV(FCF) 5,517 12,667 12,007 11,401 11,335 264,204 PV(FCF) 317,130$ +PV(Non-Oper) 38,294$ - PV(Debt) (14,963)$ - PV(ESOP) (689)$ - PV(Operating Leases) (1,579)$ PV(Equity) 338,193$ Shares Outstanding (millions) 8,400 Target Price 40.26$ Adjusted Target Price 42.82$
EP ModelROIC 1241% 156% 152% 146% 147% 149%EP 14,349 14,333 14,677 14,839 15,574 365,899 PV(EP) 13,362 12,430 11,853 11,159 10,907 256,255 PV(EP) 315,967$ Invested Capital 1,163$ PV(Operations) 317,130$ + PV(Non-Oper) 38,294$ - PV(Debt) (14,963)$ - PV(ESOP) (689)$ - PV(Operating Leases) (1,579)$ PV(Equity) 338,193$ Shares Outstanding (millions) 8,400 Target Price 40.26$ Adjusted Target Price 42.82$
Discount Factors 1.07 1.15 1.24 1.33 1.43 1.43
Today 4/25/2011Next FYE 6/30/2011Last FYE 6/30/2010Days in FY 365 Days to FYE 299 Elapsed Fraction 0.819
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Relative P/E AnalysisEPS EPS
Ticker Company Price 2011E 2012E P/E 11 P/E 12AAPL Apple Inc. 348.51$ $22.97 $26.46 15.2 13.2 CSCO Cisco Systems, Inc. 17.15$ $1.59 $1.76 10.8 9.7 GOOG Google Inc. 530.70$ $34.55 $39.92 15.4 13.3 AMZN Amazon.com Inc. 180.01$ $3.19 $4.43 56.4 40.6 ORCL Oracle Corp. 34.18$ $2.17 $2.39 15.8 14.3
Average 22.7 18.2
MSFT Microsoft Co. 25.37$ $1.77 $1.84 14.4 13.8
Implied Value: Relative P/E * EPS 2011 $ 40.13 Relative P/E * EPS 2012 33.55$
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Microsoft Inc.Dividend Discount Model (DDM) or Fundamental P/E Valuation ModelFiscal Years Ending June 30
2011E 2012E 2013E 2014E 2015E 2016CV
EPS 1.77$ 1.84$ 1.91$ 1.96$ 2.07$ 2.14$
Key Assumptions CV growth of EPS 3.00% CV ROE 11.72% Cost of Equity 7.77%
Future Cash Flows P/E Multiple 14.35 EPS(next period) 2.14$ Future Stock Price 33.38 Dividends Per Share 0.48 0.50 0.52 0.53 0.56 Future Cash Flows 0.48 0.50 0.52 0.53 33.94
Discounted Cash Flows 0.442853 0.428$ 0.412$ 0.392$ 25.160$
Intrinsic Value 26.39$ Adjusted Price (Today) 28.07$
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Ratio Analysis2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E
Liquidity Ratios:Current Ratio 1.45 1.82 2.13 2.28 2.73 3.10 3.42 3.75 4.09
Cash Ratio 0.79 1.16 1.41 1.54 2.02 2.41 2.76 3.10 3.47
Asset Turnover Ratios:Asset Turnover 0.83 0.75 0.73 0.72 0.64 0.58 0.54 0.50 0.46
Financial Leverage Ratios:Debt Ratio 0.06 0.15 0.16 0.12 0.11 0.10 0.09 0.08 0.08
Debt-to-Equity Ratio 0.13 0.30 0.29 0.22 0.18 0.15 0.13 0.12 0.11
Profitability Ratio:Return on Equity 49% 37% 41% 29% 23% 19% 16% 14% 13%
Return on Assets 24% 19% 22% 17% 14% 12% 11% 10% 9%
Dividend Policy Ratios:Payout Ratio 23% 32% 24% 27% 27% 27% 27% 27% 27%
Dividend Yield 1.88% 1.82% 1.75% 1.67% 1.63% 1.57%
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