Examining the inherent value of Microsoft Corporation (NASDAQ:MSFT)

noteworthy observations

• The fair value projected for Microsoft based on 2 stage free cash flow to equity is US$379

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• At a share price of US$370, Microsoft appears to be trading close to its estimated fair value

• The analyst price target for MSFT is US$404, which is 6.7% above our fair value estimate

Does the November share price for Microsoft Corporation (NASDAQ:MSFT) reflect its true value? Today, let’s gauge the intrinsic value of a stock by considering the anticipated future cash flows and discounting them to their present value. Our analysis will make use of the Discounted Cash Flow (DCF) model. Surprisingly, it’s not too challenging to follow, as illustrated by our example!

We would like to highlight that there are numerous methods to evaluate a company and, similar to DCF, each approach has advantages and disadvantages in specific situations. Anyone keen to learn more about intrinsic value should peruse the Simply Wall St analysis model.

View our most recent analysis for Microsoft

Procedure

We employ a 2-stage model, indicating that we have two distinct periods of growth rates for a company’s cash flows. Normally, the initial phase is characterized by rapid growth, while the subsequent phase experiences slower growth. In the initial step, we must estimate the cash flows to the business over the next ten years. Whenever possible, we utilize analyst estimates, but in their absence, we estimate the previous free cash flow (FCF) from the prior estimate or reported price. We believe that companies with declining free cash flow will experience a deceleration in their contraction rate, and companies with increasing free cash flow will witness a slowdown in their growth rate over this period. We do this to reflect the notion that growth in the early years tends to be more moderate than in later years.

Typically, we assume that a dollar today holds greater value than a dollar in the future, thus requiring us to discount the total of future cash flows to determine a present value estimate:

Forecast of Free Cash Flow (FCF) for 10 Years

(“Estimate” = Estimated FCF growth rate by Simply Wall St.)
Present value of 10-year cash flows (PVCF) = US$875b

Upon determining the present value of future cash flows over the initial 10-year period, we need to compute the terminal value, which encompasses all future cash flows after the first stage. For various reasons, an extremely conservative growth rate is employed, which cannot surpass a country’s GDP growth rate. In this instance, we have utilized the 5-year average of the 10-year government bond yield (2.2%) to approximate future growth. Similar to the 10-year ‘growth’ period, we discount the future cash flows to their current value, using an equity cost of 7.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$188b × (1 + 2.2%) ÷ (7.2%- 2.2%) = US$3.9t

Present Value of Terminal Value (PVTV)= TV / (1 + R)10= US$3.9T÷ ( 1 + 7.2%)10= US$1.9T

The sum of the cash flows for the next ten years and the discounted terminal value constitutes the total equity value, in this instance, US$2.8t. The final step involves dividing the equity value by the number of shares outstanding. Relative to the current share price of US$370, the company seems to be fairly valued at a 2.3% discount to its current trading price. However, valuations are imprecise tools, comparable to a telescope – a slight degree alteration can lead to a different galaxy. It’s important to bear this in mind.

DCF

Estimation

It’s noteworthy that the most critical inputs for discounted cash flows are the discount rate and, unsurprisingly, the actual cash flows. You don’t have to concur with these inputs; I recommend recalculating the figures yourself and experimenting with them. DCF also overlooks the potential cyclicality of an industry, or a company’s forthcoming capital needs, hence providing an incomplete depiction of a company’s potential performance. Given that we are considering Microsoft as potential shareholders, the cost of equity serves as the discount rate instead of the cost of capital (or weighted average cost of capital, WACC), which accounts for debt. In this calculation, we have employed 7.2%, founded on a leveraged beta of 0.991. Beta is a measure of a stock’s volatility in contrast to the overall market. We derive our beta from the industry average beta of comparable companies globally, falling within a range of 0.8 to 2.0, which is a reasonable span for a stable business.

SWOT evaluation for Microsoft

Strengths

Weaknesses

Opportunities

Threats

Previewing the Future:

While a company’s valuation is important, it should ideally not be the sole analysis to consider for a company. DCF models do not encompass the entirety of investment valuation. It would be beneficial to apply various scenarios and assumptions and evaluate how they might impact the company’s valuation. If a company grows at a different rate, or if its cost of equity or risk-free rate fluctuates rapidly, the output might appear markedly different. For Microsoft, there are three indispensable aspects that demand attention:

1. Risk: Assume risks, for instance – Microsoft has encountered 1 warning sign We believe you should be aware of it.

2. Management: Are insiders offloading their shares to capitalize on market sentiment for MSFT’s future outlook? Review our management and board analysis featuring insights on CEO compensation and governance factors.

3. Other premium options: Do you have a preference for a strong all-rounder? Peruse our interactive compilation of high-quality stocks to uncover what else you might be overlooking!

P.S. The Simply Wall St app conducts discounted cash flow valuations for every stock on the NASDAQGS every day. If you want to know other stock calculations just search here.

Have any feedback on this article? Anxieties about components? Keep in contact directly with us. Alternatively, email editorial-team(at)Simplewallst.com.

This article from Simply Wall St is of a general nature. We only provide commentary based on historical data and analyst forecasts using unbiased methodology, and our articles are not intended to offer financial advice. It does not advocate the purchase or sale of any stock, and does not consider your goals or your financial situation. Our aim is to present you with long-term focused analysis driven by fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.

Source: finance.yahoo.com