How Much Is Microsoft Worth?

If you listen to news reports and look at trading in Microsoft's (Nasdaq: MSFT) shares this year, you might think the company is in some dire straits. To be sure, Mr. Softy is facing very real challenges. Its search business badly lags competitors like Google (Nasdaq: GOOG), lower-cost alternatives to the company's business software are trying to make inroads, and its mobile phone platform is still sucking wind compared to the industry leaders.

But at the same time, we're still talking about a company with tremendous financial resources, stellar cash flow, and a collection of software products that far outpaces competitors and claims ridiculously high profit margins.

Has all this pessimism made Microsoft's stock a bargain? Let's take a closer look.

It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how similar companies are valued. So let's take a look at how Microsoft stacks up.

Source: Capital IQ (a Standard & Poor's company) and Yahoo! Finance.
*Average excludes Microsoft.

Using each of those averages to back into a stock price for Microsoft, and then taking the average across those results, we can come up with an estimated price per share of roughly $32. This would suggest today's price of just less than $28 could be undervalued.

A comparable company analysis like this can sometimes raise as many questions as it answers though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even over-valued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock, and vice versa.

Also, while these businesses are comparable to Microsoft, none is a perfect match. Apple could be the most comparable since it competes with Microsoft on multiple fronts, but it doesn't have the same kind of enterprise component and has been hotter on the growth front. Oracle sells enterprise software but doesn't have nearly the consumer side that Microsoft does. Google has a search business like Microsoft, but makes its money primarily through advertising, not software sales. Intel, Cisco, and Dell are tech stalwarts, but all of them are hardware-focused companies.

So with all that in mind, it's best to combine comparable company analysis with another valuation technique.

Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow (DCF). Basically, this method projects free cash flow over the next 10 years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).

Because a DCF is based largely on estimates (a.k.a. guesses) and it attempts to predict the future, it can be a fickle beast and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.

For Microsoft's DCF, I used the following assumptions:

Source: Capital IQ (a Standard & Poor's company), Yahoo! Finance, author's estimates.

While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.

But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.

Based on the assumptions above, a simple DCF model spits out a per-share value of roughly $40 for Microsoft's stock. This would suggest that the stock is even more undervalued than the comparable company analysis let on.

However, I think that number may overstate the case. My starting point for growth assumptions in these models is the current analyst estimates for long-term growth -- and that's the number included in the table above. I happen to think that 12% is more likely a top end for Microsoft's growth over the next five years rather than a "most-likely" scenario. So what I did is I ran the same numbers with a growth range of 4% to 12%. This gives us a valuation range for the stock of $29 to $40 with a midpoint (at 8% growth) of $34.

Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well-advised to play with the numbers further before making a final decision on Microsoft's stock.

That said, using the numbers we got above from the comparable company analysis and the midpoint of the DCF valuation range, we could reasonably come to a valuation of $33 for the stock. This would put today's price for the stock at roughly a 15% discount to its true value.

I've got my money where my mouth is on this one -- I own Microsoft shares and it's on my short list of stocks to add to in my portfolio. I think there's significant potential for appreciation here and investors also get a decent 2.3% dividend just for hanging onto the shares.

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