Our Top Stock Idea

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Microsoft profile

Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.

This Week's Pitch :

Microsoft isn't exactly a sexy pick right now. That can [be] reserved for tech stocks like Amazon (Nasdaq: AMZN) or Apple (Nasdaq: AAPL). However, [it is] a cash cow and [has] been remarkably consistent in terms of operating results. Here is my very simple look at valuation.

I think the correct way to look at them is in terms of Earnings Power Value using the Bruce Greenwald approach. First, I want to assess the downside.

To do this, we need to know a few things about MSFT:

1) Despite critics, they are growing. Revenue is up about 20% since 2007, operating is up 50%, and net income is up 46%. While this does not guarantee us that they will not have a slowdown in the future, the trend is clear. Therefore, an EPV of current earnings should be a very conservative valuation because it will not take into account any future growth. Therefore, if we are able to purchase MSFT at a conservative EPV value, then we get any growth for free. I think that given their track record, strong balance sheet, and current initiatives (Kinect, Windows 7, smartphones, xbox live initiatives, etc..) that purchasing MSFT at EPV value would be a steal.

2) Next, I want to look at the downside. Therefore, I took the lowest cash flow level from the past three years-- their fiscal year ending June 30 [the trailing four quarters ended June 30]. They generated FCF of approx. 16 billion (and that's a low year!). For comparison, in their fiscal year ending Sept 2010, they generated approx 24 billion in FCF.

Now, to arrive at an EPV, we would typically only subtract maintenance capex (rather than using the full capex which was used in the above FCF estimates). Even then, if we take the low FCF figure from the middle of the recession and ignore any growth, that stream of earnings is worth 160 billion with a 10% cost of capital. Then, we can add their 33 billion in net cash to arrive at a very conservative EPV value of 193 billion. This is slightly less than the current enterprise value of MSFT (209.53 B).

Now that calculation used some seriously conservative assumptions.. let's now use the latest FCF number to find an EPV. We will again use the full capex (another conservative assumption) in the FCF calculation.

They generated approx 24 B in FCF in their fiscal year [ended] Sept 2010. With 10% cost of capital, its worth about 240 B, then add 33 mm in net cash, we get to 273 B. Dividing by the 8.56B in shares outstanding gives us an EPV value/share of approx $32/share. This is approx. an 11% discount from the current price at time of writing.

Therefore, we are able to purchase a growing business at a historically low valuation at a discount to its EPV-- and get the growth (and more) for free. I like my chances with this investment. I would sell 1/3 when it reaches EPV. From there, it depends on your estimates of future growth (analysts have eps growth over next five years at over 11%).

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