Over the last couple of days we have offered a valuation of Microsoft’s future cash flows, under the assumption that in ten years a paradigm shift in communications will occur and render its profitable products obsolete. Yet, as some readers have observed, such an approach is too simplistic to provide a fair valuation. For one thing, even if a paradigm shift could occur, it is not 100% certain that it will. And secondly, it is likely that Microsoft’s research and development teams could develop a viable product for the new paradigm.

At least three future possibilities are conceivable, and for our purposes, let’s assume that the probability of each possibility is greater than zero. On the one hand, let’s say that it is 20% likely that Microsoft will suffer significantly from a paradigm shift in communications in ten years; in this case, the company will be worth 17.08 per share (based on our previous calculations). Call this the pessimistic view.

On the other hand, let’s say that it is 40% likely that Microsoft will continue growing its free cash flow at (what I take to be) its historical 4% annual rate for the next two decades. In this scenario, I estimate the NPV of Microsoft’s cash flows to be worth $21.06 per share, discounted at 15%. Call this the prudent view.

In a third scenario (call it the rosier view), let’s say that it is 40% likely that Microsoft will continue growing its free cash flow at a higher 7.4% annual rate (gurufocus’ numbers) for the next decade, and then grow cash flows at 5% for the next decade (5% is roughly what I would consider a stagnant business since it approximates the rate of population growth plus future annual inflation). In this scenario, I estimate the NPV of Microsoft’s cash flows to be worth $25.15 per share, again discounted at 15%.

So now we have three future scenarios, with three different valuations, and we’ve estimated the likelihood of each. We can combine these scenarios along the lines that commentator Eboro suggests:

Microsoft’s intrinsic value = (Scenario #1 * Probability) + (#2 * Prob.) + (#3 * Prob.)

Or

$21.90 = (17.08 * .2) + (21.06 * .4) + (25.15 * .4)

Of course, investors should seek a margin of safety when deploying their investing dollars. Since we have used a 15% discount rate, a 25% discount to Microsoft’s intrinsic value should be sufficient. So investors should be willing to pay $16.43 per share for Microsoft, even after taking account for a future paradigm shift in communications in which Microsoft’s Windows and Office are virtually obsolete. As of today (2/23/09), Microsoft closed at $17.21.

Disclosure: No position in the aforementioned companies at the time of this post.

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