Running The Numbers - Microsoft ($MSFT) Trading Under US$20 A Share

This valuation is part of this blog post:

http://blog.valuecruncher.com/2008/12/running-the-numbers-microsoft-msft-represents-value-trading-under-us20-a-share/

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. Conservitively we have used 3.0% as our terminal growth rate.

Running The Numbers – A Five-Minute Valuation Of Microsoft

This valuation is part of this blog post:

http://blog.valuecruncher.com/2008/09/running-the-numbers-a-five-minute-valuation-of-microsoft/

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.

Valuing the core Microsoft business

This valuation is part of this blog post:

http://blog.valuecruncher.com/2008/07/as-microsoft-assesses-their-options-what-about-the-core/

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.

Microsoft Assumptions

Microsoft has growth still to experience in the core business but it is reasonably predictable. That growth will slow over time. Despite a significant R&D spend - Microsoft doesn't have new hi-growth businesses that have the potential to significantly impact the share price. Microsoft is still a very valuable entity - but it isn't the growth story it had the potential to be.

A discount rate of 11.5% and terminal growth of 4%. EBITDA margins top out in the low to mid-40% range. Terminal CAPEX tops out at $2.5 billion - but that continues to be extensions to the core business not new innovation.

Vista Balls Up

Revenue growth slowing unless they manage to sort out the Vista debacle.