The Biggest Bargain Of The Year

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Too many investors assume that stock performance is directly related to company performance. They see a stock which hasn't moved for a decade, and write it off as "dead money." But that mistake could cost investors dearly.

Witness Microsoft (NASDAQ: MSFT). Here's its 10-year stock chart:

MSFT data by YCharts

If you had bought shares of Microsoft exactly 10 years ago, you would be basically even (not counting dividends). And indeed, Microsoft was a terrible investment 10 years ago. But people tend to extend this argument and claim that Microsoft is therefore a terrible investment today. It's human nature to look at the past and extrapolate into the future, but this exercise is very often a mistake. Here's another plot:

MSFT Free Cash Flow TTM data by YCharts

Microsoft's annual free cash flow has doubled since a decade ago. So why has the stock price remained constant? Because Microsoft was overvalued a decade ago. And buying an overvalued stock more often than not leads to underwhelming performance.

But the story is different today. Microsoft has finally reached the point where its stock is cheap compared to its fair value. Let's dive into the numbers to see how much Microsoft is really worth.

Cash Is King
Microsoft is sitting on a mountain of cash, according to data from Morningstar. At the end of September 2012, it had $76.7 billion in cash and investments, compared to $12 billion in debt. By the way, the company paid only $380 million in fiscal 2012 (ending in June) on that $12 billion in debt,  for a 3.17% interest rate. Opportunistic borrowing at its finest.

This leaves a net cash position of $64.7 billion. With a diluted share count of 8.5 billion, the company has about $7.60 in cash.  For comparison, at the end of fiscal 2008, Microsoft had only $23.6 billion in net cash. So in five years, Microsoft added $41.1 billion in cash to the balance sheet. If profits had remained the same, the company would be worth $41.1 billion more than it was five years ago. But of course, profits increased. Quite a bit.

A Money Machine
In fiscal 2012, Microsoft generated $29.3 billion in free cash flow, or $3.45 per share. FCF grew by 19% from the previous year; since 2008, it has grown by 59%.

So in five years, not only did Microsoft add $41.1 billion in cash to its balance sheet, but free cash flow also grew by 59%. Already, without even doing a proper valuation, this stinks of a great deal. Let's put a value on Microsoft and see how much of a bargain the stock really is.

Valuation
Microsoft currently trades for $27.09 per share. Backing out the net cash position of $7.60 per share, the market is valuing all of Microsoft's future profits at $19.49 per share. This puts the adjusted P/FCF ratio at 5.65. If you could buy Microsoft for its current market capitalization, you would make your entire investment back in 5.65 years, assuming that the free cash flow remained constant. For a company as large and dominant as Microsoft, that seems a bit absurd.

I'll use a discounted cash flow analysis to estimate the fair value of a share of Microsoft. I'll assume that the free cash flow will grow at a 6% rate for the next 10 years, and 3% thereafter. This puts the free cash flow 10 years from now at about $53 billion per year, 80% growth in a decade. For my discount rate, I'll use both 12% and 15%, and define a fair value range from those values. Using the above parameters, I arrive at a fair value range of $43.35 - $56.17. 

Here's something interesting: even if I assume zero growth, the fair value range would be $30.60 - $36.35. This means that the market is pricing Microsoft in a way that assumes that the company will whittle away into nothingness.

The Future Of Microsoft

Will all the talk of the declining PC market and the rise of mobile devices such as smartphones and tablets, pessimism surrounding Microsoft is at an outrageous high.

Microsoft released its newest operating system, Windows 8, in October. Windows 8 runs on desktops and laptops but also is designed to run on tablets, including Microsoft's own Surface. Windows Phone 8, Microsoft's newest phone operating system, was also recently launched.

Microsoft dominates the desktop and laptop market, but has very little market share in the mobile space. Apple (NASDAQ: AAPL) launched the first iPhone to almost no real competition, dominating the smart phone market until Google's (NASDAQ: GOOG) android devices caught up. At the end of September, Apple had a 13.9% market share to Google's 72.4%. Of course, Apple sells its hardware directly, while Google only supplies the (free) software, so Apple still makes plenty of money off the iPhone. Meanwhile, Microsoft has a measly 2.4% share. Mobile will be the engine powering Microsoft's future growth, but it has some fierce competition in front of it.

The Bottom Line
Microsoft is cheap. Really, really cheap. The market is pricing the company at a negative growth rate, which is overly pessimistic in my view. Even if Microsoft's profits stay at 2012 levels, the company is significantly undervalued. I can't say where the stock will be a month from now, or even a year from now. But a decade from today, Microsoft will be worth a lot more than the $27 it currently sells for. 

 


TheBargainBin has no positions in the stocks mentioned above, but may purchase shares of Microsoft within the next month. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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