# Microsoft (MSFT) Represents an Attractive Investment

In this article, let's take a look at Microsoft Corporation (MSFT), which has recently announced a dividend hike of 16% in its quarterly dividend rate to \$0.36 from \$0.31. The stock yields 2.85% if the share price stays at current levels and it is close to 10-year high.

Intrinsic Value

The Yahoo! (YHOO) Finance consensus price target is \$50.17, so now let´s try to estimate the fair value of the firm, for that purpose I will use the Dividend Discount Model.

In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods, so we can use some growth models like Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).

Once selected the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

Let´s estimate the inputs for modeling:

First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium

Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So, I believe it is more appropriate to use this rate.

Gordon Growth Model Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]

Beta: From Yahoo! Finance we obtain a beta = 0.865987

The result given by the CAPM is a cost of equity of = 14.80%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged, and it doesn´t issue new equity.

g = b x ROE

b = retention rate

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Collecting the financial information for the last three years, each ratio was calculated, and then to have a better approximation I proceeded to find the 3-year average:

 Retention rate 1.52 Profit margin 0.22 Asset turnover 0.53 Financial leverage 2.03

Now, is easy to find the g = Retention rate × Profit margin × Asset turnover × Financial leverage = 35.95%

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= (\$44.25 × 14.80% – \$1.44) ÷ (\$44.25 + \$1.44) = 11.18%.

The growth rates are:

 Year Value g(t) 1 g(1) 35.95% 2 g(2) 29.76% 3 g(3) 23.57% 4 g(4) 17.37% 5 g(5) 11.18%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Now that we have all the inputs, let´s discount the cash flows to find the intrinsic value:

 Year Value Cash Flow Present value 0 Div 0 1.44 1 Div 1 1.96 1.705 2 Div 2 2.54 1.928 3 Div 3 3.14 2.075 4 Div 4 3.68 2.121 5 Div 5 4.10 2.055 5 Terminal Value 125.88 63.136 Intrinsic value 73.02 Current share price 44.25 Upside Potential 65%

Final Comment

Intrinsic value is above the trading price by 65%, so according to the model and assumptions, the stock is undervalued and subject to a potential “buy” recommendation. However, we must keep in mind that the model is a valuation method, and investors should not be relied on alone to determine a fair (over/under) value for a potential investment.

In my opinion, this stock represents an attractive investment and will continue to deliver attractive dividends.

Similar thoughts may have Jeffrey Ubben or Jean-Marie Eveillard. The gurus are the major shareholders of the stock in the second quarter, with 75.27 and 33.97 million shares, respectively.

[1] This value was obtained from the U.S. Department of the Treasury

[2] These values were obtained from Blommberg´s CRP function.

Published on Sep 23, 2015
By Omar Venerio
Capital Markets, Derivatives and Financial Management Professor, Master in Finance and CFA candidate. I am an independent trader of stocks and options and passionate about the stock market.

Copyrighted 2019. Content published with author's permission.

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