Geoff Gannon Investor Questions Podcast: #1 - Intrinsic Value Walkthrough

Hey this is Geoff Gannon. And you’re listening to the Investor Questions Podcast. The show that answers questions from investors like you. If you have a question you’d like answered call 1-800-604-1929 and leave us a voicemail. That’s 1-800-604-1929.








Today’s question is about intrinsic value. A listener wrote: “I’d like a podcast which walks through determining the intrinsic value of a company.”



Okay. We’re going to take a look at Microsoft (MSFT) since that’s a company and a stock a lot of people know a lot about. But first I want to get us in the mood with a quote from Warren Buffett. Here it is:


“If I ran a business school there would be only 2 courses. How to value a business and how to think about markets. No modern portfolio theory, no beta, etc. You don’t have to be right on 4,000 or 400 businesses - not even 40. Circle of competence. Start with a small circle and slowly expand. Don’t spend time on companies that don’t lend themselves to valuation. Accounting is useful, but sometimes it is not meaningful. Durability of competitive advantage is the key. And market fluctuations. The market is there to serve you - not instruct you.”





Okay. I picked that quote because it’s a good thing to read right before doing an intrinsic value calculation. It reminds us we don’t need to be precise. And we do need to be humble. But we don’t need to follow the crowd. We can come up with an intrinsic value estimate totally different from the market if our reasoning is right.


It also reminds us that a lot of companies can’t be analyzed all that well. I think Microsoft can. And that’s one reason I’m talking about it today.


Why do I think Microsoft can be analyzed? Or - to put it in Buffett’s terms - why do I think Microsoft lends itself to valuation?


Basically it comes down to free cash flow. Microsoft produces a lot of free cash flow. And it does it consistently. Year in and year out for a lot of years. In fact if you look at the SEC reports available on EDGAR going back to the 1993 10-K which includes data for 1990 through 1993 you’ll see that Microsoft has been consistently profitable both on its income statement and its cash flow statement for at least 20 years.


Only something like 1 in 25 public companies have 10 years or more of uninterrupted free cash flow generation. About 95% of the companies out there either haven’t been public for 10 years or haven’t managed an unbroken streak of free cash flow. Now - to be fair - I excluded financial services firms - things like banks and insurance companies - from this calculation because its hard to evaluate them on the basis of free cash flow.


Microsoft’s record of generating free cash flow is a lot more consistent than almost any other company. I keep a list of 300 or so public companies who have an unbroken streak of being free cash flow positive for at least the last 10 years. It’s an interesting list. There are companies with market caps of less than $10 million in the group. And there are companies with market caps of more than $100 billion. That means the biggest businesses on the list are more than 10,000 times the size of the smallest businesses.


Microsoft’s yearly free cash flow number has varied less than 99% of the companies on that list. And we’re talking about a list that includes businesses in things like dentistry, trash collection, personal care products, and hair salons. Those industries have maybe 2 or 3 down years in a century.


Ben Graham wrote a book called . In it he made a point of distinguishing between meaningful and not meaningful averages. He thought it was important to look not just at a company’s average earnings over say 5 or 7 or 10 years. But to see if the average was actually meaningful in the sense that all the yearly numbers tended to fall around a certain point.


We can measure that tendency statistically. But the first and best way to look at a company’s past earnings record is just to eyeball the numbers. I’ll read you Microsoft’s average free cash flow per share - adjusted for the current share count - for each of the last ten years. Just listen and hear the consistency: $1.06, $1.47, $1.39, $1.55, $1.68, $1.44, $1.75, $2.08, $1.79.


The numbers are tending to fall around an average of $1.60. Statistically speaking the range is $1.06 to $2.08. The mean is $1.60. The median is $1.61. The standard deviation is $0.26. And the variation as measured by the standard deviation divided by the mean is just 16.54%.


That’s a lot of numbers. What matters is what you heard with your own ear. The stats are just there to quantify what you picked up on right away. By comparing Microsoft to other companies with at least 10 straight years of free cash flow generation we see objectively that Microsoft’s free cash flow has been less variable in every sense than at least 9 out of 10 companies I can compare it to.


I’m telling you all this stuff because its exactly where I’d start if I were doing this on my own. The first thing I‘d ask is: “Has this company generated free cash flow year in and year out for at least 10 years?” For Microsoft the answer is yes. Then I’d figure out what the average free cash flow was and how much it varied by. I’d then try to benchmark that free cash flow variation against the toughest competition I could think of - consumer products companies and the like.


And I’d see that Microsoft is a lot more consistent than most of those businesses. But that kind of thinking can only take you so far. It doesn’t tell me anything about durable competitive advantage.


I won’t go into specific data on Microsoft’s competitive advantage because I’m sure you know all about it. I’ll just say it earns very high returns on assets and equity as well as sales. Microsoft converts a very high percentage of its sales into free cash flow and its segment operating margins are insanely high.


If we take the 3 years from 2007 to 2009 we see that operating margins for Windows are 76%. Margins on Office - that’s Microsoft Word and Excel and all that - are 65%. And Server operating margins are 35%. Those are the only businesses that make money for Microsoft. Everything else loses money.


Now we’re getting to the heart of the intrinsic value estimate. Years ago I wrote that the things you should focus on in investing should be constant, consequential, and calculable. In Microsoft’s case that means focusing on free cash flow and the businesses that drive Microsoft’s results.


I’m not going to talk about Xbox or Zune or Bing because I don’t think those things matter. Not to an investor. What matters is Windows and Office and to a lesser extent the Server business.


Right away we see that - yes - Microsoft is a technology company but it’s probably better thought of as a business services company. If you read Microsoft’s 10-K this comes through loud and clear.


More than 80% of Microsoft’s sales and more than 100% of its operating income comes from Windows, Office, and Servers. Close to 60% of sales and 85% of operating income comes from just Windows and Office. Those 3 businesses are tightly connected. And the Windows and Office businesses are practically inseparable. Remember when we talk about Windows and Office we’re talking about more than four fifths of Microsoft from an investor’s perspective.


The Windows and Office franchises make up the vast majority of Microsoft’s value. And any serious intrinsic value estimate needs to focus on those businesses and their future.


Some people think it’s a grim future. I don’t. Windows and Office have a lot of competitive advantages. Their market share is very high. And their relative market share is as good as any product out there. By relative market share I mean Microsoft’s market share divided by the market share of its nearest competitor.


Microsoft’s competitors in the operating system business are small and specialized. That’s usually a sign that head on competition is nearly impossible. For instance Apple’s operating system is subsidized by its hardware. Apple takes an integrated approach to computers and basically gives away its operating system.


As a result it is close to impossible to evaluate demand for Apple’s operating system. But it’s safe to say that if Apple software and hardware were separated into two different companies the software business would not be much of a competitor.


Microsoft’s franchise value can be destroyed in a couple ways. The most obvious - and most likely - scenario is one in which society shifts away from the category Microsoft dominates and towards one it doesn’t. Societal shifts kill brands that don’t adjust.


If you make caskets and folks start cremating Mom and Dad - you’re in trouble. If you run classified ads in your newspaper and people start using Craig’s List - you’re in trouble.


In some cases it’s unlikely your company’s culture requires you to stay on the losing horse. In others - like the newspaper example - the transition is basically impossible. Newspapers define themselves by the news they make not the classified ads they run. So as classified advertising moves away from newspapers - yeah you can put the news online - but you’ll never get the classified ads back. They’ve gone to a better place. So you’ve lost your competitive advantage. And you’ve lost your profits. You can do great reporting online, but unless you attract more national advertising or you charge readers a lot more you can’t regain your past profits because people aren‘t using your paper as a bulletin board anymore. And that bulletin board feature is what made papers profitable.


How about Microsoft? If the world moves away from desktops and laptops towards netbooks and tablets and smartphones will Windows die out?


I don’t think so. But I don’t know. There are real threats if everything moves online. But Windows and Office are still used by lots of individuals in lots of businesses. For those businesses to switch over to something else they have to get individual employees to make the switch. And from what I’ve seen of people’s computing habits they’ll be a ton of resistance to any switch like that.


I’m sure that if there are cheaper alternatives that are just as good as Windows and Office most people using Microsoft’s products today will keep using them. Cost alone won’t cause businesses to switch because making the switch will be too painful.


On the other hand alternatives that are clearly better than Windows and Office and much, much cheaper might be successful.


That’s about as far as I can take this thought experiment.


The bullet points are that I would focus on the things that matter for Microsoft investors. And those things are Windows and Office. Servers matter too but I don’t have a lot to say about them and they matter a lot less.


Once I’ve thought all this through I’d take a look at where triple A bonds are trading. Triple A corporate bonds - and Microsoft is a triple A rated company - yield about 5.3% right now. If you invert that number - that means you divide 1 by 5.3 percent - you get 18.87. That’s the multiplier I would use to get Microsoft’s intrinsic value.


Microsoft’s 3-year average free cash flow per share is about $1.87. By now it might be closer to $1.90 - some of the figures I’m using are a bit out of date. If it’s $1.87, Microsoft’s intrinsic value would be $35.35. If it’s $1.90, Microsoft’s intrinsic value would be $35.85. Not much of a difference.


The minimum free cash flow number for the last 10 years was $1.06 a share which gives an intrinsic value of 20 dollars even. The maximum was $2.08 a share which gives an intrinsic value just under 40 dollars. The mean and median were $1.60 and $1.61 which translate to $30.20 and $30.40.


I don’t want to be too precise so I’m going to say Microsoft’s intrinsic value is about $35 a share. I’m also going to say that the range in which I’d have a high confidence is something like $20 to $50 a share. There’s a high chance Microsoft’s intrinsic value is somewhere in that $20 to $50 range and a very, very low chance Microsoft’s intrinsic value is less than $20 a share.


Microsoft’s history of stock buybacks adds to my confidence in that estimate. It’s hard to see how Microsoft could possibly be worth less than $20 a share if the company keeps buying back stock at anything close to the rate it has been.


Now the obvious complaint here is that I’ve given you a useless answer. Microsoft’s stock is trading a buck or two shy of $30 a share. That makes my estimate of $35 a share and my range of $20 to $50 a share look pretty useless.


And it is useless for now. I never want you to buy a stock at 80% of its intrinsic value. A 20% discount doesn’t leave enough room for error. You can think seriously about buying a stock at 65% of intrinsic value. And I hope you usually buy stocks at 50% or less.


Microsoft is nowhere near that cheap. And it’s a huge company with limited growth potential. All huge companies have limited growth potential. Don’t let anyone tell you different. Yeah - the stock buybacks are a big help at low prices. But at fair to expensive prices they don’t add value.


So all this thinking about Microsoft boils down to nothing actionable. That’s what happens most times you look at a stock. You don’t buy and you don’t sell. You just move on.


But remember Microsoft got real cheap in 2008. The stock was below $18 a share for a while. And it hit a low of $15 a share in March of 2009. Based on our estimate anything less than $17.50 a share would be a screaming buy. So even with a big, predictable company like Microsoft you’ll sometimes see the stock fall to a price that’s way too cheap.


And the beauty of a business with competitive advantages - and especially one that’s buying back stock - is that you can buy it at $17.50 a share and hold it to $35 a share without losing sleep.


Microsoft is the kind of business that’s a joy to own. You don’t get too many chances to buy that kind of business at a good price so it helps to know what it’s worth ahead of time.


Well that’s it for today’s show. If you have a question you’d like answered call 1-800-604-1929. That’s 1-800-604-1929.


And don’t forget to visit InvestorQuestionsPodcast.com


Thanks for listening.