Are Investors Undervaluing Microsoft Corporation (NASDAQ: MSFT) By 24%?
How far is Microsoft Corporation (NASDAQ: MSFT) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking the company’s expected future cash flows and discounting them to their present value. The DCF (Discounted Cash Flow) model is the tool we will apply to do this. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for all situations. Anyone interested in learning a little more about intrinsic value should read Simply Wall St analysis model.
Check out our latest analysis for Microsoft
The calculation
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
Typically, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | 54.7 billion USD | US $ 63.1 billion | 68.4 billion USD | 83.3 billion USD | 101.8 billion USD | 114.2 billion USD | 124.6 billion USD | 133.2 billion USD | 140.6 billion USD | 146.8 billion USD |
Source of estimated growth rate | Analyst x16 | Analyst x16 | Analyst x7 | Analyst x4 | Analyst x3 | Est @ 12.17% | Est @ 9.12% | Is 6.98% | Is 5.48% | Is 4.43% |
Present value ($, millions) discounted at 6.5% | US $ 51.3K | US $ 55.7K | US $ 56.7K | US $ 64.8K | US $ 74.4K | US $ 78.3K | US $ 80.3K | US $ 80.7K | $ 79.9K | US $ 78.4K |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 700 billion USD
The second stage is also known as terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.5%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = 147 billion USD × (1 + 2.0%) ÷ (6.5% – 2.0%) = 3.3 t USD
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= 3.3 t USD ÷ (1 + 6.5%)^{ten}= 1.8 t USD
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is 2.5 t USD. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 252, the company appears to be a bit undervalued with a 24% discount from the current share price. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
The hypotheses
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Microsoft as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 6.5%, which is based on a leveraged beta of 0.950. Beta is a measure of the volatility of a stock, relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Looking forward:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only analysis you look at for a company. DCF models are not the alpha and omega of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company trades at a discount to its intrinsic value? For Microsoft, we have compiled three relevant aspects for you to assess:
- Risks: Take, for example, the ubiquitous spectrum of investment risk. We have identified 2 warning signs with Microsoft, and understanding them should be part of your investment process.
- Future income: How does MSFT’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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