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11/18/2010

MICROSOFT, CORP.
Investments Term Paper
Joshua Berk, Kevin Hylant, & Sarah Noah

Joshua Berk, Kevin Hylant, & Sarah Noah

MICROSOFT, CORP.
Investments Term Paper

SUMMARY
COMPANY OVERVIEW
MICROSOFT, Corporation One Microsoft Way Redmond, WA 98052-6399 (United States) Phone: (425) 882-8080 Website: http://www.microsoft.com Sector/Major Industry Information Date Current Stock Price (NASDAQ) 52-Week Price Range Current P/E Ratio (12-mo trailing) Beta Estimate Current Dividend Yield 2009 EPS DPS 1.62 0.52 2010 2.10 0.52 Technology/Application Software & Programming 16 November 2010 $25.57 $22.73-$31.58 11.26 1.07 2.40% 2011 (estimate) 2.51 0.64

SUMMARY OF CONCLUSIONS
Microsoft, Corporation is an information technology firm experiencing stagnant stock price growth as the company matures in the industrial life cycle for the technology sector. We preformed comparable analysis, beta comparisons, forecasting EPS and DPS, and valuations models (P/E Ratio Model, Discounted Cash Flow Model, and Dividend Discounting Model) in order to evaluate the financial state and market value of the company. Our results for the valuation models are summarized in the chart below. Model P/E Model Discounted Cash Flows Model Dividend Discounting Model Stock Price $43.62 $33.80 $17.89 Over/Under-Valued? Undervalued Undervalued Overvalued Reliability Poor Good Moderate

Through a thorough analysis of Microsoft, Corporation we have concluded that the stock price is undervalued and investors should buy.

Joshua Berk, Kevin Hylant, & Sarah Noah

Contents
SUMMARY .......................................................................................................................... 1
COMPANY OVERVIEW .............................................................................................................................. 1 SUMMARY OF CONCLUSIONS ................................................................................................................. 1

I. INTRODUCTION ............................................................................................................. 3
MICROSOFT ................................................................................................................................................ 3 MACROECONOMIC ENVIORNMENT ...................................................................................................... 4 COMPETITORS ........................................................................................................................................... 5

II. COMPANY ANALYSIS ................................................................................................... 7


FINANCIAL RATIO COMPARABLES ........................................................................................................ 7 RISK ANALYSIS & DEBT STRUCTURE ....................................................................................................8 CALCULATING BETA .................................................................................................................................8 BETA COMPARISIONS ...............................................................................................................................8 FORECASTING EARNINGS PER SHARE ............................................................................................... 10 FORECASTING DIVIDENDS PER SHARE ............................................................................................. 10

III. VALUATION ............................................................................................................... 12


SUMMARY OF STOCK PRICES FROM VALUATION MODELS ........................................................... 12 P/E MODEL ............................................................................................................................................... 12 CAPM CAPITAL ASSET PRICING MODEL ......................................................................................... 13 SECURITY MARKET LINE (SML) ........................................................................................................... 13 CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC)................................................. 14 DISCOUNTED CASH FLOWS MODEL ................................................................................................... 15 DIVIDEND DISCOUNTING MODEL ....................................................................................................... 17

IV. CONCLUSIONS ........................................................................................................... 18 BIBLIOGRAPHY ............................................................................................................... 19 APPENDIX A ..................................................................................................................... 20 APPENDIX B ..................................................................................................................... 22 APPENDIX C ..................................................................................................................... 24 APPENDIX D..................................................................................................................... 29

Joshua Berk, Kevin Hylant, & Sarah Noah

I. INTRODUCTION
MICROSOFT
Microsoft is a public multinational information technology company that received widespread recognition in the 1990s for the development of the user-friendly Windows operating system and Office suites. One of the most recognizable brand names in the world, Microsoft was founded by two friends who shared a passion for computer science specifically program development. The development of DOS, and a smart partnership with IBM, Bill Gates and Paul Allen soon saw their operating systems on personal computers, IBM PCs. Now headquartered in Redmond, Washington, this once garage-based business became a dominant force in the marketplace with the graphical operating system Microsoft Windows. Microsoft continued to released improved editions of Windows and Office, while ever-expanding its reach into other technology areas, such as the gaming/entertainment industry with the release of the Xbox gaming console in 2001 and, more recently partnering with cellular providers with the release of Windows Mobile. Once a high-growth company, Microsoft has recently reached maturity in the marketplace and is now fighting to maintain ground in the market as new power-players such as Apple and Google expand. The main reason for the shift in market share is the national and global driving-force transition from enterprise demands to a consumer demands. Consumers were once not even considered a variable in the information technology market, and were instead delegated to membership in the consumer electronics market. On a daily basis, innovation is being driven and rewarded by the average consumer; therein lies the information technology markets problem. While enterprise contracts wanted efficient products with a longer lifespan, the consumer demands the newest, the best, and the smartest most innovative product on the market and the company that has that product yesterday is the company that stays on top of that industry sector. One advantage for Microsoft is sustainability in enterprise contracts; Windows PCs may not be the current fad or cult-favorite, but the Windows OS is reliable, dependable, familiar, and promises consistent improvements with the release of newer versions every few years. Company contracts make up a majority of Microsofts revenues, with $4.01 billion in sales of server software alone. At the end of the 2010 fiscal year, Microsoft announced impressive earnings, with revenues of $4.55 billion of the anticipated Windows 7 and $5.25 for the new Office Suite 2010. And yet, despite record earnings and profits, Microsoft is still not seeing any movement in stock price. These stagnant stock prices are a reflection of investor trends and confidence, and Microsofts software development has taken a back burner in light of more trendy and hot products such as the iPhone 4G and Android mobile. Constant stock prices reflect that consumers and investors Figure 1.1: No significant stock price movement alike are concerned that Microsoft is not keeping indicating stagnant confidence from investors since 2000. up with the latest in IT trends. Microsoft may [Note: visible dip in early 2009 after recession & have leaned too heavily in recent years on the announcement of failed Yahoo acquisition]. corporate replacement cycle and not focused on Source: Google Finance the IT shift of designing for the consumer. Steve Ballmer, CEO since 2001, admitted in June, 2010 that Microsoft missed a whole cycle in the smartphone market.

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That being said, Microsoft is working on repositioning itself as a brand in multiple areas of the information technology industry market. The growth of software as a service (SaaS) allows for greater competition for traditional Microsoft products (e.g. Microsoft Office). Although shareware, open-source, or low-cost alternative software (e.g. Google Apps) dont fulfill the security and functionality that most businesses mandate, this trend will remain persistent in the foreseeable future. Piracy is also a major issue, as Microsoft suffers massive losses from the distribution of pirated software. Interestingly enough, the countries with the highest piracy are those with the largest growth in PC purchases. The software giant is, thus, unable to tap into these expanding markets. Microsoft, however, is able to leverage control over its proprietary systems to enable economies of scale and unify its application development across segments/platforms (Xbox, Windows, and Windows Phone 7), which eases developer access to consumers (and does not force them to pick one platform over another, which also provides incentives for crossdevelopment and long-term relationships). In the competitive realm, Microsoft faces a variety of threats. In operating systems, Oracle is a far greater threat to Microsoft than Apple (despite popular conception and media attention), since Apples strength is among consumers (not corporate environments). Oracle is poised to challenge Microsoft, both through its support of Lintel (Linux OS plus Intel processor chips) and in replacing Microsoft's developer base (with its own improved Linux-based developer platform). Google outperforms Microsoft by a wide margin in Internet services and cloud-computing based software offerings. Microsoft recently signed a ten-year partnership with Yahoo! in February 2010. Under the terms of the revenue-sharing agreement, Yahoo will receive 78% of the search revenue generated from Microsoft's sites during the first 5 years of the agreement and 88% of search revenue generated from Yahoo's sites. Microsoft's two primary competitors in the Entertainment & Devices sector are the Nintendo Wii and the Sony Play Station 3. Following the announcement of the Kinect peripheral device to the Xbox 360, Sony plans to release Move (similar to Nintendos Wii peripheral). Other competitors include SAP (servers), Red Hat (Linux software), Symantec (Internet Security) and Cisco (internet telephony). Overall Microsoft is still a thriving company facing increased pressure from an increasingly consumerdriven industry. Microsoft has enough corporate contracts and loyalty for the Windows and Offices programs to maintain sustainability and continued growth. However, in order to maintain market capital, Microsoft needs to begin tailoring to the consumer. The possibilities for growth are available; Microsoft just needs to be one step ahead of its competitors in order to capture the market. Microsoft may have missed beating the other firms out to the fields of smartphones and home entertainment, but they are paving the way for the cloud-computing.

MACROECONOMIC ENVIORNMENT
The most recent financial crisis was triggered by a liquidity shortfall in the United States banking system. Considered by economists to be the worst crisis since the Great Depression of the 1930s, it contributed to the failure of key businesses (e.g. banking, retail, automotive), declines in consumer wealth estimated in the hundreds of billions of U.S. dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity. Many causes have been suggested, with varying weight assigned by experts. Both market-based and regulatory solutions have been implemented or are under consideration, while significant risks remain for the world economy in the foreseeable future. The Obama administration has taken a rhetoric (and passed legislation) that is considered by many corporations to be hostile. Due to actions by government entities and market fluctuations, interest-rates are at record lows and should not rise in a substantial manner for quite some time. For this reason, Microsoft recently sold $1 billion each of 3-, 10- and 30- year bonds and $1.75 billion of 5-year debt. Demand for the securities,

Joshua Berk, Kevin Hylant, & Sarah Noah

from one of only four non-financial U.S. companies with the AAA rating (Automatic Data Processing, Johnson & Johnson, Microsoft, ExxonMobil), was huge across the globe. Proceeds from the bonds will be used to fund working capital, capital expenditures, stock buybacks and acquisitions. The higher dividend (increased to $0.16 per share), combined with Microsofts share repurchase program, reflects their commitment to returning capital to shareholders and confidence in its long-term growth.

COMPETITORS
Apple (Source: Yahoo! Finance) Sector/Major Industry: Technology, Personal Computers Information Date: 18 November 2010 Current Stock Price: $300.50 (NASDAQ) 52-Week Price Range: $188.68 - $321.30 Current P/E Ratio: 19.83 (trailing twelve months) Beta Estimate: 1.36 Current Divident Yield: 0% Apple, Incorporated is a multinational information technology firm founded in 1976 that began as a manufacturer of personal computing devices. It saw a rise and fall in competition with Microsoft in the early 1990s. Microsoft focused on providing affordable at-home computing solutions, while Apple focused on delivering a much more extensively engineered, and consequentially expensive, at-home computer experience. Once almost off the charts completely, Apple reinvented the firms image with the help of Jonathan Ive and the iMac, and the later iPod and iPhone. Now a technology cult-favorite, Apple designs and markets consumers-oriented products, and is widely considered one of the hottest and most innovative tech firms of the developing market. Oracle (Source: Yahoo! Finance) Sector/Major Industry: Technology, Application Software & Programming Information Date: 18 November 2010 Current Stock Price: $27.91 (NASDAQ) 52-Week Price Range: $21.24 - $29.82 Current P/E Ratio: 22.27 (trailing twelve months) Beta Estimate: 1.07 Current Divident Yield: 0.7% Oracle Corporation is an enterprise software company. It develops, manufactures, markets, distributes and services database and middleware software, applications software and hardware systems, consisting primarily of computer server and storage products. Oracle has leveraged its dominance of the database software industry to become a major provider of enterprise software solutions. The recent acquisition of Sun will enable the firm to further its strategy of providing complete IT solutions to its clients. Microsoft and Oracle compete fiercely in the space of operating systems, primarily for servers in the corporate sector. Oracle's claims that it offers excellent system availability, scalability, energy efficiency, powerful performance, and low total cost of ownership relative to its competitors (e.g. Microsoft). Oracle was founded in 1977 and is headquartered in Redwood City, California.

Joshua Berk, Kevin Hylant, & Sarah Noah

Google (Source: Yahoo! Finance) Sector/Major Industry: Technology, Internet Information Providers Information Date: 18 November 2010 Current Stock Price: $583.55 (NASDAQ) 52-Week Price Range: $433.63 - $630.85 Current P/E Ratio: 23.71 (trailing twelve months) Beta Estimate: 1.13 Current Divident Yield: 0% Google Inc. maintains index of Web sites and other online content, which helps users to obtain instant access to relevant information. Further, the company provides Android, a mobile software platform (which rivals the Apple iPhone and Microsofts Windows Phone 7). The firms main source of revenue is derived from its advertising offerings, primarily AdWords (auction-based), but also AdSense (for content owners), and various forms of Display advertising. The company also offers Google Enterprise product line comprising Google Apps that provides hosted communication and collaboration tools, which are intended to compete with Microsofts Office Suite. Due to the creative versatility and intellectual aptitude of technology companies, each will continually converge on competitors offerings within the market. An example of this is Microsofts Bing search engine and complementary advertising platform, which are a direct response to Googles dominance and incredible profitability.

Joshua Berk, Kevin Hylant, & Sarah Noah

II. COMPANY ANALYSIS


FINANCIAL RATIO COMPARABLES

Figure 2.1: Comparable Analysis (used financial ratio comparable analysis) Source of Ratios: Yahoo! Finance

Quarterly revenue growth (YoY) is in line with the industry. EBITDA (ttm), operating margin, and net income are significantly higher than competitors and the industry. ROE is much higher than competition and the industry average, at roughly 43%. Debt/Equity is also lower than the industry, but higher than Apple (AAPL) and Google (GOOG), since neither carry any debt. Given the conditions of this model (an unknown Enterprise Value), we took the average of multiples for the three comparable firms (AAPL, GOOG, ORCL) and multiplied them by Revenue and EBITDA (respectively) to get values of $306.9B and $378.2B for a mean value of $342.55B. Obviously, since we know that Microsoft's enterprise value outside of this model was calculated to be $299.151B, this model (or the given comparable firms) is extremely inaccurate. When comparing other multiples (e.g. ROE, PE, Dividend Yield), Microsoft is significantly undervalued by the market given its consistent performance over investor expectations. Although we believe that this model should be considered in other situations in which less information is provided, it does not appear to be appropriate for our purposes. In $Billions Enterprise Value Average Revenue Multiple EBITDA Multiple MICROSOFT - Comparable $342.55B $306.9 $378.2 MICROSOFT -Actual $299.151B

Figure 2.2: Results of comparables in estimating the enterprise value (all of which are higher than the enterprise value calculated from the DCF)

Joshua Berk, Kevin Hylant, & Sarah Noah

RISK ANALYSIS & DEBT STRUCTURE


The threat to Microsofts core businesses of Windows and Office (via cloud computing) is the primary risk of concern. Google is intent on disrupting Microsofts cash cows in a proactive move to restrict Microsofts ability (with Bing) to encroach on Googles primary revenue-stream. Regulatory and antitrust issues are also an issue. Given the disruption of cloud-computing, Windows OS and Office will be nearly irrelevant to MSFT and contribute immaterial amounts to revenue in no less than ten years. The vast majority of Microsofts revenue will eventually derive from Azure, which should eventually become a very profitable business. Due to the implicit barriers to establishing a cloud platform (technical expertise, high fixed costs, massive returns to scale), it is expected that the industry will resemble a mature one very quickly, comprised of a few (very large) participants. This opportunity could become an enormous risk if investment is not planned and/or implemented properly. (See Appendix A: Item 1 for complete breakdown of Microsoft business components). Financially, even after buying back $60 billion of stock during the last five years, Microsofts fortress-like balance sheet still boasts $40 billion of cash and long-term investments against only $39 billion in total liabilities. With a growing pile of cash and an AAA debt rating, Microsoft is one of a select few firms with such financial resources at its disposal. A quick glance at its capital structure indicates that it has little incentive to take on extra debt aside from tax purposes and to time the market for financing future growth or distributing further capital to shareholders. Simply put, Microsoft is in excellent financial position.

CALCULATING BETA
In order to get an idea of the risk associated with Microsofts stocks, and the volatility of the share in market climates, we calculated Microsofts beta.

The entire calculations for Microsofts beta over the past 5 years are displayed in Appendix A: Item 2, which calculated out the per-month percentage change in Microsofts stock and the per-month percentage change in the S&P 500. Calculating covariance and variance yielded

Beta is a measure of a stocks systematic risk (non-diversifiable) in relation to the stock market, and can be and indicator of future stock performance. However, beta is determined based on historical data and therefore is no guarantee for future performance or volatility of Microsofts stock. How Microsoft has done in the past 5 years may be no indicator of future performance.

BETA COMPARISIONS
Beta comparison can be a useful method of evaluating a company relative to other companies based on the potential risk o. Figure 2.3 displayed on the next page - compiles 3 collected beta estimates from various financial monitoring websites, alongside our Beta estimate (value determined in the precious section Calculating Beta).

Joshua Berk, Kevin Hylant, & Sarah Noah

Figure 2.3: Beta values for Microsoft from multiple sources

SOURCE Google Finance Calculated Beta Yahoo! Finance S&P 500 NASDAQ

BETA 1.07 1.04 1.01 1.00 0.88

Expected Return 11.91% 11.58% 11.24% 11.13% 9.79%

Risk Relative to S&P 500 Slightly more risky than market Slightly more risky than market Stock price fluctuates almost identical to rate of market Stable, index benchmark Less volatile, less risky than market

Across the board there are slight variations in the beta estimation. The NASDAQ lists Microsoft as significantly less risky than the market, which if used in the DCF would have a negative impact on shareholder value by increasing the cost of capital and decreasing the present value of future cash flows. Google, Yahoo!, and our own estimations vary over a spread of about 6%, and seem more probable than the NASDAQ average. While in a state of slow growth and low stock prices, Microsoft is still a technology firm and appears to have more risk associated with it than Starbucks Corporation (12-m0 trailing NASDAQ beta of 1.22). While the beta may not be the best average of the actual future movement of stock prices in the market for Microsoft, it does shed some light on investor attitude towards the stock when compared to its competitors. Figure 2.4 displays the beta values for Microsofts main competitors.
Figure 2.4: Beta values of comparables from multiple sources

FIRM Apple Google Microsoft Oracle Benchmark

Google Finance Beta 1.36 1.13 1.07 1.07 1.00

Yahoo! Finance Beta 1.36 1.13 1.01 1.07 1.00

NASDAQ Beta 1.04 1.08 0.88 0.60 1.00

Across the board there are slight variations between the financial indexes, however it is possible to see the difference in betas between the comparables. Google and Apple are considered to be high-growth tech firms right now, and are experiencing record high stock prices and sales as they coast along the frontiers of technology innovation driven by consumer trends. Microsoft and Apple, considerably older firms, have lower betas as the majority of their clients are enterprise contracted for business solutions. As discussed in the opening introduction, investors and consumers alike are more concerned with what is hot, new, and trendy. While Microsoft and Oracle may be experiencing sound revenue growth, they are not meeting investor expectations for innovation and future growth. This seeming disadvantage is what protects Microsoft against the volatility of the market; consumer trends are temporary, and demand fluctuates much more drastically and quickly than enterprise demands. Therefore, even though all four companies are in the information technology sector, Microsoft is currently estimated to be a mature, less-risky firm when compared to its high-growth competitors. Therefore we decided that Microsoft, as a mature tech firm in between extreme stages of cyclic growth in the technology industry, should have a beta fairly close to our calculation of 1.04 (which is consequentially the average of the Google Finance and Yahoo! Finance beta estimations). Some risk is associated with the industry, and Microsoft will yield returns slightly above the market rate, but overall a lower-risk

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technology firm. Because of this analysis, we decided to use a beta of 1.04 for all of our following cash flow models.

FORECASTING EARNINGS PER SHARE


Figure 2.5: forecasted earnings per share

HISTORICAL 2010 2.10

2011 2.25

2012 2.45

FORECAST 2013 2.65

2014 2.85

2015 3.05

The future earnings per share for Microsoft were estimated using linear regression. When graphing the previous 5 years-worth of EPS, we see a linear, consistent growth (graphed in Figure 2.6). This visual assumption is validated by a correlation coefficient of R2 = 0.9332, which indicates a very close fit. We used the linear regression trend-line equation to calculate future earnings per share, displayed on in Figure 2.5. Because of the linear relationship, it is safe to estimate that in the coming few years, with no major business 3 restructuring, Microsoft will continue to see growth in EPS. 2.5 This is supported by the 2 business model of enterprise solutions that Microsoft has 1.5 EPS focused on, creating product sustainability through corporate Linear (EPS) 1 contracts. Windows/Office 0.5 software is cyclically repositioned as a leader in the 0 marketplace upon the release of new versions, updates, and addons. While Microsoft is trying to reposition itself and reinvent Figure 2.6: graph of EPS included forecasted data points the Microsoft image to keep 'in the game' with younger, 'hotter' consumer-based companies such as Apple and Google, the very nature of corporate clients provides more reliable consumption, less prone to profit fluctuations due to consumer trends and fashions, and therefore more reliable earnings.

MICROSOFT - EPS Annual, Forecast

2006

2004

2008

2003

2005

2007

FORECASTING DIVIDENDS PER SHARE


Figure 2.7: forecasted dividends per share

HISTORICAL FORECAST 2010 *2011 2012 2013 0.52 0.64 2.45 2.65 *Special forecast for 2011 DPS, explained in following analysis

2009

2010

2014

2011

2012

2013

2014 2.85

2015 3.05

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The future earnings per share for Microsoft were estimated using linear regression. We plotted the previous 5 years-worth of annual dividends per share. Based on historic trend, we were able to create a graph similar to that of EPS. Noting a similar linear trend (displayed in Figure 2.7) we plotted the linear trend-line which had a correlation-coefficient of R2 = 0.9573, indicating strong correlation. Therefore, we used the equation for the trend-line in order to predict future DPS values, displayed in Figure 2.6. As noted in Figure 2.6, the forecast for the fiscal year of 2011 for Microsoft was actually determined based on historical trend. For the previous 5 years, with only one exception, dividend increases were announced in Q1 and that dividend remained constant through Q4. Instead of following the linear regression line for 2011, we simply took the latest dividend, for Q1 2011 DPS = $0.16, and carried it through the year, resulting in an annual DPS of $0.64 for 2011. Because of some variation in previous years from this pattern, we chose to continue the linear regression out from 2011 due to a lack of uncertainty in Microsofts dividend payout decisions. Dividends are hard to compare and analyze in the technology industry as many high-growth and maturing technology firms chose not to pay dividends. Microsoft started inconsistent dividends in 2003, and consistent dividends in 2006. The choice to pay dividends was made in late 2002, when the cash-machine Microsoft started to realize it was maturing as a company and despite the effort to remain cool and innovative needed to keep investors interested. If Microsoft continues on its current path with dividend payouts, the company will most likely begin to face financial trouble in light of high dividend yields. Already having a dividend yield of 2.40% (much higher than any other tech firm, many of which sport a dividend yield of 0.00%), and encountering slow but steady growth in the years following the recession, Microsoft cannot sustain having such a high dividend growth rate. After 2015, Microsoft may find need to drastically decrease the growth rate of dividends, or potentially even off their dividend payouts altogether.

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III. VALUATION
SUMMARY OF STOCK PRICES FROM VALUATION MODELS
Figure 3.0: table summarizing valuation modeling results

Model P/E Model Discounted Cash Flows Model Dividend Discounting Model

Stock Price $43.62 $33.80 $17.89

Over/Under-Valued? Undervalued Undervalued Overvalued

Reliability Poor Good Moderate

P/E MODEL
The Price-to-Earnings model is a quick and easy way to value a company, especially privates companies that do not pay dividends. The value of the stock is expressed in the following equation:

For Microsoft, we projected the EPS for 2011 through linear regression trend-lines (see Figure 2.5), discussed in the previous section Earnings and Dividend Analysis. Through research, we obtained the P/E ratio for the technology sector from Yahoo! Finance. The expected stock value was calculated using the aforementioned equation;

For the current stock price, as of November 16, 2010, this would imply that Microsoft stock is drastically undervalued, by $18.05. However, the P/E Model of forecasting stock price leverages the industry average of price-to-earnings in the calculation, which may not be and accurate representation of Microsoft. A high P/E ratio indicates that investors are expecting high returns in the future from the firm, however recent historical stock price trends indicate that investors have much lower expectations from Microsoft than that of other technology firms. Another factor that affects the P/E ratio of a firm compared to that of the industry is the cyclical nature of the industry. Microsoft is currently in the midst of an upswing in revenues, with significant revenue increases in certain business segments with the renewal of enterprise contracts due to the release of Windows 7 and Office 2010. Knowing that Microsoft relies heavily on enterprise contracting, it is possible to determine that these large increases in revenues raise earnings per share correlate to a lowered P/E ratio. Microsofts current 12-month trailing P/E ratio is 11.26; a lower P/E ratio is also indicative of a larger, more mature firm with less room for growth. For a mature company such as Microsoft, stocks are purchased for consistent earnings and dividends, and not for growth potential. Other competitors, such as Apple and Google, are expecting record high P/E ratios as a result of consumer attention and investor optimism for market growth. The market is expecting significant innovation and growth from technology firms, and is focused on the production of products and services that cater to the new consumer-driven 12

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technology industry. Therefore, we concluded that the P/E Model is not an accurate method of forecasting stock price for Microsoft because it misrepresents shareholders expectations of the company by determining the price based off of shareholders expectations of the industry as a whole.

CAPM CAPITAL ASSET PRICING MODEL


We calculated the CAPM for use in the Discounted Cash Flow (DCF) Model and the Dividend Discounting Model (DDM). The CAPM is a measure of theoretical rate of return on an asset, and is defined by the following equation: ( )

We decided to use base our calculation of the risk-free rate off of the 10-year Treasury notes as opposed to the 20-year or 30-year bond because the 10-year bond is more liquid, and the investments are traded much more frequently. Therefore there is less risk associated with the holding of the security. The riskfree rate was then calculated by taking the average of the monthly yields on 10-year Treasury notes over the past 5 years, where rf = 3.902% (see Appendix B: Item 1). We already determined that Microsofts beta = 1.04 in the previous section. The expected rate of return for the market determined by averaging the daily year-over-year yield for the past five years (see Appendix B: Item 2). This gave a yield of rm = 10.902%. When plugged into the CAPM ( )

SECURITY MARKET LINE (SML)


The CAPM enables us to see the effect of beta on stockholder expectations. Calculating expected return with variable beta values using the CAPM formula provides a linear trend-line of expected returns. When compared with different beta-return combinations, it is possible to determine whether a stock is over- or under-valued. Figure 3.1 is a graph with the plotted CAPM security market line, and labeled points indicating where Microsoft sits on the expected return line for varying beta values (values from the previous section Beta Comparisons). From this plot, we can see that Microsoft stock is currently undervalued, because an investor could be expecting a greater return (which would be reflected in high stock prices) for the same amount of risk.

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SECURITY MARKET LINE (SML)


20 18 16 14 12 B 10 C 8 6 4 2 0 0 Point A B C D
D

Expected Return

Estimated MSFT Beta 0.88 1.01 1.04 1.07

0.5

1 Beta

1.5

2.5

Figure 3.1: SML trend-line using Microsoft CAPM

CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC)


The first step taken in creating the DCF for Microsoft was the calculation of the weighted average cost of capital (WACC), using the following equation: ( ) Re Rd i Tc E D V Cost of Equity After-Tax Cost of Debt Interest Rate Tax Rate Market Value of Equity Market Value of Debt Total Value ( ) 11.18% 2.03% 3.12% 35% $218,879.2m $9,817.25 $228,696.5m Determined in CAPM Capital Asset Pricing Model =(interest)*(1-tax rate) See INTEREST RATE below See TAX RATE below (Share Price)*(Shares Outstanding)=($25.57)*(8,560B) See Appendix C: Item 1 V=E+D

INTERST RATE The interest rate for the company is determined by the quality of the debt issued. In the 2010 10K in the Credit-Risk-Related Contingent Features, Microsoft stated that they received a AAA bond rating as of June 30, 2010 for long-term unsecured debt. Using the Standard & Poors index, the AAA bond rating of 10-yr Corporate Bonds yielded an interest of 3.12%. TAX RATE The tax rate for Microsoft was determined in two ways. One was by dividing the taxes paid into the EBIT values for a few years, which averaged at about 36%. The other was to take Microsofts 2010 annual taxable income, approximately $24billion, and see what federal tax bracket the company fell into. Taxable income over $18million is in the 35% tax bracket, and therefore Microsofts tax rate is 35%.

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Using the above data, Microsofts weighted average cost of capital is ( ) ( )[ ]

DISCOUNTED CASH FLOWS MODEL


Companies that have fallen out of investing favor are good news for the value-investor, and Microsoft is no exception. A company that is always late to be dominant in an industry (Microsoft is rarely the first to enter a market), Microsoft is experiencing low stock prices indicating decreased shareholder expectations and value from the previous decade, as well as relatively low expectations when compared to industry comparables. Figure 3.2 shows the assumptions for growth as determined by the percentage of each value to revenues, or the growth percentage of that value on itself. The percentage-change and percentage-ofrevenue calculations, and the averages, are compiled into Appendix C: Item 2.
Figure 3.2: Growth Assumptions

Sales COGS Gross Profit Margin SG&A EBITDA Depreciation EBIT EBIT*(1-tax rate) Depreciation Capital Expenses NWC

Assume 8.0% growth until 2019, then 4% after that Assume constant 16.26% of revenues Sales-COGS Assume constant 41.85% of revenues GP-SG&A Assume growth of 0.5% of previous years percent of revenue EBITDA-Depreciation

Assume growth of 0.5% of previous years percent of revenue Assume constant 4.36% of revenues 0.51% growth of average NWC (taken from historical data)

A complete DCF which utilizes these growth percentages is in Appendix C: Item 3. REVENUE (SALES) GROWTH ESTIMATE A complete analysis of how we obtained an 8% growth rate for the first 10 years, followed by a 4% growth rate indefinitely is located in Appendix C: Item 4. Following the projection of sales, using these growth assumptions from Figure 3.2, were we able to compute the projects of sales for Microsoft and therefore calculate all of the Pro-Forma Income Statement values in order to find the Future Free Cash Flows.

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In order to evaluate stock price, we determined Microsofts terminal value to be $474.35 billion.

Discounted back to today and added to the present value of all future cash flows from DCF

gives the value of the firm. From the value of the firm, it is possible to determine the share price for Microsoft stock by solving for equity and dividing by the current number of shares outstanding

Terminal Value (of DFC) Value 2019 and beyond $ Value of Firm PV Cash Flows 2011-18 $ + Terminal Value $ VALUE OF FIRM $

474,347.94

110,485.72 188,665.78 299,151.50

A share price of $33.80 indicated that the current value of stock for Microsoft is Value per Share = val of equity / # of shares out undervalued at its current price of $25.57 Number shares out. 8560 by $8.23. This is our best estimation of Value of equity $ 289,334.25 intrinsic stock value and it avoids falling into the trap of making bad comparisons. VALUE PER SHARE $ 33.80 However, because of the difference Figure 3.3: Table of calculation of share price for DCF between what Microsoft has done and how the firm would like to be preforming, it is hard to predict if there will be a major reconstruction of the business model in order to maintain market cap and regain a position in the spotlight with Apple and Google. While pointing out the more poignant issues Microsoft is facing with low capital growth, and potentially uncertain sales as other firms rise to the top, our DCF for Microsoft definitely displays the firm to be a sustainable success for years to come.

Value of Equity = val of firm - mkt val of debt Value of firm $ 299,151.50 Market Value of debt $ 9,817.250 VALUE OF EQUITY $ 289,334.25

Figure 3.3 is a table summation of these calculations for the share price using DCF.

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DIVIDEND DISCOUNTING MODEL


Our final model for valuing Microsoft stock is the Dividend Discount Model which is a relatively simple measure to determine stock price. The trouble comes from estimating and calculating the values for growth and expected return. In order to estimate the future growth in dividends, we used 5 years-worth of quarterly dividends payments. Appendix C: Item 5 consists of a table that shows the calculated dividend growth. Also included is a table, Appendix C: Item 6, which displays the two calculated averages geometric and arithmetic. We chose to use the geometric average for the Dividend Discounting Model for Microsoft because it was both downwardly conservative and also because we were looking at historical data, and the geometric average accounts for compounding. The geometric average of dividend growth was 10.20%. The constant model was chosen for Microsoft because they are a firm experiencing long-term stable growth. Microsoft is no longer in a period of supernormal growth, and is not expected to be a high-growth firm. This is reflected in the relatively stable stock prices over the past decade, indicating that investors do not see innovation necessary to invest in the firm. We assumed constant growth for Microsoft because it is currently in a stage of maturity, and we predict that over the course of the next 8-10 years, the company will remain in a steady state of slow growth as it maintains a certain market cap but struggles to introduce itself into new, emerging markets faster than its younger competitors. The DDM for constant growth is Gordons Growth Model, and is expressed by the following equation

Calculating next periods dividend is a nave calculation, based solely upon the current dividend payout and the projected growth rate of dividends. Therefore, by using the growth rate as determined by historical dividends, we get a dividend of $0.1763.

This implies that Microsoft will pay a dividend of approximately 18 cents in the second quarter of the 2011 fiscal year. We already calculated the CAPM (see CAPM Capital Asset Pricing Model) for previous valuation models. Plugging all the variables in, we get a stock price of $17.89.

This model suggests that Microsofts stock is overvalued by $7.89. The Gordon Growth model is best suited for firms that are growing at a rate comparable or lower than the nominal growth in the economy, and have established dividend payouts that they intend to continue with in the future. Overvalued stocks are usually indicative of an inflated market price or deterioration in financial strength. Microsoft is not suffering for inflated market prices like its high-growth competitors, and after careful analysis through this report, is not experiencing a period of financial weakness either. Therefore, it appears that the DDM is not a very accurate model for forecasting Microsofts future stock price.

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IV. CONCLUSIONS
Given the provided analysis, our group believes strongly that Microsoft is extremely undervalued and should be considered a buy. Qualitatively speaking, the firm's ability to pursue opportunities are being underestimated by the market (Bing, Mobile, Xbox) and its potential downfalls are exaggerated (the eventual downfall of Windows OS + Office). With Windows Azure, which will leverage the enormous set of developers, and the cross-pollination of product divisions, Microsoft is uniquely positioned to leverage its core competencies in the market. Quantitatively, we proved through comparables, DCF, and P/E that the underlying financials are not correctly valued by investors. The P/E model was determined to be a poor indicator of Microsofts stock price because the P/E ratio of the industry is weighed too heavily towards the high-growth firms, and the maturing Microsoft stocks are not providing the same yield. However, the P/E model did show that Microsoft stock was heavily undervalued, which is in congruence with our DCF. The DCF also showed heavily undervalued stock prices, indicating that future growth exceeds the expectations of the market and investors. This is backed up by the security market line, which showed that the markets betas for Microsoft place it way below our calculated CAPM trend-line. Finally, the DDM model was dismissed as an accurate methodology for determining Microsofts stock price because Microsoft is not showing any signs that would lead to overvaluation. The macroeconomic landscape is one that favors debt issuance, which is the reasoning behind Microsoft's recent move to capture low lending rates; this move should not be interpreted as one of desperation (in fact, Microsoft's balance sheet is excellent; the overall firm is one of four non-financial U.S. companies with a AAA credit rating). See Appendix D: Item 1 for multiple charts and tables breaking-down Microsofts debt structure. In the immediate future, Microsoft should aggressively pursue growth opportunities even more (mobile) and further embrace industry trends (collective shift to the "cloud").

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BIBLIOGRAPHY
"About Microsoft: Your Potential. Our Passion.."Microsoft.com. Microsoft Corporation, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.microsoft.com/about/en/us/default.aspx> "Historical Dividend Data for Microsoft (MSFT)."Dividend.com. Dividend.com LLC, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.dividend.com/historical/stock.php?symbol=MSFT>. "Investor Relations." Microsoft.com. Microsoft Corporation, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.microsoft.com/investor/default.aspx>. Maheshwari, Sapna, and Tim Catts. "Microsoft Plans $4.75 Billion, 4-Part Bond Sale."BusinessWeek.com. Bloomberg L.P., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.businessweek.com/news/201009-22/microsoft-plans-4-75-billion-4-part-bond-sale.html>. "Microsoft Corporation, NASDAQ:MSFT News & Quotes." Google Finance. Google, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.google.com/finance?q=microsoft>. "MSFT Microsoft Corporation." Morningstar.com. Morningstar, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://quote.morningstar.com/stock/s.aspx?t=msft>. "MSFT: Microsoft Corporation." Yahoo Finance. Yahoo, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://finance.yahoo.com/q?s=MSFT>. "MSFT Stock Quote - Microsoft Corporation."NASDAQ.com. NASDAQ Stock Market, Inc., 18 Nov. 2010. Web. 18 Nov 2010. <http://quotes.nasdaq.com/asp/SummaryQuote.asp?symbol=MSFT&selected=MSFT>. "Microsoft (MSFT) Stock Research, Investment News, & SWOT Analysis." WikiWealth.com. Guerilla Investments LLC, 18 Nov. 2010. Web. 18 Nov 2010. <http://www.wikiwealth.com/research:msft>. "S&P 500 Equity Indeces." StandardAndPoors.com. Standard & Poors Financial Services LLC., 18 Nov. 2010. Web. 18 Nov 2010. <http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDTType&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline;+filename%3DFactshe et_SP_500.pdf&blobheadername2=ContentDisposition&blobheadervalue1=application/pdf&blobkey=id&blobheadername1=contenttype&blobwhere=1243765720036&blobheadervalue3=UTF-8>. Siegler, MG. "Thats Ballmer With A B For Billions." TechCrunch.com. AOL, Inc., 5 Nov. 2010. Web. 18 Nov 2010. <http://techcrunch.com/2010/11/05/ballmer-stock-sale/>. Wilcox, Joe. "Why won't Wall Street give Microsoft a break?." BetaNews.com. Betanews, Inc., 7 Nov. 2010. Web. 18 Nov 2010. <http://www.betanews.com/joewilcox/article/Why-wont-Wall-Streetgive-Microsoft-a-break/1289152037>.

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APPENDIX A
ITEM 1: breakdown of sales and market share for various Microsoft departments Microsoft Corporation is the world's largest software maker by revenue, with $58.43 billion of revenue in FY2009. It develops, manufactures, licenses, and supports a range of software products and services for various computing devices worldwide. Full-time employees in 2009 exceeded 90,000 worldwide. While the bulk of Microsofts profits derive from corporate contracts, a significant amount of its profits result from consumers. Despite the prevalence of other operating systems (OSX, Linux), Windows is growing in market share. With the release of Windows 7 in December 2009, Windows finished the year with roughly a 92% market share. Microsoft reported a record revenue of roughly $19 billion for 2Q10, a 14% increase (YoY) from 2Q09. Growth was primarily driven by the well-received release of Windows 7, which was launched globally in October 2009 and sold more than 60 million copies in 2Q10 (the fastest selling OS in history). It was also boosted by a 15-17% YoY increase in unit PC sales, as well as the sale of 5.2 million XBOX 360 consoles. Its Online Services Division experienced a 5% YoY decline, hurt by a 2% decline in online advertising revenue. However, MSFT's ability to simultaneously cut costs resulted in a net income of $6.66 billion for the quarter, a 60% increase over 2Q09. The company also managed to generate $5.0 billion in operating cash flow, $4.8 billion of which it returned to investors. Microsofts products and service offerings fall into five divisions or business sectors: Client - Windows/Windows Live Division, (28% of revenue, 45% of net income in FY2009), Server and Tools - Products for IT Professionals (22% of revenue, 16% of net income), Business (32% of revenue, 42% of net income), Online Services (5% of revenue, -4% of net income), Entertainment and Devices (13% of revenue, 1% of net income).

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ITEM 2: Calculation of Beta from monthly changes in return on Microsoft and the S&P 500

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APPENDIX B
ITEM 1: Table of Monthly Yields on 10-yr Treasury Notes: used to calculate Risk-Free Return for CAPM

Risk-Free Return = 3.902%

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Item 2: Daily year-over-year yield of the S&P 500

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APPENDIX C
ITEM 1: Table for Market Value of Debt: used to calculate WACC

ITEM 2: Calculations to determine growth of sales and subsequent growth of margins


Calculating Growth COGS DEP SG&A Cap.Ex NWC 2006 15.04% 2.24% 42.55% 3.56% 2007 18.10% 2.82% 0.58% 45.45% 41.85% 4.43% -19.86% 2008 15.79% 3.40% 0.59% 42.78% 40.60% 5.27% -5.06% 2009 16.42% 4.38% 0.98% 24.61% 43.30% 5.34% 15.21% 2010 15.95% 4.04% -0.34% -2.15% 40.97% 3.19% 11.75% AVERAGES 16.26% 3.38% 0.45% 27.67% 41.85% 4.36% 0.51% ASSUMPTIONS assume constant 16.26% revenues ave dep change %revenue per year ave difference per year as % revenue ave dep change % of previous year growth assume constant 41.85% of revenues assume constant 4.36% of revenues growth of ave NWC (taken from historical data)

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ITEM 3: DCF Model Calculating WACC COST OF CAPITAL CAPM (Cost of Equity) Rf Rm Market Risk Premium Beta After-Tax Cost of Debt interest* tax rate (from bracket) Book Value of Debt Market Value Equity Share Price # Shares outstanding Total Value 10.79% 11.18% 3.902% 10.90% 7.00% 1.04 2.03% 3.12% 35% 9817.250 218879.2 25.57 8,560 228696.450 Revenue Growth Rate Estimate* Terminal Growth Rate Estimate*
*from Appendix C: Item 4

8.00% 4.00%

Calculating NWC Current Assets Current Liabilities NWC NWC 49,010.00 22,442.00 26,568.00 40,168.00 23,754.00 16,414.00 -10,154.00 43,242.00 29,886.00 13,356.00 -3,058.00 49,280.00 27,034.00 22,246.00 8,890.00 55,676.00 26,147.00 29,529.00 7,283.00

Terminal Value (of DFC) Value 2019 and beyond $ Value of Firm PV Cash Flows 2011-18 $ + Terminal Value $ VALUE OF FIRM $

474,347.94

110,485.72 188,665.78 299,151.50

Val of equity = val of firm - mkt val of debt Value of firm $ 299,151.50 Market Value of debt $ 9,817.250 VALUE OF EQUITY $ 289,334.25 Val per share = val of equity / # of shares out Number shares out. 8560 Value of equity $ 289,334.25 VALUE PER SHARE $ 33.80

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ITEM 4: Revenues (Sales) Growth Predication Explanations

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ITEM 5: DDM Growth Calculations Per DPS

ITEM 6: Table outlining DDM Calculations for Stock Price

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APPENDIX D
Item 1: capital structure and debt structure (from Morningstar)

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