Microsoft (MSFT, Financial) has been without a doubt one of the greatest stocks to own in the past decade. In the past year alone, shares in the technology group are up 42%. Since the beginning of 2020, the stock is up nearly 900%, excluding dividends.
With the shares now trading above $300, and after their momentous rally over the past decade, I thought it might be worth looking at the business to see if it can continue to increase in value, based on what we know today.
The outlook for Microsoft
Microsoft's valuation presents a mixed picture. Using a simple discounted cash flow analysis, the stock has a fair value of $300 per share. This is assuming a discount rate of 2.5%, currently double the 10-year Treasury rate, and a long-term growth rate of 9% for free cash flow. I settled on this free cash flow growth rate estimate because it is the average for the company over the past 10 years.
Using the average of the past five years, which is 18%, the fair value increases to $882 per share. I do not think it is reasonable to assume the company's free cash flow will grow at a compound annual rate of 18% indefinitely. I think 9% is a more realistic figure and, more importantly, includes a margin of safety.
The main drawback of using a discounted cash flow analysis is the fact that while it gives an estimate of intrinsic value, it does not tell us anything about the company's cash flows. Just because Microsoft has earned x billion dollars this year does not necessarily mean it will continue to do so for the foreseeable future. If it cannot, the entire calculation is a waste of time.
Sticky revenues
Microsoft essentially has three business divisions. The first is Productivity and Business Processes, which made up around a third of fourth-quarter revenue and comprises products such as Microsoft Office and LinkedIn. Next, there is the Intelligent Cloud division, which accounted for nearly 40% of fourth-quarter revenues. And finally, More Personal Computing includes Windows Commercial products, Xbox and Surface revenue.
Of these three business divisions, Productivity and Business Processes and Intelligent Cloud are the more exciting. They also have the most room for growth. Revenues in these divisions jumped 25% and 30%, respectively, last year as more customers joined the company.
These products have a sort of sticky nature to them. Companies using Microsoft products such as Office and the cloud won't be able to change easily. There will be costs of doing so, and it will be a time-consuming process. Therefore, customers will likely stay with the enterprise and be happy to pay more if prices increase.
And that is precisely what is happening. Last week Microsoft announced "substantive" price increases for its Office applications suite. It claimed this is the first substantial price increase since it launched Office 360 a decade ago.
Of course, only time will tell if customers will stick with the company after this increase, but experience suggests they will. The Microsoft Office Suite has been a staple for businesses around the world for the past three decades. Even though competitors have emerged during this time, none have taken out the industry champion.
While the outlook for these two divisions appears attractive, it is impossible to tell what will happen in the More Personal Computing business. There are a few more moving parts here. It's also not possible to tell if Microsoft will be able to continue to fight off challenges from competitors.
However, the information above shows this is a business with a sticky customer base, which should help underpin cash flow growth in the years ahead. Unfortunately, even with these qualities, the stock still looks expensive based on my conservative growth rate. Other investors may draw different conclusions.
