Valuing Microsoft

Microsoft is a software services and hardware games company. In this segment, we will look at Microsoft's earnings and estimate Microsoft's intrinsic value. We take a variant of the approach described in "Value Investing - from Grahamto Buffett and Beyond" written by Bruce C. N. Greenwald et. al.

Microsoft is a very profitable company. In FY2006, Microsoft had 28.5 cents of net income on every dollar of revenue. The total net income at Microsoft has remained stagnant at 12.5 billion dollar range for the past couple of years. The investments in less profitable ventures such as XBox and MSN have compensated the lack of revenue growth.

It is natural that a business that is very profitable attracts competition. Microsoft has attracted competition in a variety of forms from free software (Linux) and that includes government intervention from places like the European Union and Korea. The one time charges that Microsoft has been taking is endless and is not likely to subside anytime soon.

Let us take Microsoft's net earnings from FY2006 and assume no growth. This assumption makes sense for a conservative evaluation because of the many legal and competitive challenges Microsoft faces. FY2006 income came in at 12.5 billion. We will add 25% of R&D to net income as this expenditure will accrue to earnings. We will also add 10% of marketing revenue to the earnings. Marketing is less important at Microsoft because of its dominant position in the desktop and server markets. Putting these together puts Microsoft net earnings at 15.1 billion. Now we need to subtract capex and expense for stock based compensation and add back amortization/depreciation. Microsoft spent 1.6 billion in additions to property and equipment. So the total income after adding these in is 14.4 billion. At a cost of capital of 0.08, the earning power value of Microsoft comes in at 180 billion. However, we still have to substract the effects of stock based compensation of 1.8 billion. If we take into account the effects of stock based compensation, the earning power value declines to 157.5 billion. The effects of stock based compensation has been declining but will probably settle around 1.4 billion. In this case, the EPV of Microsoft comes in at 162.5 billion.

To this we need to add the cash in the balance sheets which was at 34 billion at the end of FY06. Adding these in, Microsoft's intrinsic value comes in around 194.5 billion dollars. Even if one completely negates the effects of stock based compensation, MSFT intrinsic value comes in at 214 billion dollars.

At the current market cap of 268 billion dollars, Microsoft is still over valued by about 20%. Given the world wide recognition of its brand name, executives and its software, Microsoft is trading at a premium and cant be considered a value stock at the moment.