This is the first post in a new series called Model Vs. Market where we compare a company’s intrinsic value, as calculated by our discounted cash flow model, with the company’s current share price.
“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”
– Warren Buffett
If a company’s current share price is lower than your estimate of its intrinsic value you should consider buying it. Every model using the discounted cash flow approach is based on assumptions and, like pizza, the quality of the results are only as good as the quality of the ingredients.
The first company we’re looking at in Model Vs. Market is Microsoft Corporation. Here is some background on the company:
Microsoft Corporation is a computer software and services company incorporated in 1993 with headquarters in Redmond, Washington. It is engaged in the development, licensing and distribution of a range of software products and services for enterprise and individual end-users. Its business is divided into five segments: DC (Devices and Consumer) Licensing (Windows platform), D&C Hardware, D&C Other, Commercial Licensing and Commercial Other.
The company’s core product is the Microsoft operating system (MS-OS) for computers, phones, servers and other devices. Other products and services include server applications, productivity applications, business solution applications, desktop and server management tools, software development tools, games, advertising tools and cloud-based solutions like Skype, Xbox Live, Bing and others. On the services side, the company offers consulting, training and certification for system developers and integrators. Microsoft does business worldwide, with offices in over 100 countries.
What is Microsoft worth?
Our valuation model is indicating that shares of Microsoft are worth $57. Here are the key assumptions used to arrive at this value:
- Revenue Growth – Over the last 5 years revenue has grown at an average rate of 8.6%. The model assumes this same growth rate for the next 4 years followed by a terminal growth rate of 2.5%.
- Profitability – Over the last 5 years the EBITDA margin has averaged 41%. The model assumes this same margin going forward. Note that the EBITDA margin has been declining to over the last 5 years to 38.1% in fiscal 2014. Using a 38% EBITDA margin for the projection reduces the valuation to $53 per share.
- Depreciation – Depreciation in 2014 was 6% of revenue. Our model assumes this same rate of depreciation going forward.
- Income Taxes – The average effective tax rate for the last 5 years was 21.2%. Our model assumes this same effective tax rate going forward. Increasing the effective tax rate to 40% reduces the valuation to $45 per share.
- Capital Investment – Over the last 6 years the company has spent an average of 8.9% of its revenue on capital investments, net of dispositions. Since much of this capital investment has fueled the company’s revenue growth the model assumes the same level of investment going forward.
- Working Capital – After netting out cash, short-term investments and short-term debt the company operates with negative working capital. The model assumes this will continue in the projections at the same rate as revenue grows.
- Discount Rate – The assumed cost of equity is 10% and the assumed cost of debt is 3.5% over the 10-year U.S. treasury rate. Since the company has no debt the average cost of capital is 10% in the model. Reducing this to 8% increases the valuation to $75 per share.
This model was created by extrapolating the last 5 years of performance into the next 5 years of performance. Before making an investment decision you should run your own model with your own assumptions based on your own research of the company. Download this model to perform your own valuation and let us know what you think shares of Microsoft are worth on Twitter @tagnifi.
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