Summary

Microsoft is set to continue dominating indices, occupying a significant weight percentage.

Discounted cash flows suggest that the stock is currently undervalued by around 30%.

EPS and DPS growth suggests annualized CAGR returns of around 12%.

Despite the recent rally, Microsoft remains an attractive buy.

Introduction

In late February, since the initial COVID-19 sell-off, the market has completed a full V-shaped recovery. A few days ago, the Nasdaq hit an all-time high by crossing the 10,000 thresholds for the first time. The underlying economy may not have recovered, but the stock market is not the economy. Stocks are forward-looking and price in the potential of future profits. A particular sector’s future profitability has undoubtedly been boosted amid COVID-19, and that is tech. More specifically, big tech.

As a result, while other sectors like energy and financials have stayed beaten down, tech has been hitting all-time highs. The critical thing to remember is that the technology sector has the most concentrated top holdings of all. For example, in the Technology Select Sector SPDR Fund (NYSEARCA:XLK), which is the biggest tech ETF along with its Vanguard counterpart, Vanguard Information Technology ETF (NYSEARCA:VGT), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) constitute more than 40% of the overall weights. Because these two stocks are currently the most significant in the world, in terms of market capitalization, their recent rally has significantly shifted the weights of the overall market indices.

In March, information technology accounted for around 25% of the SPDR S&P 500 ETF (NYSEARCA:SPY). Today, the sector accounts for 31% of total holdings, as displayed below.

Source: etf.com

The rally in technology stocks and the unrecovered losses in other sectors have created possibly the biggest wealth transfer in history. The question is whether tech has more room to run. In our case, we want to examine whether Microsoft, which holds the biggest and most diversified portfolio of tech products in the world, has more room to run, taking over an even bigger chunk of the weighting pie in the overall market.

The case for $250/share

First, we have to establish that Microsoft is not a huge late-stage-cycle company whose growth keeps on declining as it matures further. The company’s Q1 results confirm this. Growth for the quarter was 14.6% YoY, compared to 14% for the same period last year. The company’s growth is not just well-sustained but slightly accelerating as well. In the meantime, gross margins have been consistently improving, boosting profitability.

As COVID-19 has forced businesses to increase their digital footprint, we expect that Microsoft’s Intelligent Cloud segments, as well as its Teams and Azure revenues, to continue increasing.

With the stock having a considerable run, investors may feel that the current price of $197 signals overvaluation and may hesitate to add to their position before a potential pullback. However, we believe that Microsoft is still mostly undervalued. Let’s break this down.

Discounted free cash flow

The company’s free cash flow for the past quarter was $13.7B, suggesting a run rate of around $55B over the next 12 months. This figure is prudent, considering that Microsoft’s free cash flow trend grows on a QoQ basis as well. For the quarter, free cash flow growth was up 25% YoY. However, we are going to assume a much lower rate of 8% towards 2021. This is even lower than the 14.6% revenue growth, just to make sure we are not overstating assumptions.

FCF/Year (In Billions)
2020 2021 2022 2023 2024 2025 2026 (terminal)
8.00% 6.00% 5.00% 4.50% 3.00% 3.00% 2.50%

Source: Author

To visualize it, our expected free cash flow growth looks like this:

Source: Author

Now, let’s discount this.

The discounting

Discounting cash flows is a real challenge nowadays. The risk-free rates are so low, that risk premium has become a useless metric. The 10-year U.S. T-bill currently yields 0.7%. Intrinsic value loses its meaning when the terminal value is discounted at such low rates. I wish we could argue that the rates will slowly move back up, which would allow us to assume a higher yield, but the truth is, this will hardly be the case. Not only is the trend clearly moving lower, but the majority of government bonds are now in a negative yield territory.

Assuming the historical market risk premium in equities of 5.6% and Microsoft’s five-year average beta of 0.93, we come to a cost of equity of 5.91%. Keep in mind that the lower the cost of equity, the higher our intrinsic value will come out.

Market Assumptions
Risk-free rate 0.70%
Market risk premium 5.60%
Equity Assumption
Beta 0.93
Cost of equity 5.91%
MV of Equity est ($B) 1447

Source: Author

The intrinsic value

Plugging the discounting cash flows in, Microsoft’s low-cost, long-term debt of $62B, and the share count, we come to an intrinsic value of $258/share. This suggests an additional upside of around 31%.

Source: Author

To many, this may seem like an absurd estimate, since equities have already enjoyed a massive run. However, as long as there is enough return surplus in stocks relative to bonds, there is the case that they can shoot higher until it’s captured. The reason is that, for the first time in history, there is simply no alternative route, as bond yields don’t even cover for inflation. Even if Microsoft’s CAGR return were, say, 5%, it would still be an attractive investment in the macroeconomic context. But, as our model suggests, this should be a lot higher. Discounted cash flows aside, let’s predict the potential expected returns from EPS and DPS growth alone.

We assume an EPS CAGR growth of 10%. We believe this is prudent, considering the 5-year CAGR has been around 32%. We have also set the DPS expected CAGR at 10%. We believe this is a fair measure since Microsoft has plenty of room to grow the dividend, and there shouldn’t be any reason to slow down.

Assuming that the stock maintains its current P/E of around 32, which is fair for such a quality and growth company, we get expected annualized CAGR returns of around 11% if one were to buy the stock at its current price.

Conclusion

Over the past five years, Microsoft has been rewarding shareholders with market-beating returns on an annual basis. We believe that, despite the considerable rally on equities and the stock itself, it is not over yet. Backed by impressive earnings growth and robust cash flows, we find the stock still being undervalued. The potential for market-beating returns is confirmed by further projecting prudent EPS and DPS growth. We can see the stock further occupying indices in terms of weight allocation. All points considered, we believe that Microsoft is a strong buy.

Author: Nikolaos Sismanis

Source: Seeking Alpha: Microsoft Is Worth $250/Share – Potential For Double-Digit Returns Remains

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