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IVS: Microsoft
A Pictorial Review of MSFT's Financials

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By TMFShadowDragon
February 3, 2010

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Hi Value-Able Folks,

Rob has already posted a link to Microsoft's quarterly report.

So, rather than repeat the details of the report, I thought I'd take the long view of Microsoft. It's, as people like Buffett have mentioned, difficult to evaluate companies in the technology sector. Even if you understand the current products on offer and the products under development that only gives you a few years of predicted cash flow at best. [BTW, it's the same problem evaluating drug companies.] However, it is possible to look not at the specific products currently offered or under development, but the long view which assumes the companies ability to maintain a pipeline of products (i.e., it's ability to innovate, develop and market technology).

Since a picture's worth a thousand words, rather than give you tables to decipher I'll give you pictures. Unfortunately TMF software only allows links to the pictures, so you'll have to click on the links.

First up, here is MSFT's reported quarterly income since 1985.

This graph shows not only the ups and downs from quarter to quarter (you can see the up turn in the last couple of quarters at the end of the graph) you can also see that the slope of the graph is leveling off. The graph is plotted with a logarithmic vertical axis. With a logarithmic plot, constant growth would be a straight line and the rate of growth would be the slope of that line. So, what we see here is a steady overall decline of growth rates that's typical of maturing companies - especially maturing, large companies.

Let's look at the same information but with the trailing twelve month (TTM) income summed up for every month. This will smooth out the graph and give us a view of the changes to annual income.

Here we see the same trend to declining growth. So if we wanted to estimate MSFT's growth with this assumption of declining growth, let's estimate the slope toward the latter years of the graph. Using linear regression for the years 2005 to 2009 (and a half), the slope and hence growth rate is estimated at 2.9% annually. If I extend the range back to 2002 (from the dip in the earnings) then the growth rate is 6.0%. It's not exactly high growth. It's hardly keeping up with GDP growth. That's not an unexpected result for a maturing company that dominates its market - after all growth's not going to come from stealing market share but from ever increasing new products and new products in new types of markets.

Let's look at the revenue picture.

It's the same story, but it's even more consistent. Using the same approach to estimating growth, I get 4.5% and 4.7% growth. From this I would postulate that the 6.0% earnings growth above is due to starting from the temporary dip in earnings in 2002. If I extend the growth estimate period back to 2000, I get results for earnings growth consistent with revenue growth.

Here's the profit margin picture.

This is interesting since the bulge before 2002 is about the time that various authorities launched anti-trust actions against MSFT. We see the dip in margins shortly after that. You can get into the details of the reduction in margins, but I suggest that with the anti-trust actions MSFT, besides effects of maturing markets, competition, overall economic factors, has faced a lot of restrictions on its freedom of maneuver (i.e. to innovate, develop, market, etc.). Nonetheless, margins today are at least as high as the period prior to 1997.

All of this gives us a starting point to evaluate MSFT as a "stable growth", mature company. I'll use the TTM earnings as typical earnings (by doing so I'm assuming that 28% current margin is typical or that MSFT's typical cash flow > earnings offsets a slightly lower net margin of, say, 25%).....in other words, I don't have any better starting point! I'll further assume that MSFT's future revenue and earnings growth rate will approximate the recent past revenue growth rate of 4.5%.

At the moment (12:50 PM, 2 Feb 2010) MSFT's market cap is $253,648 Million. So, with $36,099 Million in cash, its operating value is the difference or $217,549 Million. I'll ignore the rather minuscule "other income" portion of overall income and compare this figure to the an estimate of value using a stable growth discount model with TTM earnings of $16,258 Million as the starting point and, as mentioned, 4.5% for growth. The question is, "What discount rate results in the above market value for MSFT's operations?"

By the way for "Mathmo's" the discount model for stable growth is Cash Flow * (1 + growth) / (discount rate - growth). Non-mathmo's...please ignore.

Anyway, back to the story....

Using this approach, I get a 12% discount rate.

I don't know about you, but I would normally give a stable - look at that revenue chart again - company a lower discount rate than that, but let's look at IV's valuation of MSFT. IV has intrinsic value of $34.50 per share or $307,000 Million market value. Subtract out the cash and that gives us a fair value for operations of $271,000 Million. The discount rate associated with that figure and my stable growth assumptions is 10.8%.

If we went with a 10% discount rate, the share value of MSFT would be $38.75 and the buy below $29.00. MSFT's not a screaming bargain but it's still reasonable.

Cheers

The Dragon
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