Microsoft is an interesting company. It was a feared technology behemoth a few years back but the stock return has been lackluster for the past nine years. In this segment, we will analyze Microsoft from three angles. (a) Discount cash flow analysis (b) Compare it to the 10 year bond and (c) finally analyze it with the option contracts.
One of the main complaints against Microsoft is that it doesnt know how to allocate capital. This part was covered in great detail in the following story. As the article points out, the XBoX division has bled 5.4 billion on 21 billion of investment in the past five years. A 2% return on 21 billion over five years would have yielded 2.1 billion to the share holders. If it were distributed as dividends, it comes to about 21 cents a share, not exactly chump change.
In addition to XBoX, the other divisions such as MSN, Mobile and Embedded Devices and Microsoft Dynamics have been bleeding cash. Only the windows and office divisions have been profitable and have been keeping Microsoft aloft.
First, let us look at Microsoft's discount cash flow model. The cash flow has been declining in the past few years and one can expect the trend to stabilize in the upcoming years but not subside. Let us look at the free cash flow in the past eight years.
9,447.0 13,082.0 12,319.0 13,739.0 14,906.0 13,517.0 15,793.0 12,826.0 11,917.0
As one can notice, the cash flow has been trending downwards primarily because of XBox and MSN divisions.
A discount rate of 8% to 10% range gives a valuation in the range of 175 billion to 225 billion. The valuation is based on free cash flow growing at the rate of 8% per year which is optimistic. The current Microsoft market cap is about 280 billion dollars.
The second approach is based on EPS and comparison to the 10 year bond. If the analyst EPS of 1.47 and 1.64 for FY07 and FY08 holds true, a stock price of 29.4 and 33.4 seem appropriate. Looking at the current price of Microsoft, the upside in a year's time is about 13.6% if the company is able to meet the earning estimates.
The third aproach is based on option contracts. Looking at the option contract for January 2009, a range of values between 30 and 35 seem more likely with the median of 32.5 being more likely. This compares well with the long bond comparison approach noted above.
Looking at all the approaches, the upside in MSFT is somewhat limited even in the best of environments. There is significant concern about the cash flows with XBoX and the MSN/Search divisions burning cash with no return in sight. It is unlikely Microsoft will spin off these divisions and fend for themselves. It would be good to have these divisions compete on their own merit without getting a life line from Microsoft.