STOCK ANALYSIS

MICROSOFT CORPORATION

Prepared By:
Vansh Khanuja
Vanshkhanuja78@gmail.com
July 5, 2021
PREFACE
This analysis report covers various aspects of stock selection.
Although my report is not something you should solely base
your investments on, but I'm sure it can surely serve as a guide.
Stock selection is a process of elimination, with an approach
like this, one should constantly find reasons not to buy the
stock. This will help you make better investment decisions as
stock selection can be quite tedious.
The reasons for eliminating a stock can be different and does
not necessary give a negative opinion about the company.
Everyone has different investment horizons and different risk
appetite; this makes it tough to make an analysis that will serve
everyone equally because of the bias towards different
companies we all have. Thus, it would be better for me to
explain my perspective so you can better understand the
reasons I select/reject a stock.
I’m looking for undervalued growth stocks. My time horizon
varies with kind of stocks but generally you expect it to be at
least 5 years. The company should have excellent management
and display consistent growth over a long term. While the latter
can be easily known just by analyzing the financials, The major
concern is regarding how to check if the management is
competent enough.
The only thing one could do is again try to gain some insights by
looking at the financials. A healthy growth rate added with
better than average margins will display managerial
competency. Along with this, careful scrutinization of
management’s discussion section in the annual reports over the
last few years can surely yield some insights.
Valuation is the last step in stock analysis. The basic role is to
use all the facts obtained to find a price that is justified. This is
probably the most controversial part because there is no
perfect way to value a company. I will be using a DCF
(Discounted Cash Flow) model and use the risk-free-rate as the
discount rate. I understand the conventional method of DCF
includes calculation of weighted average cost of capital that is
used to discount the cash flows but I'm not using it because I
will deduct 25% of the calculated value to get a margin of
safety. Furthermore, I will be conservative in my projections so
using risk-free-rate is appropriate.
Given the fact that the intrinsic value of any given company
cannot be calculated with exact precision, it is important to
consider that I can be wrong in my projections. This is the
reason I will be deducting 25% of the calculated value. If then
the stock is selling at around the price I calculated, then only I
will be bullish on that particular investment.
The strategy I just mentioned is a rough explanation of what I
will follow. There can be certain adjustments that will vary
according to the company. Note that the valuation is based on
forecasts of Future Cash Flows (FCFs) and thus carry an
inherent flaw I.e., predictions. Given that there are many
variables that can disrupt cash flows, you are advised to invest
only after you’ve understood all the points I've mentioned and
if you can hold the stock patiently for years until the
discrepancy between the price and value is fixed. This process
can be frustrating and you’ll be tempted to sell in bear markets,
but if you truly understand the principles of investing, I expect
you to buy more during such conditions. If there are any
questions concerning any phase of the report, I would welcome
hearing from you.
TABLE OF CONTENTS:

(1) General Information:

• Introduction
• Business
• Microsoft’s Future
• Other info
(2) Financial Statements and valuation
• The Balance Sheet
• P&L Statement
• Cash Flows
• Other info
• Valuation
(3) Conclusion
• Who Should Buy this Stock?
(4) Appendix
• Opportunity cost
(5) References
 (1) General Information
Introduction
Microsoft Corporation is a technology company founded
(1975) by Bill Gates and his friend Paul Allen. I recently
read ‘Hit Refresh’ written by Satya Nadella (Microsoft’s
current CEO) which led me to value this company.
Microsoft’s market cap as of 5th July,2021 is 2.09 trillion
USD; Currently it’s trading at 37.8 times earnings. Now
before going into anything related to business, let’s
review the numbers.
The interest rates are really low in the US (1.54%) which
makes high stock prices seem normal. Now, if we make
our required rate of return 200% of the prevailing
interest rates (because of equity risk [200% because
rates are too low]), then the required ROI is 3%
(rounded off). For a 3% yield, you need to pay 33.3 times
earnings (100/3). The current p/e ratio implies a return
of 2.64%, or 71% more than the risk-free-rate.
Thus, Microsoft is by no means overvalued (I’m saying
this just by looking at the numbers). The reason I
explained this is that many people use stock screeners
and set their P/E criteria at < 20 or 25 at max. This will
make perfect sense when interest rates are higher.
This is the reason many people are saying that the stock
market is currently in a bubble. The current S&P 500 P/E
is around 45 (2.2%), I will not say the market is cheap by
any means, but it’s not highly irrational either.
Coming back to Microsoft:
Microsoft enjoyed huge success during the 90s, Bill Gates
led the company to a point where anti-trust lawsuits
were filed against it. Eventually, Microsoft revived Apple
(Gates purchased $150 million of non-voting shares and
allowed Apple to use Microsoft Office for free).
After Bill Gates stepped down as the CEO, Steve Ballmer
replaced him. Ballmer was not a tech guy; his focus was
more on marketing. Ballmer made a series of bad
decision with the smartphone market, first by not
adopting Android and then by partnering with Nokia.
(I’m not saying Ballmer was a bad CEO, profits doubled
under his leadership but the problem was that Microsoft
lost its market dominance)
Microsoft was on the verge of decline, then in 2014,
Satya Nadella stepped up as the new CEO. Microsoft has
undergone a cultural reform under his leadership and
Microsoft is back on the right track.
REVENUES PROFITS
2020 143,015 44,281
2019 125,502 39,240
2018 110,175 16,571
2017 96,016 25,489
2016 84,695 16,798
2015 93,580 12,193
2014 86,833 22,074
2013 77,849 21,863
2012 73,723 16,978
2011 69,943 23,150
($ in millions)
*SOURCE: 10-K
The size of the company makes faster growth difficult,
but looking at how profits have doubled after Satya
became CEO, I believe we can expect Microsoft to grow
at a healthy rate. With a 40% return on equity and low
debt-to-equity (.46), the company is fundamentally
strong. I will explain the Microsoft’s business in the next
section.
BUSINESS
Microsoft is a technology company that innovates
through its software and services. The company offers an
array of services, including cloud-based solutions that
provide customers with software, services, platforms,
and content, and provides solution support and
consulting services. The company also deliver relevant
online advertising to a global audience. Products include
operating systems; cross-device productivity
applications; server applications; business solution
applications; desktop and server management tools;
software development tools; and video games. The
company also designs, manufactures, and sells devices,
including PCs, tablets, gaming and entertainment
consoles, other intelligent devices, and related
accessories.
The major business segments are:
1. MS OFFICE and related services
2. Cloud Computing
3. PC (Software and devices)
4. Search
5. Gaming
 6. Enterprise services

1. MS OFFICE and related services

The company offers wide range of office related services.
These services are categorized as productivity and
business processes.
The OFFICE 365 is a subscription-based service. Through
Skype and LinkedIn, Microsoft has diversified into all
sorts of office related services.
The services include:
MS OFFICE- This includes various office products like MS
Excel, MS PowerPoint, MS word, MS Teams, MS Outlook,
OneDrive, etc.
These applications are used for a variety of purposes. For
instance, the Excel is a spreadsheet program.
OneDrive is a cloud storage service offered by Microsoft.
Along with these services, Microsoft also owns Skype
(video-conferencing) and LinkedIn (social-networking).
The diversified services offered by Microsoft
complements each other.
 2. CLOUD COMPUTING
“Azure is a comprehensive set of cloud services that offer
developers, IT professionals, and enterprises freedom to
build, deploy, and manage applications on any platform
or device. Customers can use Azure through our global
network of datacenters for computing, networking,
storage, mobile and web application services, AI, IoT,
cognitive services, and machine learning.”
*Source: 10-K
If you didn’t understand still what Azure is, I will explain
it more simply:
Azure is a cloud service that helps developers to create
applications on any platform or device. The services are
highly flexible and economical as well. A developer can
get everything he/she needs from database to
networking.
If you still didn’t understand what Azure is, then I
recommend you to watch Microsoft’s YouTube video
that explains Azure:
How does Microsoft Azure work?

3. PC (Software and Devices)

The Windows operating system was a key driver of
Microsoft’s initial success. Recently, Microsoft has
announced a new edition, Windows 11.
The Operating System is user-friendly and dominates the
market. The problem is with piracy. People usually save
up on windows license by using a pirated software. The
windows cloud software includes services like Microsoft
Defender Advanced Threat Protection (anti-virus
software).
The Devices segment includes Microsoft’s Surface laptop
series and related accessories.
4. Search
The search business includes Bing search engine and
Microsoft Advertising. Microsoft has partnered with
Verizon Group to monetize search queries.
The business model of a search engine is not too
complex. Companies usually pay search engines to
display advertisements.
For example) If I own a company XYZ ltd. and I want my
company’s website to be displayed when someone
searches XYZ, then I will have to pay the search engine’s
owners.
Bing faces competition from Google and Apple. Clearly,
Google dominates the search engine market. I am not
too bullish on the search engine segment.
5. Gaming
Microsoft’s gaming segment includes the Xbox. The
exclusive games are created through the Xbox gaming
studio. Project xCloud utilizes Microsoft’s Azure cloud
technology to allow direct and on-demand streaming of
games to PCs, consoles, and mobile devices, enabling
gamers to take their favorites games with them and play
on the device most convenient to them.
Xbox live is used by players to connect and share with
other players.
The major competitors in this segment are Sony (through
PlayStation) and Nintendo (through Nintendo Switch).
6. Enterprise services
Microsoft’s Enterprise Services includes Premier Support
Services and Microsoft Consulting Services, assist
customers in developing, deploying, and managing
Microsoft server and desktop solutions and provide
training and certification to developers and IT
professionals on various Microsoft products.

This concludes the business section. I will review

Microsoft’s future objective and current focus in the next
section.
MICROSOFT’S FUTURE
To understand Microsoft’s future, I will have to be a
visionary. This adds a speculative element. The
management is innovative and I believe that Microsoft
will bring new technologies that will change a lot. This is
not a 1- or 2-year process. Artificial intelligence is going
to change everything and Microsoft has the resources to
bring that change. Amazon, Google and Apple are going
to be the major competitors. The economics of any
technology company is hard to predict.
I have seen how windows 11 can use AI supported
software and they’ve also introduced Android apps for
windows, so they are going in the right direction.
Microsoft’s revenue from cloud services has been
increasing relative to other business segments, that
shows how focused Microsoft is in expanding the cloud
business. In my view, this is a good thing because
Microsoft’s strength is not gaming or search engines.
The problem with Microsoft’s valuation would be that of
a moat (competitive advantage). Apple’s competitive
advantage is the brand loyalty. For Microsoft, the
advantage is that of the software. Microsoft it trying to
use this advantage to expand its search business as well
(by setting Bing as the default engine for Windows).
When it comes to Software and Office apps, I believe
Microsoft will continue to dominate the industry in the
coming years. There’s no substitute for Excel (except for
google sheets but Excel is much faster when working
with big data). The Office365 provides a lot of features
(Now they have LinkedIn and Skype too) and it’s very
convenient. I don’t see anybody easily replacing
Windows and Office365.
The search engine segment is where Microsoft will have
to do something truly unique to beat Google. There’s no
doubt that Google rules the search engine business (I
personally prefer Bing over Google because of the
interface). Microsoft has one advantage, the default
search engine for Windows is Bing, If the company can
somehow retain customers when they first use Bing to
download Chrome, the search engine business can grow.
(Here the problem is different, smartphones are much
more used than computers and Google rules the
smartphone market through Android. Either the user will
use Google’s search engine or Apple’s Safari browser.
There is no reason for the customer to download Bing.)
The gaming market for Microsoft is an area where the
growth seems much more stable. The simple reason is
that there is only 1 competitor without any sustainable
competitive advantage. The Sony’s PlayStation
dominates the gaming console industry but Xbox has a
great share of the market too. The Market Share
according to stats-counter
(https://gs.statcounter.com/os-market-
share/console/worldwide) Is as follows:
PlayStation: 59.38% Xbox: 40.62% Nintendo: 0.01%
I don’t know how reliable the data is, but surely the real
story is somewhat similar.
The cloud services segment is a growing business for
Microsoft. The Intelligent cloud segment revenues
increased at 21% and 24% from FY18-19 and FY19-20
respectively. The main threat to this business is Amazon’s
AWS. Both are equally good in their own ways but Azure
is more economical. This cost-advantage can surely help
Microsoft.
Microsoft’s Surface Laptops are also competing with a lot
of different PC manufacturers. The only problem is that
there’s no competitive advantage. The laptops are said to
be really efficient and powerful, but the average
consumer prefers cheaper alternatives. In the high-end
segment, people will prefer buying the MacBook.

The major issue is competition:

Bing competes with Google’s search engine.
Xbox competes with Sony’s PlayStation
Azure competes with Amazon’s AWS
Windows competes with Apple’s MacOS

We will account for this in the valuation section.

OTHER INFO
Microsoft has acquired GitHub in 2018, a popular code-
repository service used by many developers and large
companies. The company was acquired for $7.5 billion
(30 times revenues in 2018). The revenues for 2020 were
only 300 million USD. I do not understand the reason for
this acquisition.
LinkedIn for acquired in 2016 for $26 billion (7 times
revenues).
Many people argue that the high sum is paid to acquire
users who can then be converted to Microsoft’s
profitable services. These acquisitions are called
‘strategic’, I don’t know if that makes sense to anyone.
To put the numbers in perspective:
If Microsoft aims to earn 5% on LinkedIn’s acquisition,
then they will have to earn $1.3 billion every year in
profits from that segment only. The numbers just don’t
make any sense. You cannot earn a billion dollars in
profits from that every year.
The below points are extracted from the 10-K (The
information seemed important so I just copied it here)
“Highlights from fiscal year 2020 compared with fiscal
year 2019 included:
• Commercial cloud revenue increased 36% to $51.7
billion.
• Office Commercial products and cloud services revenue
increased 12%, driven by Office 365 Commercial growth
of 24%.
• Office Consumer products and cloud services revenue
increased 11%, with continued growth in Office 365
Consumer subscribers to 42.7 million.
• LinkedIn revenue increased 20%.
• Dynamics products and cloud services revenue
increased 14%, driven by Dynamics 365 growth of 42%.
• Server products and cloud services revenue increased
27%, driven by Azure growth of 56%.
• Enterprise Services revenue increased 5%.
• Windows Commercial products and cloud services
revenue increased 18%.
• Windows original equipment manufacturer licensing
(“Windows OEM”) revenue increased 9%.
• Surface revenue increased 8%.
• Xbox content and services revenue increased 11%.
• Search advertising revenue, excluding traffic acquisition
costs, was relatively unchanged.”
For the fiscal years 2020, 2019, and 2018, the company
repurchased 126 million shares, 150 million shares, and
99 million shares of the common stock for $19.7 billion,
$16.8 billion, and $8.6 billion, respectively.
The company paid 2.04$ dividend per common stock in
FY20 as against 1.84$ in FY19. The book value growth has
been almost 43% (cumulative) for the last couple of
years. $82,718 in FY18 to $118,304 (millions) in FY20.
The stock has grown at 29% CAGR in the last 10 years.
The stock has grown 444% (cumulative) in the last 5
years only.
I will review the financials in the next section and value
the company to check if it can grow more from here.
(2) FINANCIAL STATEMENTS AND VALUATION
I am reviewing the numbers only until June 30, FY20. The
reason is that the 10-K for 2021 is not yet available yet
and it makes no sense to stress about quarterly figures.
Thinking about the long term, I believe annual results are
just fine.
THE BALANCE SHEET
The company’s total assets equal $300 billion with $118
billion in shareholder’s equity. Company’s long-term debt
Is at $59.5 billion and lease liabilities at $7.6 billion. The
company has $136 billion in cash (including short-term
investments).
The company carries $43 billion in goodwill that will be
amortized over the upcoming years; this will understate
the net income. Net PPE stands at $44 billion ($43 billion
accumulated depreciation) and the income for the year
was $44 billion as well. The business is asset-light and
does not require a lot of capital expenditure. The
liabilities section then contains the liabilities related to
deferred revenues (common in subscription-based
business models), deferred taxes and lease liabilities.
The balance sheet is really strong, I don’t see any sort of
capital related problems that Microsoft can face in the
near future. The main thing is earnings power of the
business.
(The balance sheet section was not detailed because tech
companies are usually valued more by earnings power,
the balance sheet can highly understate the true
potential of the company. Hence, it is common for tech
companies to trade at high Price/Book-Value multiples.)
THE INCOME STATEMENT
The company’s revenues have increased from $110
billion to $143 billion from FY18 to FY20; The profits have
increased from $16.5 billion to $44.2 billion in the same
time.
FY20 FY19 FY18
Product revenues 68 66 64
Service revenues 74 59 45
Total revenues 143 125 110
(USD in billions)
The Cost of Revenues has been $46 billion, $42 billion
and $38 billion for FY20, FY19 and FY18 respectively.
Every line item in the income statement has increase in
proportion to revenues except for Provision for Income
Taxes. The most important thing for Microsoft (for any
technology company) is research and development
expenditure. Usually, investors would want expenses to
be as low as possible, but if I’m investing in a technology
company, I want the R&D expenses to be at least in
proportion to revenues. R&D is going to create growth
opportunities, If Microsoft does not spend enough to
keep up with the competition, it can lose the dominant
position.
The R&D for Microsoft has grown from $14 billion to
$19billion from FY18 to FY20. This, along with all other
expenses have grown in line with revenues.
THE CASH FLOW STATEMENT
The company has generated cash at a steady rate,
generating $60.6 billion, $52.1 billion and $43.8 billion in
FY20, FY19 and FY18 respectively. [CFFO]
The capital expenditures for the same have been $15.4
billion, $13.9 billion and $11.6 billion.
In financing activities, the cash have been mainly used to
repay debt, repurchase common stock and pay
dividends. I have already discussed this.
The company has invested heavily in investments. The
total purchases for this year have been $77 billion
(mainly in government securities, commercial paper,
bonds and deposits).

FY20 FY19 FY18

Purchases of (77,190) (57,697) (137,380)
investments

Maturities of 66,449 20,043 26,360

investments
Sales of investments 17,721 38,194 117,577

The Free Cash Flows are:

(CFFO – Capex)
FY20: $45,234 millions
FY19: $38,260 millions
FY18: $32,252 millions
OTHER INFO
Microsoft also has off-balance sheet liabilities. They
provide indemnification to customers for claim against
the customers by third parties for intellectual property
infringement arising from the use of Microsoft’s products
or services.
The company also covers losses to the customers arising
from security breaches in the cloud business. Suppose
your data is leaked from the Microsoft’s database, then
your losses would be covered by Microsoft.
The company is facing many lawsuits as well. Mainly for
anti-trust and unfair competition. Any judgment against
Microsoft can adversely impact the operations.
________
The excerpt below highlights an important change:
“In July 2020, we completed an assessment of the useful
lives of our server and network equipment and
determined we should increase the estimated useful life
of server equipment from three years to four years and
increase the estimated useful life of network equipment
from two years to four years. This change in accounting
estimate will be effective beginning fiscal year 2021.
Based on the carrying amount of server and network
equipment included in “Property and equipment, net” as
of June 30, 2020, it is estimated this change will increase
our fiscal year 2021 operating income by $2.7 billion.”
Thus, the net income is overstated by $2.7 billion. [This is
not necessarily a bad thing; the cash flows are anyways
not affected by these changes]
KEY RATIOS*:

Current ratio 2.5

Debt-Equity ratio 0.53
Gross Margin 67%
Net Margin 30.9%
Return-on-Equity 37.4%
Return-on-Assets 14.6%
Return-on-Investment 24.8%

(As at June 30, 2020)

(*Source:
https://www.macrotrends.net/stocks/charts/MSFT/micr
osoft/financial-ratios)
VALUATION
The Valuation of Microsoft isn’t easy because there are
so many different segments with different economics. To
make the job easier, I will simply project growth at 5.5%
for the next 10 years (Free Cash Flow growth). I will
discount back earnings at 4% (interest rates in US are low
(1.54%) so I’m adding a few percentage points) and use
1% as perpetual growth rate.
[To understand why I use DCF and how it works, you can
read my article on DCF at
https://thesecurityanalyst.weebly.com/investing-
concepts.html ]
There is nothing magic about 5.5% growth rate or 4%
discount rate. The business surely can grow at rates as
high as 10% or may not grow at all. Obviously, it's going
to happen in cycles. So, the best way is to use an average
growth rate that seems reasonable.
The reason I’m not using 1.54% as discount rate is that
it's too low. With that number, the valuation would be
extremely high.
I’ve shared the excel calculation in the next page.
 Year Nominal Discounted
0 $45
1 $47 $46
2 $50 $46
3 $53 $47
4 $56 $48
5 $59 $48
6 $62 $49
7 $65 $50
8 $69 $50
9 $73 $51
10 $77 $52
10 $2,588 $1,748
TOTAL $2,236

The calculated Intrinsic value is $2.2 trillion. The market

cap is $2.09 trillion. If we apply a margin of safety of 10%,
then the calculated value would be $1.9 trillion. [We
cannot apply high margin of safety because it’s a great
company. Sometimes, paying a little premium is also
justified because companies with great economics and
excellent management are rare.]
 (3) CONCLUSION

WHO SHOULD BUY THIS STOCK?

The stock is fairly valued in my view. The problem is with

the expected return.
If you’ve read my report on Apple (available at:
https://thesecurityanalyst.weebly.com/equity-
analysis.html ) Then you already know the conclusion.
Because Microsoft and Apple are both above $2 trillion
and both are excellent businesses, the stock can be a buy
for someone who wants to diversify his/her holdings
without much risk.
Even if you are an active investor, you can surely invest
5%-10% in companies like Microsoft and Apple.
The only thing you need to keep in mind is that your
expected return should not exceed 7-8%. At this
valuation, 7% return would mean that the market cap of
Microsoft will reach $4 trillion by 2029.
So, the investment decision depends a lot on your
portfolio, 7-8% is the highest you can expect. If you
expect anything more, it would be speculative (it might
work but it’s much riskier).
There’s one more thing-
I mentioned in the report that the acquisition of LinkedIn
and GitHub does not make any sense (at that price). If
you feel I’ve missed something in those deals, do let me
know. This is the problem with ‘Strategic’ acquisitions,
you cannot properly distinguish between good and bad.
 (4) APPENDIX
OPPORTUNITY COST
Opportunity cost is one of the most important aspect of
Capital allocation. You have to constantly compare the
returns possible in different securities.
In theory, this is really simple. If you were given an
opportunity between choosing two securities yielding
10% and 12%. You would obviously choose the latter.
But in equities, you do not know what the returns are
going to be. This is where opportunity cost becomes a bit
tricky.
The key here is to keep searching for undervalued
opportunities. People are too tempted to always stay
invested. This can cause problems because of short-term
irrationality of the market.
For example)
Suppose you invest your money in a low-cost index ETF
because you were not able to spot opportunities. Now
the market crashes and you have many companies you
believe are trading at bargain levels. The problem
however, is that you do not have the same purchasing
power because your portfolio would have been impacted
too.
“It takes the character to sit with all that cash and to do
nothing. I didn’t get to where I am by going after
mediocre opportunities”
-CHARLIE MUNGER
Another important aspect of capital allocation is circle of
competence. If you find that rare opportunity, you
should have the confidence to bet heavy.
“The wise ones bet heavily when the world offers them
that opportunity. They bet big when they have the odds.
And the rest of the time, they don’t. It's just that simple.”
-CHARLIE MUNGER
Thus, the key is to wait for the correct opportunity and
then bet heavy when the opportunity comes. If you
invest within your circle of competence in great
companies after doing your due diligence, you are going
to do great in the long run.
 (5) REFERENCES
• Microsoft: 10-K. [Online] 2020. Available from
https://www.microsoft.com/en-us/Investor/sec-
filings.aspx
• Microsoft: 10-K. [Online] 2017. Available from
https://www.microsoft.com/en-us/Investor/sec-
filings.aspx
• Microsoft: 10-K. [Online] 2014. Available from
https://www.microsoft.com/en-us/Investor/sec-
filings.aspx
• Yahoo Finance: Microsoft. Historical Data. [Online]
2021. Available from
https://finance.yahoo.com/quote/MSFT/history?p=
MSFT
• Macrotrends: Microsoft. Financial Ratios. [Online]
2021. Available from
https://www.macrotrends.net/stocks/charts/MSFT/
microsoft/financial-ratios
• GS stats counter: market share. Console. [Online].
2021. Available from https://gs.statcounter.com/os-
market-share/console/worldwide
(Accessed 5th and 6th July, 2021)