Microsoft ($MSFT) continues to trade under US$20 a share.  We have previously looked at $MSFT and felt it was undervalued in the US$20-25 range.  We decided it was time to revisit our valuation.

Valuecruncher valuation model of $MSFT with interactive assumptions

Valuecruncher produces a valuation of US$25.34 for $MSFT. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 33.6% above the current share price of US$18.96.

Assumptions

• Revenue: Reuters aggregates 30 analysts covering $MSFT and the mean estimate of 2009 revenues is US$67.3 billion. For our analysis we have used US$64.0 billion in 2009, US$68.5 billion in 2010 and US$72.5 billion in 2011.  Between 2004 and 2008 $MSFT grew revenues at a compound annual growth rate of 13.2% - revenues of US$36.8 billion in 2004 to US$60.4 billion in 2008.
• Profitability: We have used an EBITDA margin of 40.0% to 2011. Reuters has $MSFT‘s EBITD margin at 39.25% last year and an average of 37.0% over the last five-years.
• Capital Expenditure: We have assumed capital expenditures of US$3.75 billion per annum moving forward.
• Discount Rate: 11.0%.
• Terminal Growth Rate: 3.0%. In our assumptions we have 2010/11 revenue growth at 5.8% - we have assumed that growth eventually slows to a 3.0% long-term stable growth rate.  We have used 3.0% as our terminal growth rate.

Our analysis incorporates the cash on the $MSFT balance sheet – Valuecruncher calculates a net debt number.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $MSFT we looked at four peer companies - IBM ($IBM), Apple ($AAPL), HP ($HPQ) and Google ($GOOG). We calculated enterprise values - market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $MSFT and the peer set.

We have used the last financial year (LFY) as the base set of metrics. $MSFT is currently priced at the bottom of the peer group for the EV/EBITDA and EV/EBIT metrics and in the middle for the EV/FCF metric.  The market is currently valuing the profits (EBIT and EBITDA) and free cash flow produced by $MSFT at less than half that of the comparable numbers for $GOOG. This reflects the perceived different future growth prospects of the two businesses.  The comparator numbers show $MSFT is comparably priced against the peer group - even with the strengths of their business model (39.8% EBITDA margins vs 18.9% for $IBM and 11.7% for $HPQ).  $MSFT’s growth is slowing - but it is still a very good business.  Should $MSFT’s profits (at the EBITDA and EBIT levels) really be valued less than $IBM and $HPQ?

Play with our assumptions – what does your analysis say? We think that $MSFT looks undervalued.  Our model is interactive - you can change any of our assumptions.

Disclosure: None

Last week a Global Equities Research analyst Trip Chowdhry put out a research note laying out his argument for Google ($GOOG) posting negative revenue growth in the current 2008 year. Chowdhry’s analysis (and we have not seen the original full research note) has $GOOG posting revenues of US$15.71 billion in 2008 (5% below actual 2007 revenues of US$16.94 billion), US$15.23 billion in 2009 (3% below his 2008 projection) and US$14.57 billion in 2010 (4% below his 2009 projection). This analysis was picked up by a range of commentators that we really respect. These included analyst’s like Barron’s Eric Savitz, Silicon Alley Insider and Ashkan Karbasfrooshan. The only problem is that the analysis is deeply flawed.

At Valuecruncher we believe that top-down analysis can lead to flawed conclusions. Current trends can be mistakenly extrapolated out. We believe that you need to work from the bottom up. This appears to be a case of top-down analysis gone wrong.

Why?

Chowdhry’s 2008 revenue number appears based on currently deteriorating marcro conditions - remember 2008 revenues of US$15.71 billion. However, through three quarters of 2008 $GOOG has reported US$16.09 billion of revenues (through three quarters). $GOOG already has reported 2008 revenues above Chowdhry’s projection (through three quarters). Unless $GOOG announces negative Q4 revenues it is not going to be posting revenues for the 2008 financial year of US$15.71 billion.

So what do we think about $GOOG’s future revenues and the implications for valuation?

Valuecruncher valuation model of $GOOG with interactive assumptions

Valuecruncher produces a valuation of US$350.60 for $GOOG. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 11.0% above the current share price of US$315.76.

Assumptions

• Revenue: Reuters aggregates 26 analysts covering $GOOG and the mean estimates of 2008 and 2009 revenues are US$22.4 billion and US$27.9 billion respectively. For our analysis we have used US$21.5 billion in 2008, US$24.75 billion in 2009 and US$29.0 billion in 2010. Citi analyst Mark Mahaney has some assumptions around revenues that we are broadly in agreement with. Assuming Q4 revenues are in line with Q3 then 2008 revenues come in at US$21.635 billion.
• Profitability: We have used an EBITDA margin of 40.0% to 2010. Reuters has $GOOG‘s EBITD margin at 36.4% last year and an average of 36.0% over the last five-years.
• Capital Expenditure: We have assumed capital expenditures of US$2.75 billion in 2008 then US$3.0 billion per annum moving forward.
• Discount Rate: 11.0%.
• Terminal Growth Rate: 5.5%. In our assumptions we have 2009/10 revenue growth at 17.2% - we have assumed that growth eventually slows to a 4.0% long-term stable growth rate.

Our analysis incorporates the cash on the $GOOG balance sheet – Valuecruncher calculates a net debt number.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $GOOG we looked at a two peer companies - Microsoft ($MSFT) and Yahoo ($YHOO). We calculated enterprise values - market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $GOOG and the peer set.

We have used the last financial year (LFY) as the base set of metrics. Of the peer group $YHOO is the closest direct competitor. But $YHOO has had a number of recent struggles and their LFY performance against $GOOG is not pretty. $MSFT’s numbers are an interesting comparison. $MSFT shows how far $GOOG still has to go from a financial perspective. $MSFT has over 3.6x the revenues of $GOOG (on a LFY basis). $MSFT’s financial performance is comparable to $GOOG. The market is currently valuing the revenues, profits (EBIT and EBITDA) and free cash flow produced by $MSFT at less than half that of the comparable numbers for $GOOG. This reflects the perceived different future growth prospects of the two businesses. That is an interesting observation - but to properly understand the implications you need to do the bottom-up analysis for each (probably using a discounted cash flow model).

Play with our assumptions – what does your analysis say? Our model is interactive - you can change any of our assumptions.

Disclosure: None

At Valuecruncher we have looked at Apple ($AAPL) twice over the last six-months. In June with the $AAPL share price at US$186.10 we produced a valuation of US$146.70. Then in September with the $AAPL share price at US$131.05 we had a valuation of US$163.98. We are now in early-December and $AAPL has continued to head south - with the market generally. $AAPL is now trading at US$94.00 - just over half the price we first looked at in June. We felt it was time to revisit the valuation of $AAPL from an intrinsic value perspective - and most importantly the assumptions that we are using. We have also completed some high-level comparator analysis looking at the current price of $AAPL against some broad peers using a range of metrics.

Valuecruncher valuation model of $AAPL with interactive assumptions

Valuecruncher produces a valuation of US$109.55 for $AAPL. This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price. This valuation is 16.5% above the current share price of US$94.00.

Assumptions

• Revenue: Reuters aggregates 29 analysts covering $AAPL and the mean estimate of 2009 revenues is US$40.6 billion. For our analysis we have used US$36.5 billion in 2009, US$43.5 billion in 2010 and US$49.0 billion in 2011.
• Profitability: We have used an EBITDA margin of 19.0% to 2011. Reuters has $AAPL‘s EBITD margin at 20.8% last year and an average of 16.8% over the last five-years.
• Capital Expenditure: We have assumed capital expenditures of US$1.15 billion per annum moving forward.
• Discount Rate: 11.0%. In our June valuation we used a discount rate of 11.0% but dropped that to 10.0% in September. We believe 11.0% is a reasonable assumption in the current market conditions.
• Terminal Growth Rate: 4.0%. In our assumptions we have 2010/11 revenue growth at 12.6% - we have assumed that growth eventually slows to a 3.0% long-term stable growth rate.

Our analysis incorporates the cash on the $AAPL balance sheet – Valuecruncher calculates a net debt number.

Comparator Analysis

Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. At Valuecruncher we have previously looked at comparator analysis.  For $AAPL we looked at a range of broad peers.  We calculated enterprise values - market capitalisation plus net debt (long-term borrowings less cash).  Then we measured a range of metrics against the enterprise value for $AAPL and the peer set.

We have used the last financial year (LFY) as the base set of metrics.  Of the peer group $EBAY and $YHOO had rough LFY performance.  The other numbers are interesting.  The one that stands out a mile to us however is that $AAPL is currently trading at 7.0x last years free cash flow (FCF).  Remove the cash and you can have the business for 7.0x last years FCF - no growth assumed.  Wow - that looks cheap.

Using our valuation of US$109.55 that gives a EV/FCF multiple of 8.7x.  That is still pretty resonable compared to the peer set.

Play with our assumptions – what does your analysis say?

Disclosure: None

$YHOO has had a horror run since rebuffing Microsoft’s ($MSFT) takeover offer at US$31 a share.  Today $YHOO closed at US$12.86 – just above 40% of the $MSFT offer (from 31 January 2008).

Valuecruncher valuation model of $YHOO with interactive assumptions

Valuecruncher produces a valuation of US$17.62 for $YHOO.  This is a current valuation (an estimate of intrinsic value using a discounted cash flow model) not a target price.  This valuation is 37% above the current share price of US$12.86.  This valuation of $YHOO focuses on the core business – we have ignored the investments $YHOO holds in Alibaba, Yahoo Japan and G-Market.

Assumptions

Revenue: Reuters aggregates 25 analysts covering $YHOO and these analysts have mean estimates of 2008 and 2009 revenues of US$5.69 and US$6.42 billion respectively.  For our analysis we have used US$5.50 billion in 2008, US$6.15 billion in 2009 and US$6.75 billion in 2010.

Profitability: We have used an EBITDA margin of 33% flat to 2010.

Capital Expenditure: We have assumed capital expenditures of US$700 million in 2008, US$800 million in 2009 and 2010 and then US$750 million beyond that.

Discount Rate: 11.0%.

Terminal Growth Rate: 4.5%.

Our analysis incorporates the cash the $YHOO balance sheet – Valuecruncher calculates a net debt number.

Disclosure: None

With the turmoil in the world’s financial markets over the last few weeks we have been asked why we don’t have valuations of financial institutions here at Valuecruncher.  The last few weeks have actually shown exactly the reason why we don’t.

When we launched Valuecruncher our objective was: “making the valuation methodologies used by corporate finance professionals more accessible to a wider audience”.  To achieve this we provide a three-year discounted cash flow (DCF) calculator.  This approach works well for most companies.  However there are several instances where it does not.  One of these is financial institutions.

For financial institutions (such as Goldman Sachs) a key to understanding their intrinsic value is the value of assets and liabilities held on their balance sheet - in the form of different financial securities.  These assets and liabilities are difficult to value (as an outsider) in normal times - and almost impossible at the moment.  This isn’t the case for a company like Microsoft - where balance sheet items (such as cash) are important but easy to measure.  Microsoft’s value is driven by the cash it generates from selling software - and adjusting for cash and any debt on the balance sheet.  Goldman Sach’s earnings are important - but not as important as changes (both positive and negative) to the securities they hold on their balance sheet.  As the current financial conditions illustrate - the value of these assets can move quickly and dramatically.

Some quick numbers:

Microsoft: 2008 revenues US$60.4bn, operating income US$22.2bn, total assets US$72.8bn, total liabilities US$36.5bn, total equity US$36.3bn.  Market Capitalization US$250bn.

Goldman Sachs: 2007 revenues US$88.0bn, operating income US$17.6bn, total assets US$1,119bn (US$1.1 trillion), total liabilities US$1,077bn (1.1 trillion), total equity US$42.8bn.  Market Capitalization US$54bn (Note: this market capitalisation is approximately 55% of the 52 week high).

Two companies with comparable revenues and operating income (and total equity) - but very different balance sheets.

Valuecruncher will help you to value Microsoft - but not Goldman Sachs.  Here at Valuecruncher we are focused on providing tools for valuing listed companies.  If the tools we provide are not appropriate for a particular company or industry (i.e. financial institutions) then we will exclude those companies.

Note: the other significant industry that we don’t cover at Valuecruncher is natural resources companies.  This is for a similar reason.  The value of natural resources companies is driven by the assets they hold (i.e. oil and gas deposits) not near-term cash flows.  Hence we don’t cover natural resources companies either.

In our experience, most private investors don’t complete fundamental financial analysis on prospective investments.  They often recognise this and say they would like to do more – but “it is hard work”.  They are right – but running financial analysis on prospective investments, even at a high-level, is a vital step in making quality decisions.  The professionals don’t pull the trigger without running the numbers.

One of the aims of our Valuecruncher interactive tool is to make it easier for people to complete fundamental valuation analysis using a discounted cash flow valuation methodology.  Here is our quick guide to completing a high-level discounted cash flow valuation analysis in five-minutes.  We have chosen Microsoft (MSFT) as the example company.

The default Valuecruncher interactive tool is a starting point for the valuation of companies in our database.  Instead of having to build a discounted cash flow model and source the various company projections – Valuecruncher gives you the valuation model and starting inputs.  We start on the MSFT company page.

Valuecruncher MSFT Company Page

To get started – hit the “Create Your Valuation” button.  This takes you to the default Valuecruncher valuation for MSFT.  This default valuation isn’t a recommendation it is a starting point to create your own valuation.

Profitability

The profitability tab covers the company’s anticipated revenues and profitability (at the EBITDA level).  The starting numbers in the default valuation are based on estimates of the company’s prospects moving forward.  To complete a high-level valuation of MSFT we round the revenues to three significant figures – US$67.5 billion in 2009, US$74.5 billion in 2010 and US$79.4 billion in 2011.  We have used a flat EBITDA margin of 40% to 2011.

Key Valuation Assumptions

Discount Rate – reflects the required rate of return on an investment. The discount rate consists of two key components, the time value of money and risk.  The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital (WACC).  The higher the discount rate the more variable (greater risk) the cash flows generated by the company.  For US companies we would expect to see discount rates in the 8-12% range – 8% being stable utility style businesses and 12+% being riskier technology-based companies.  For MSFT we have used a 10% discount rate.

Terminal Growth Rate – is an approximation of the growth rate beyond the next three years into perpetuity (i.e. forever) of the company’s cash flows. The company’s growth rate will fluctuate with economic and industry cycles with the terminal growth rate representing an average growth rate.  The long-run expectation for economy wide growth is approximately 2-3% (nominal).  We have a blog post with a table showing how to estimate terminal growth.  But the place to start is 2-3% + a factor for near term growth.  We have completed a valuation for Google (GOOG) that used a 6.5% terminal growth estimate – that is pretty high.  You would expect to typically see terminal growth in a 2-4% range.  For MSFT we have used 3%.

Tax – The tax rate entered is used to calculate the tax payable for the first three years. Beyond that the marginal tax rate of the country of domicile is used.  For MSFT we have used 35%.

Capital Expenditure / Depreciation

How much does the company have to spend to generate the revenues and profits for the business?  Capital expenditure is a cost that is not included in the revenue or EBITDA margin assumptions.  This covers: the acquisition or disposal of operating assets, research and development costs not included in the EBITDA margin and changes in net working capital.  The terminal capital expenditure represents an estimate of the ongoing investment required to facilitate the forecast long term growth. The terminal capital expenditure value should be viewed as a simplified estimate of a more complex series of expenses.  For MSFT we have assumed capital expenditure of US$3.25 billion in 2009, US$3.75 billion in 2010 and 2011 then terminal capital expenditure of US$4.0 billion.  We have assumed depreciation of US$2.75 billion in 2009, US$3.0 billion in 2010 and US$3.25 billion in 2011.

That is it – 16 variables with default numbers provided.  Other inputs from the balance sheet that form part of a net debt calculation (long-term borrowings and cash) are calculated automatically by Valuecruncher based on the latest balance sheet numbers.

This gives us a valuation for MSFT of US$30.86 – 25.6% above the current share price of US$24.57.  Based on this high-level analysis MSFT looks cheap.

Valuecruncher valuation model of MSFT with interactive assumptions

With a valuation created it now appears on the company page for others to see.  Other users can create their own valuations or they can then take the assumptions from an existing valuation and change ones they choose to create a separate valuation.  Saving changes to a valuation simply creates a new valuation.

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Microsoft (MSFT) is in an interesting place at the moment - which is only in part to losing Bill Gates from day-today management. It created one of the dominant global businesses of the late 20^th century but has struggled to move beyond the core products that drove this success. The Client (Windows), Server and Tools (enterprise solutions) and MBD (Office) divisions drive 83% of revenues and over 100% of operating profits (the On-line Services and Entertainment divisions are still operating at a loss). Microsoft has spent a lot of money and resources (especially senior management focus) on the aborted (maybe) attempt to acquire Yahoo (YHOO). We agree with the analysis that the pursuit of Yahoo is an attempt to compete with Google (GOOG) in what has become one of the dominant global businesses of the early 21^st century (on-line advertising driven by search). The Microsoft acquisition of Powerset is a further example of this strategy of aiming to compete directly with Google.

At Valuecruncher we are not convinced by this strategy of competing with Google - we are not alone. We completely respect Microsoft’s previous successes in following into and then dominating markets. But in the on-line advertising and search market we see some of the same network effects that suggest a “winner takes all” competitive situation. At Valuecruncher we can see a situation where Google’s current dominance is eroded – but not because of a head-to-head battle with either Yahoo or Microsoft (or a potential combination). At Valuecruncher we believe that Microsoft should be looking beyond the current competitive situation to the next big profit pool. Hockey great Wayne Gretzky when asked about why he was successful is credited with the quote “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be”. Easily said we recognise, but that is our view of where Microsoft should be directing their strategic efforts – not competing head-to-head with Google in a market their competitor dominates.

Any potential acquisition of all, or part, of the Yahoo business clouds any current valuation discussion of Microsoft. Some influential Microsoft insiders have suggested in a piece of high-level analysis that 1% of the global search market is worth US$1 billion in market capitalisation. Microsoft’s potential acquisition of Yahoo valued their share of the search market at more than that - US$47 billion for approximately 20% market share. What about the core Microsoft business? What if we ignore the potential Yahoo scenarios – what is the core Microsoft (MSFT) business worth?

The core Microsoft business is reasonably easy to value – if you exclude growth options. The business is growing well (if not at the levels of ten years ago) with robust margins. There is capital expenditure required to achieve the revenues and profitability. There is strong competitive positioning around these core products but with credible low-end competitors that have the potential to disrupt (i.e. Google Docs). The current business will change as technology develops – but as the current dominant player, Microsoft is well positioned to respond to competitive threats and to potentially lead innovation. At Valuecruncher we are not sure that Microsoft should be investing heavily in the on-line advertising and search market - they should be aiming beyond it.

MSFT Valuation

Microsoft grew revenues from US$36.8 billion in 2004 to US$51.1 billion in 2007 – an 11.5% compound annual growth rate. Our assumptions of revenues for the next three years are US$60.0 billion in 2008 growing to US$74.0 billion in 2010 – a 13.1% compound annual growth rate. We have projected EBITDA margins to be flat at 40%. We have used a terminal growth rate of 4.5%. We calculated this terminal growth rate based on year three growth of 10.4% dropping to a 4% stable growth rate by year 10. We used a terminal capital expenditure number of US$3.0 billion. We have used a WACC (discount rate) of 10.5%. Both the terminal growth rate and WACC have a material impact on the valuation.

Valuecruncher Valuation MSFT

Our analysis incorporates the cash on the Microsoft balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$33.01 which is 20% above the current share price of US$26.03. The market appears to be placing a negative value on the noise around an acquisition of all or part of Yahoo. Focusing on the harvesting the core business and innovating (by making small bets) beyond that core appears to be the highest value strategy for Microsoft.

Based on our analysis the core business looks undervalued. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.