☁️💻 Business Overview

🎯Key Metrics

Total: 12/17

• +2 ✅✅ Projected Operating Margin: 50%
• +1 ✅ Projected 5-Year Revenue CAGR: 16%
• +2 ✅✅ Last 5-Year ROIC: 26.49%
• +1 ✅ Estimated Cost of Capital: 10.94% (lower than ROIC)
• +1 ✅ Last 5-Year Shares Outstanding CAGR: -0.25%
• +1 ✅ Projected 5-Year EPS CAGR: 13.65%
• +0 ⚠️ Projected 5-Year Dividend CAGR: 8.07%
• +2 ✅✅ Moody’s Debt Rating: Aaa
• +2 ✅✅ Morningstar Moat: Wide
• +0 ⚠️ Morningstar Uncertainty: Medium

Microsoft is one of the best companies there is, and the above metrics show exactly that. Some of these metrics are extrapolations from the current situation of the business, its expansion or disengagement from certain business segments and my assumptions for the future of the company that I will proceed to explain in detail during the Business Valuation section below.

Some good things to point out are the projected margin expansion into the 50% territory. This shows the company has pricing power and an entrenched competitive advantage over competitors. This is all implied by the Morningstar Wide moat rating. The fact that the company manages to return almost 3 times its cost of capital its also a good sign that management are allocating and reinvesting well their capital. However, it should also be noted, as we will explore in the below sections, the ROIC seems to be declining a little bit over the course of the previous years.

As a little disclaimer before jumping into the “awesome” valution fire, I normally use these key metrics as an “allocation helper” to manage my investment portfolio, however take all of this with a grain of salt, and do as you see fit. Feel free to override and change some of the assumptions I’ll make during the valuation, and as with anything please take responsability for your own investment decisions.

📈Business Valuation

Before presenting you the final valuation I will show you my assumptions, as well as the historical data and framework its based on.

Revenue Growth

Below is the last ~10 years of revenue growth for Microsoft.

💡Given the historical data presented, my assumption is that the company will be able to growth its revenues ~16-18.5% (higher probability on the upper end) during 2027 (Year 1) and ~14-18% each year from 2028-2031 (Year 2-5).

Cost of Capital

I’ve used the latest annual report of the company, the 10-Year US bonds as the risk free rate and revenue geographic exposure to come up with its cost of capital, cost of debt and cost of equity. Also, given the fact that Moody’s provided a rating for the company I used it as the debt rating.

Cost of Capital: 10.94%.

This value will be used later as a discount rate in the valuation methods.

Please feel free to come up with your own values by using the tool I’ve used: Cost of Capital – The Fair Value Journal. It is and will ever be completely free 🙂

Also, keep in mind that the average cost of capital in the US for a company similar to Microsoft is ~9.34%.

💡My assumption for the cost of capital is that it would start at around its estimated value of 10.94% and gradually converge to the industry average 9.34%. Later, we will explore some variability over these values by using the Monte Carlo simulations.

Operating Margin

Microsoft has its revenues spread over the 3 business segments described below:

Productivity and Business Processes : 42.19%

• Microsoft 365, LinkedIn,Dynamics products
• operating margin: 59.92%

The Productivity and Business Processes segment has expanded its operating margin from ~45% to ~60%. It does not show signs of slowing down, despite the fears of AI penetrating the Office products space.

Intelligent Cloud : 41.52%

• Azure, GitHub cloud services, SQL Server, Visual Studio, Enterprise/Partner services
• operating margin: 41.35%

For the Intelligent Cloud segment you can see that the operating margin remains equal or even in a slow decline. This may be a sign of the difficulty in raising prices within a very competitive environment, where for example there is the AWS from Amazon or GCP from Alphabet.

More Personal Computing : 16.29%

• Windows and Devices, XBOX, Search Advertising
• operating margin: 26.62%

The More Personal Computing has the lowest operating margin of all the 3 segments.

This graph below also shows the company’s overall operating margin expansion over time:

Microsoft during the last ~5 years has expanded its operating margin from ~40-41% to ~46-47%, an increase of ~5%.

Now, we can also map out and see the graph for the contribution of each segment to the company revenues over time:

As you can see, the company has been reducing its exposure to the lowest operating margin segment More Personal Computing and this fact alone may be the main contributor to the operating margin expansion discussed before. Also, from the graph above, we can also extrapolate that given the formidable Azure cloud growth, the Intelligent Cloud segment will probably surpass the Productivity and Business Processes during the next couple of years.

I will go a step further and extrapolate from this that Microsoft will continue to reduce its exposure to the More Personal Computing segment and the cloud will gain more % of total revenues. This may be a double edged sword, because despite Intelligent Cloud being the faster growth segment, its operating margins are below the overall company operating margin and also, this business segment may see their margins continue to contract given the fierce competition on the Cloud space.

💡My assumption is that Microsoft will still see some margin expansion, however I see it taper around the 50% mark given the competition and probable decrease in the cloud operating margins. Also for me, there’s uncertainty around the Office products, because is still not clear to me what will happen to the Productivity and Business segment operating margins during the next couple of years with the introduction of AI.

Sales / Capital ratio (Reinvestment)

This ratio shows you how the capital invested is being translated into the business revenues. Please remember that sometimes the company may invest today to only reap the benefits and sales after a couple of years.

Below you can see the last 5 years of Sales to Capital ratio for Microsoft:

This is really an indication that the company is investing for the future, and that this capital invested is still not being materialized into its sales/revenues.

💡My assumption is that the company will gradually reap some benefits from their current investments, however I will not compromise too much with this assumption, because is still not clear to me how much the business will gain and how much it will still need to reinvest even if AI becomes profitable. I’m assuming the Sales / Capital ratio starts at around the current values of 0.7-0.8 and gradually converges to 1-2, still below their 2021 values.

ROIC

Still related with the company’s reivestments, but this time with their return on the capital invested.

This ratio has also been declining over the last couple of years:

However, it still is very good and still above (well above) the estimated cost of capital.

💡My assumption is that the company will still be able to return above its cost of capital long-term. I will have it converge to a ROIC of ~10.94% (its estimated cost of capital) to a maximum of 20%.

Discounted Cash Flows (Weight: 60%)

I’ve used the latest annual report and my assumptions explained above to complete my Discounted Cash Flow valuation:

Some notes on the inputs above:

• Terminal Revenue Growth – I’m using the risk-free rate (10-Yr bonds of the US), because long term the company should not grow more than the rate of the economy. I’m using the risk-free rate as a proxy to it, so the terminal growth becomes it;
• Initial and Terminal Tax Rate – Given the fact that its recent averages are around ~20% I’m assuming the same value for both.

All the other inputs were taken from the financial statement or from my assumptions.

The DCF gives us an estimated fair value of 498.85 dollars for Microsoft.

Something that we can also do now is to play around with Monte Carlo simulations. What this will allow us to do is to simulate multiple DCF valuations with pre-defined ranges for each of the inputs. Each simulation will randomize the inputs between these pre-defined values. For this I also used my assumptions and the range explained on during that sections.

As you can see from the above Microsoft seems to be fairly valued given that its current price of 464 dollars is around the median. From these simulations we can extrapolate that there’s between ~50% probability of Microsoft being overvalued and ~50% of being undervalued.

Please be free, as before, to fill in your own values. Make the valuation your own and do yourself a DCF valuation using your own assumptions: DCF – The Fair Value Journal

EPS Growth (Weight: 40%)

For the EPS valuation, I designed three different scenarios, to be used later on the Monte Carlo simulation: a bad, a base and a good scenario. Everything about them is explained below.

Please note that the EPS reported on the annual report was $18.00.

Also some relevant historical notes about the company:

Revenue Growth (CAGR)

Shares Outstanding (CAGR)

Net Profit Margin (Average)

P/E ratio (Average)

Knowing this, these were my three scenarios for the next 5 years:

Bad Scenario

• Revenue Growth (CAGR): 14.00%
• Net Profit Margin (Average): 33.00%
• Shares Outstanding (CAGR): -0.05%
• P/E ratio: 26
• EPS 5th Year: 28.47
• EPS CAGR: 9.60%

Base Scenario

• Revenue Growth (CAGR): 16.00%
• Net Profit Margin (Average): 36.00%
• Shares Outstanding (CAGR): -0.20%
• P/E ratio: 28
• EPS 5th Year: 34.13
• EPS CAGR: 13.65%

Good Scenario

• Revenue Growth (CAGR): 18.00%
• Net Profit Margin (Average): 39.00%
• Shares Outstanding (CAGR): -0.35%
• P/E ratio: 30
• EPS 5th Year: 40.58
• EPS CAGR: 17.65%

Given these assumptions, based on the historical data, I filled in and valued the company using the EPS Growth projections, discounted by the estimated cost of capital previously calculated and using the assumptions of the base scenario.

Then again, I used the Monte Carlo simulations to explore the possibilities on the lower (bad scenario) and on the higher (good scenario) end.

From this valuation, Microsoft looks undervalued given that its current price of 464 dollars is below the P10. We can extrapolate that there’s ~90% probability of the company being undervalued given this valuation method.

As before, feel free to try this yourself: EPS Growth – The Fair Value Journal

EPS Scenario Returns

We can also explore a little further the different scenarios by projecting in time the bad, the base and the good case scenarios.

Feel free to try this yourself: EPS Scenario Returns — The Fair Value Journal

✍️Summary

Now that we did all the heavy work, let’s take the above and come up with the company weighted average fair value.

I basically take each valuation method used and given my confidence on the company apply a 20% or 10% discount (when to buy) and addition (when to sell) or use the Monte Carlo P10, P20, P80 and P90 values:

Feel free to choose your own values, but for me I would start adding again or initiating a position in Microsoft below the 468.55 dollars mark, because I believe, despite all the fear mongering nowadays, that Microsoft will maintain its wide moat and be an active player during the AI implementation and integration in the future. Its office products may serve as a good entrypoint for an AI “product” for example. Also its Azure platform is one of the key players in the cloud provider space.

Please, as always, remember that the fair value estimate has a 100% probability of being wrong and it will never be a precise number, even if it has decimals next to it 😮

Overall it seems Microsoft is a little undervalued or at most fairly valued at its current market price.

Fair Value: 507.34 dollars.