Stock Analysis: Microsoft (MSFT) - Part 2

After going through more of a fundamental analysis in Part 1, now it's time to analyze where Microsoft stands in terms of its historical valuation versus S&P 500 and versus its own competitors.

Below is a snapshot from Morningstar.com showing how MSFT's valuation mutliples in terms P/E, P/B, P/S, and P/CF have changed over the past 10 years.


In general, you can see that it has commanded a higher P/E than S&P 500 until 2008 when it became on par with it and then even went lower. Of course, you could argue that this downward trend may continue because more and more investors have come to a realization that MSFT isn't a "growth" stock anymore. However, I would take that point and go a step further. Indeed, I think that this a transition period in terms of mutual fund ownership. My hypothesis would be that growth investors are selling off their stakes but value funds have not opened their arms to this stock yet, hence the compression in P/E multiples. With a dividend yield being a respectable 2% right now and a earning yield of 8%, this seems to be quite a value-type of a stock. It really doesn't make sense for MSFT to be valued lower than the S&P 500: its 5-yr earnings growth forecast is slightly higher (11.1%) than the S&P (10.8%), its AAA credit rating is better than 99% of other S&P stock components, its sitting on a huge cash pile, which can potentially create move value than is currently expected. And that's just the "low-hanging fruit" comparison of MSFT vs. S&P 500 (don't get me started on MSFT's superior profits margins and ROE, which even when reasonably compressed due to market pressures are still way better than your S&P 500 company) - my point is that MSFT by itself is a far better quality stock than the average S&P 500 stock, so at the very least it should trade at the same P/E as the index, if not at a slight premium. At this time, Microsoft's forward P/E is 10.5 while S&P 500 is commanding a 14.8 multiple. This would imply that if the company meets its earnings forecast, the stock would have rise by 40% just to be on par with the index in terms of the P/E multiple, which would mean that its price could reach $39-40 per share once that happens. This is not inconsistent with the fundamental analysis done in Part 1 where I came up with an intrinsic value of $41.50/share for Microsoft. In all honesty, I'm not sure how likely the company is to reach its intrinsic value in the next 12 months, but I do believe that its far more likely to trade in the $33-35/share range than in the current $25-28/share range.

Brief review of the competitive valuations (below) doesn't really tell us much either way. Again, I used Morningstar's peer information and those are the metrics they had readily available. Also, Apple, IBM, and HP weren't considered to be MSFT's peers by Morningstar, but I've added them to the lineup since Apple seems to be one of the major competitors in the consumer products segments (and of course the OS), while IBM and HP are, like Oracle, converging in the business services segment along with the Microsoft. So, P/S and P/B doesn't seem to be very telling for this industry. P/S ignores profitability, since these aren't start-ups, I'd say that's kind of important. P/B, on the other hand, would need to be adjusted for all the intangibles these companies have. In this industry, there is a huge amount of acquisitions beings done and goodwill amounts are quite substantial. Therefore, the picture is distorted there. So, we are back to the P/E ratio. In my view, the most telling point here is that only Novell, which has plenty of its own issues, has a lower P/E than MSFT. HP is close at 12.2, but that's at least in part due to the recent top management turmoil. By the way, the reason P/E listed here is higher than the one I've mentioned earlier is because Morningstar appears to be using trailing P/E in the peer analysis, while I was focusing on the forward-looking P/E in my discussion.

Competition Valuation Analysis	Market Cap ($ in billions)	P/S	P/B	P/E
Microsoft (MSFT)	$245	3.9	5.2	12.0
Apple (AAPL)	$308	4.8	6.5	22.2
IBM (IBM)	$184	2.0	8.3	13.4
Oracle (ORCL)	$157	4.9	4.6	23.0
HP (HPQ)	$99	0.8	2.4	12.2
Citrix Systems (CTXS)	$13	7.2	5.2	48.0
Computer Associates (CA)	$13	2.9	2.4	16.0
Compuware (CPWR)	$3	3.0	2.8	27.0
Novell (NOVL)	$2	2.6	1.6	6.0
Average:	$114	3.6	4.3	20.0

Bottom line appears to be that Microsoft is currently undervalued versus its S&P 500 in general and its industry peers in particular. Furthermore, it has mostly positive potential catalysts on the horizon - corporate upgrade cycle will boost OS and Office sales, increased adoption of the successful Windows 7, increased Xbox profitability (up seems to be the only direction it can go at this point). Even improved search market share and smartphone adaption of Windows 7 are other possible positive catalysts as they are currently deeply discounted due to previous failures. I'm definitely bullish on Microsoft, but its perennial undervaluation is definitely an obvious risk. Nevertheless, I'm convinced that positives will outweigh the negatives in this stock and that it will reach mid-30s range by the year-end at which point I would probably cash-out.