A Look At The Fair Value Of Microsoft Corporation (NASDAQ:MSFT)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Microsoft fair value estimate is US$434

• Microsoft's US$425 share price indicates it is trading at similar levels as its fair value estimate

• Our fair value estimate is 9.2% lower than Microsoft's analyst price target of US$478

Today we will run through one way of estimating the intrinsic value of Microsoft Corporation (NASDAQ:MSFT) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Microsoft

Step By Step Through The Calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$69.4b	US$78.7b	US$95.7b	US$115.1b	US$139.2b	US$157.2b	US$172.5b	US$185.5b	US$196.5b	US$206.2b
Growth Rate Estimate Source	Analyst x23	Analyst x25	Analyst x14	Analyst x6	Analyst x4	Est @ 12.89%	Est @ 9.73%	Est @ 7.53%	Est @ 5.98%	Est @ 4.90%
Present Value ($, Millions) Discounted @ 7.0%	US$64.8k	US$68.7k	US$78.1k	US$87.7k	US$99.1k	US$104.5k	US$107.2k	US$107.7k	US$106.6k	US$104.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$929b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$206b× (1 + 2.4%) ÷ (7.0%– 2.4%) = US$4.5t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$4.5t÷ ( 1 + 7.0%)¹⁰= US$2.3t

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$3.2t. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$425, the company appears about fair value at a 2.0% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Microsoft as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 7.0%, which is based on a levered beta of 1.012. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Microsoft

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Software market.

Opportunity

• Annual revenue is forecast to grow faster than the American market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Microsoft, we've put together three additional elements you should further examine:

1. Risks: Be aware that Microsoft is showing 1 warning sign in our investment analysis , you should know about...

2. Future Earnings: How does MSFT's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.