Microsoft–What’s It Worth? Re-examined

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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Microsoft — What’s It Worth?

This past week, we spent some time assessing Microsoft’s moat. Though its Windows operating system and its Office suite are cheap to reproduce, easy to transfer and store, and require only a modest sales force, Warren Buffett acknowledged that a paradigm shift in communications could quickly undermine Microsoft’s position. Today Microsoft’s moat may be wide and deep, but consumer preferences may change rapidly in the next decade.

If Buffett is right, and consumer preferences could change in communications more quickly than their preferences in other areas (e.g., carbonated beverages, razors), then the prospective investor should be more conservative in her valuation of Microsoft, or perhaps, demand a greater margin of safety.

One thing is clear; Microsoft’s margins show that they offer a set of products that grant significant pricing power. Even after lumping all of their marginal products together with their cash cows Windows and Office, Microsoft has averaged over 80% gross margins on sales for the last five years (2004-2008), and a 34% operating margin over that same span. These margin numbers even best those of eBay, one of our favorite wide moat companies.

Yet, even if Microsoft’s future is less certain than Coca Cola’s, what do we think the company is worth today? Following Seth Klarman’s recommendation, it makes good sense to value Microsoft by summing its book value with the net present value of its future cash flows. Many NPV analyses estimate a company’s earnings power over the course of the next two decades. But if we heed Buffett’s warning about a potential paradigm shift, perhaps we should dial back our estimates of future cash flows. Thus, in this valuation, we will only project Microsoft’s future cash flows over the next decade.

So let’s get to work. Using Morningstar’s data, we see that Microsoft generated 18.43 billion in free cash flow in 2008. Let’s conservatively project that Microsoft will grow its free cash flow at 5% over the next ten years (which may seem low, but which is rather close to their FCF growth over the past decade). Using these estimates, the net present value of the next decade of Microsoft’s cash flows, discounted at 15%, should be 115.6 billion. Add the 36.3 billion of Microsoft’s book value, and we get a total value of 151.9 billion. In other words, Microsoft should throw off 243.4 billion in cash over the next decade. But we wouldn’t pay that much solely to have it to trickle back to us over that decade; instead, we want a decent return on your capital outlay—say 15%. Thus, we should be willing to pay 151.9 billion today for 243.4 billion in cash outflows over the next decade. Per share of Microsoft, that amounts to a price of $17.08. With a 25% margin of safety, we should be willing to buy Microsoft today for $12.81—significantly below Friday’s closing price of $18.

Now, I can anticipate some of the objections to this meager valuation for what is today a market leader and cash cow. It is unlikely that Microsoft will have no earnings power after a decade; it is unlikely that a paradigm shift in communications will occur. It may be improbable that cash flows will only grow at 5%.

Leaving such objections aside for now, it is crucial that we highlight what looks to be the most important lesson in this analysis. If we cannot predict what a company will look like in twenty years, our valuation of it and its future earnings should be far lower than we typically expect. And here we see that for an investor like Warren Buffett, what looks today like a wide moat may not be sufficiently wide if we cannot reliably foresee its likely earnings in 2029.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway and eBay at the time of this writing.