Microsoft Valuation Post Earnings - Don't Buy Microsoft Yet


  • Microsoft (NASDAQ:MSFT) fair value estimate is $ 48.50, which has upside of only 2.43% as compared to its closing price $47.35 as on 12 May 2015.
  • Launch of Windows 10 might affect the revenue negatively due to its revenue recognition policy, however, there won't be any impact on cash flows
  • Other products like, Surface Pro 3, Xbox, Cloud based services, have a potential to increase revenue marginally.
  • The company has a stable dividend policy and with $ 26.1 bn remaining of their $40 bn share repurchase program, they might add value to shareholders
  • Recent integration and restructuring expenses resulted in lower Net Income

Investment rationale and risks

Microsoft Revenue segments

  • Major portion of revenue is from Commercial Licensing (46%), so any change in revenue recognition policy pertaining to these products will have material affect on the revenue and P&L statement. Commercial Licensing comprises of server products, including Windows Server, Microsoft SQL Server; volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business and Skype, among others.
  • Microsoft will be offering Windows 10 free to all qualified existing users of Windows 7 and Windows 8. For accounting purposes, Windows 10 offer will be treated as a marketing and promotional activity, and not an upgrade. This would prevent Microsoft from recognizing the revenue as deferral. For more details you could read these posts on why Microsoft's revenue accounting policy is worth noting, and the revenue impact on Microsoft.
  • The revenue from the new sales of Windows 8 will be recognized as delivered. This would keep on adding the revenue to the "Commercial Licensing" segment for the coming quarters.
  • As per Chief Financial Officer Amy Hood, the company would defer revenue from the upgrades of Windows 10 license. This move will impact the revenues negatively, although the impact can't be judged before Windows 10 is in market this summer.

Microsoft Segment Wise Revenue

  • Positive response towards Surface pro 3, laptop - tablet hybrid released in June 2014, can lead to marginal growth in revenue as Computing and Gaming Hardware only comprises of 8% of the total revenue.
  • Microsoft faces high competition related to software, devices, and cloud-based services. Its competitors like Apple and Google have an edge in the devices and cloud-based services space. Certain competitors develop and offer free applications, online services and content, and get advertising revenue by selling third-party advertising. This advertising revenue is used to develop products and services. Competing against such competitors means increase in research and development costs and direct competition with revenue generating products.
  • The effective tax rate for Microsoft in the recent quarter was 24%. They produce and distribute their products and services through foreign regional operation centers in Ireland, Singapore, and Puerto Rico, where the earnings are taxed at lower rates.
  • The acquisition of Nokia Devices and services business in April 2014, is yet to prove its success as only 8.6 mn Lumia phones were sold as compared to 24.7 non Lumia phones
  • Integration and restructuring expenses increased due to severance expenses, reorganization costs incurred and also due to certain assets written down. This resulted in decrease in Net Income.

Microsoft Valuations

Microsoft has a history of positive Free cash flows and there is no reason to believe that this trend will not hold in future. Using Discounted Cash flow valuation model and cost of equity as 30.71% (using the PRAT model and expected dividend yield) and different growth rates scenario, I calculated the high and low fair value estimate. The mean value estimate came out to be $ 48.50.

Microsoft Cost of Equity

  • Growth rate Scenario 1:
    • Growth in first year calculated using PRAT model = 28.09% and assuming perpetual growth rate from 10th year = 5%. All other growth rates are calculated using linear interpolation.
    • Low fair value estimate:  $34.50
  • Growth rate Scenario 2:
    • Growth in first year calculated using PRAT model = 28.09% and implied growth rate in 10th year calculated using single stage model = 19.82%. All other growth rates are calculated using linear interpolation.
    • High fair value estimate :  $ 62.50


Keeping in view the estimated mean fair value of $ 48.50 and recent revenue recognition policy change along with historically stable dividend policy, I believe outlook towards Microsoft is NEUTRAL (HOLD). The outlook might change after the official launch of Windows 10 and Q4 earnings release.

Disclaimer: This is an independent article. I have no position in the mentioned stock and do not plan to initiate any position in the next 2 working days. This document does not provide personal investment advice. Please consult financial advisor before making any investment decision.

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