I’m long Microsoft (MSFT, Financial) and have been for a few years. It has been a wonderful investment for me so far. Using Warren Buffett (Trades, Portfolio)’s vocabulary, Microsoft has a huge moat around it. After many years, giants like Apple and Google have tried to destroy Microsoft’s competitive advantage but have been unsuccessful thus far. The proof that Microsoft is still strong is the fact that most businesses still use Windows as their operating system and the Microsoft Office Suite as their main software. I strongly believe that Microsoft is here to stay and that it will strengthen its brand in the future.
I have performed a Dividend Discount Model to value Microsoft. For dividend investors, Microsoft has been a great dividend payer for the last 10 years and it continues to increase its dividend year and after year.
For my dividend discount model, I used a required rate of return of 7.5% that I calculated using the Capital Asset Pricing Model (CAPM). For the next five years, I used a 12% growth rate for the dividend. I consider an 11% growth rate to be realistic considering that Microsoft’s dividend has been increasing at an average rate of 18% per year for the last 5 years. The growth rate that I used for the next 5 years is therefore 6% lower than Microsoft’s average dividend growth rate for the last 5 years. Moreover, Microsoft’s payout ratio is currently 44% of free cash flow, which means there’s a lot of room for Microsoft to increase its dividend even if free cash flow do not increase much in the next five years. Starting in 2020, I used a perpetual growth rate of 5%. I believe this is very conservative since it’s very likely that Microsoft will still have double digit growth in 2020. However, for my valuation model, I prefer to be conservative and I chose 5%.
Using the Dividend Discount Model, I get an Intrinsic Value of $70.96 per share for Microsoft, which represents a 48% margin of safety in relation to its current price of $47.81. Even assuming only 9% dividend growth for the next 5 years, I still get an intrinsic value of $62.28 per share of Microsoft. At $62.28, I still have a 30% margin of safety.
I always like to use more than one valuation model to make sure I didn’t make a mistake in my calculation of intrinsic value. Therefore, I also used a multiple valuation model based on the Price Earning. Based on analysts’ estimates, earnings per share for Microsoft will be approximately equal to 2,91$ per share for year 2015. Based on the fact that Microsoft is currently selling at 18.7 times EPS and assuming that the current P/E ratio will remain the same, a reasonable price target for Microsoft is $54.42 per share. At 54.42$ per share, I still have a 14% margin of safety.
Using two valuation models, I conclude that Microsoft shares are currently undervalued. I strongly believe that Microsoft shares are worth anywhere between 54$ and $71. The upside potential is significant. I have recently increased my position in Microsoft and I have the intention of continuing. The future looks bright for Microsoft Corporation.
Disclosure: Long MSFT
David Christopher, investor
