With so much going on in the world, everyone is looking for a safer yet fruitful option to park their money. Never in recent history, have we seen an economic cycle skipping recession for this long. As we all know, the typical economic cycle consists of a recession every 7 years and GFC being the last recession, it's been more than 13 years since we have seen a recession. The market is filled with talks about an upcoming recession and it's not recent, investors are preparing for a recession since 2016. Warren Buffet very well said 'Buy when there is blood on the street', has been accumulating cash but has not been able to find the right time since 2016 which is leading Berkshire Hathaway with huge cash reserves.
These past 2 years have changed the economic circumstances drastically. We have seen so many unprecedented activities such as the oil crisis, land conflicts, Economies moving away from Globalisation, the Russia-Ukraine war and how can we forget Covid-19! In addition to this, the recent spike in Inflation is taking a toll on all of us, we can see the impact on our daily lives and the energy crisis is adding a lot to that. Now having a decent look at the economy, we can see that the future doesn't look bright, however, what we all can do is prepare for it by investing our money in the right place.
The main goal of these financial models is to understand whether a company is worth investing your money in the long run and the financial models do not focus on short-term gains. So enough details about the market, now let's jump straight into Microsoft to understand what is the best price to buy.
Microsoft
Microsoft is an American multinational technology corporation which produces computer software, consumer electronics, personal computers, and related services. It was founded by Bill Gates and Paul Allen on April 4, 1975, to develop and sell BASIC interpreters and the rest is history. We all know how great they have done in the past and now we are all used to their products. 80% of you are reading this blog on a Windows system and those on Mac will be having at least 1 or 2 Microsoft Office products currently running on their system. In short, we know that they have done well in the past but let's look at their current as well as future plans.
Microsoft has divided their revenue streams into three categories:
- Productivity and Business Processes: The Productivity and Business Processes segment consists of products and services in Microsoft's portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises Office Commercial, Office Consumer, LinkedIn, Dynamic 365, ERP and CRM solutions and Power Apps.
- Intelligent Cloud: The Intelligent Cloud segment consists of public, private, and hybrid server products and cloud services that can power modern businesses and developers. This segment primarily comprises server products, cloud services (Azure), Enterprise services and Microsoft consulting services.
- More Personal computing: More Personal Computing segment consists of products and services that put customers at the centre of the experience with Microsoft's technology. This segment primarily comprises Windows OEM licensing, Windows commercial, Windows cloud services, Microsoft devices including Surface and PC accessories, Gaming including Xbox and search and news advertising.
The revenue of split of the aforementioned categories is as follows:
Microsoft has been in control of the upcoming technology and has been able to hold strong grounds in whatever market they enter irrespective of its competition. One great example of this is Microsoft Azure. As Jeff Bezos mentioned during his interview on The David Rubenstein
show that they had 7 years of AWS without any competition, Microsoft joined the party late and caught up strong, as it is the second biggest player in the cloud with a 21% market share. Microsoft has a culture of adapting to the ever-changing nature of technology and further becoming the leader in that domain. This quality is something that has helped them survive through 5 major recessions as well. Embracing change is a quality that many investors believe helps Microsoft with a strong foundation and great leadership. Now with a strong understanding of their business model, let's have a look at what story the numbers tell and how does the future look like.
Microsoft's Valuation
Let's start by having a look at their historic revenue growth and then the projected revenue growth as that is one of the most important factors whilst valuing a company. Having a historic growth rate of 15.47% in the last 5 years, I, like many investors, strongly believe that Microsoft can carry forward this trajectory of a growth rate of 15% p.a. and slowly move towards a rate of 10% in the next 10 years. Based on this assumption, I have built a Discounted Cashflow model projecting the revenue and costs until 2032. The DCF model has taken the financial figures from
Microsoft's SEC filing of 10-K dated 28th July 2022.
After taking the revenue projections, I projected the costs which increase in a similar fashion to the revenue as Microsoft has already achieved economies of scale for most of its costs. Once I calculated the Operating Income, I did similar projections for Tax, Depreciation, Amortization, stock-based compensation, △ working capital and Capital expenditures.
Although this is just a paragraph of text, it took me ages to project these numbers that are spread over 200 lines, 20 columns and a couple of sheets. Now back to the blog, I used these figures to get to the Free Cashflows for the following 10 years. Since we are at the start of an FY when this valuation is done, to get the Present Values (PVs) of these FCFs, I discounted the projected FCFs using a full-year discount instead of a mid-year discounting.
Discounting Factor (WACC)
In addition to the FCFs, we need to find a discounting factor with which we discount these cashflows. Generally, we use the WACC i.e. Weighted Average Cost of Capital to discount the FCFs and I have used the same. As the name suggests it is the weighted average of the cost of equity and the cost of debt that a company has. Keeping in mind the length of this blog, I'll jump straight to the WACC for MSFT which is 7.58%. With this, I calculated the PVs of the Free Cashflows for the projected 10 years and below is the screenshot attached of the projected FCFs.
Cash Flow projections
Terminal Value
After calculating the present values of the free cash flows, we have to get to the right Terminal Value. Terminal Value is calculated based on an assumption that the company will keep growing for perpetuity. We use a Terminal Growth rate to calculate this value which is typically inflation. However, as we know that we cannot take the current inflation as this does not reflect the long-run inflation, we generally stick to the inflation goal of the United States i.e. 2% but as Microsoft is beating inflation since its birth, I have taken a TGR of 3%. To calculate the Terminal Value we use the following formula:
TV = [FCF x (1 + g)] / (d – g)
Where:
FCF = free cash flow for the last forecast period
g = terminal growth rate
d = discount rate (WACC)
With all these calculations below is the summary of the financial model which also gives you the magic number i.e. the Fair value of the stock.
DCF model
As you can see from the calculations the Fair Value of the stock is $303.79 and would be a great buy for everyone in the long run. Currently, the stock is trading at $291.91 (14-08-22) so go ahead and grab the bargain. This concludes my research and findings about Microsoft and its share price.
Please feel free to share your views with me and any assumptions that you want to challenge. I have also done a sensitivity analysis of this but didn't want to bore you all to death by sharing that. Whoever is interested to have a full look into the DCF model please reach out.
I hope you enjoyed reading this blog.
Best regards,
Varun
Disclaimer: I am not a registered investment, legal or tax advisor. All financial opinions expressed are from my personal research and experience and are intended for educational purposes only.
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