The common premise goes like this: Since much of Microsoft Corporation (NASDAQ:MSFT)‘s business benefits from PC sales, which are declining, don’t invest in Microsoft.
That view doesn’t satisfy me. It doesn’t take price into consideration. And even a company amid unfortunate circumstances can be a great stock when the price is right. So let’s stop guessing. What is Microsoft Corporation (NASDAQ:MSFT) really worth?
Microsoft’s business
When you break down Microsoft’s business, revenue comes from five main divisions:
Source: SEC filings.
Though its entertainment and devices division combined with its online services account for a substantial sum of the company’s revenue, online services currently runs at a loss, and entertainment and devices runs on a slim profit.
Operating profit, therefore, paints a much clearer picture of Microsoft Corporation (NASDAQ:MSFT)’s business:
Though the above chart is only the company’s most recent quarter, the annual picture looks similar — for fiscal 2012, entertainment and devices had a very small profit and online services had a loss, too.
Estimating growth
Now that we have identified Microsoft’s most meaningful business segments (Windows, server and tools, and Microsoft business), we can take a look at their respective growth rates to decide on an estimate for Microsoft Corporation (NASDAQ:MSFT)’s future growth. Since Microsoft provides necessary adjustments for quarterly revenue in its quarterly filings, revenue will be the most useful indicator.
| Division | Percentage of Operating Profit | Q3 Revenue Growth |
|---|---|---|
| Windows | 35% | 0% |
| Sever and tools | 20% | 11% |
| Microsoft business | 42% | 5% |
Source: SEC filings. Revenue growth rates are after adjustments, from the year-ago quarter.
Declining PC sales or not, Microsoft Corporation (NASDAQ:MSFT) is growing, albeit slowly. Again, these growth rates are fairly close to Microsoft’s fiscal 2012 year-over-year revenue growth rates. Analysts expect growth, too, with a consensus estimate for almost 9% growth per annum for the next five years.
But let’s be conservative. Maybe the Microsoft bears are partially right. What chance does Microsoft Corporation (NASDAQ:MSFT) have in a mobile environment with Apple Inc. (NASDAQ:AAPL) and Google Inc (NASDAQ:GOOG) dominating it? In our discounted cash flow valuation I’ll bet on a flat 3% growth rate (in line with the historical rate of inflation) for Microsoft’s free cash flow, per annum.
Using a 10% discount rate, Microsoft Corporation (NASDAQ:MSFT) shares have a value of approximately $48.50. In other words, at $34.60 Microsoft stock, trades at a 29% margin of safety.
So it’s time to buy Microsoft stock?
Not necessarily. A discounted cash flow valuation should never replace high quality analysis and simple business savvy. But it’s a great starting point. And it does a great job of taking emotions out of the game.
That said, if you have a very good understanding of Microsoft’s business, and you are certain that it can grow free cash flow at 3% or greater per year, Microsoft Corporation (NASDAQ:MSFT) stock might be worth considering. A 29% margin of safety is nothing to sneeze at.
The article Microsoft Stock Has a 29% Margin of Safety originally appeared on Fool.com and is written by Daniel Sparks.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple Inc. (NASDAQ:AAPL), Google Inc (NASDAQ:GOOG), and Microsoft Corporation (NASDAQ:MSFT).
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