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.

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What Makes a Good Business?

Seth Klarman, clearly one of our favored sources of investing insight, recently took up the task of revising Benjamin Graham and David Dodd’s famous Security Analysis. In the introduction, Klarman observes some of the persistent difficulties in the stock market that enable some investors to generate outsized returns. One such difficulty is the lack of clarity about what makes a good business.

Klarman writes: “Another area where investors struggle is trying to define what constitutes a good business. Someone once defined the best possible business as a post office box to which people send money. That idea has certainly been eclipsed by the creation of subscription Web sites that accept credit cards. Today’s most profitable businesses are those in which you sell a fixed amount of work product–say, a piece of software or a hit recording–millions and millions of times at very low marginal cost. Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow.” (xxxv)

All told, a very useful set of criteria.  The only thing I would want is some additional criterion about increasing margins.  In highly competitive industries, some businesses find it difficult to raise prices, since their market share quickly drops when they do.  A good business has customers who are relatively unconcerned about marginal price increases.  Businesses that have this privilege include Coca-Cola, Moody’s, Mastercard, and Visa.

Case in point, at the football games this past fall, a Coke was selling for $5 a cup.  And let me tell you, you still had to wait in line to get it.

Ebay–What’s it Worth? Part II

Yesterday we noted Seth Klarman’s three methods for valuing businesses and observed that a net present value (NPV) analysis of future cash flows is most appropriate for a business with demonstrated earnings power.

With the help of Morningstar’s free cash flow data and the NPV function of Microsoft Excel, a NPV analysis is not a difficult exercise.

Since 2000, Ebay has grown its free cash flow from 50.4 million to 2.32 billion (2008). And from 2001-2008, Ebay grew its free cash flow at a 42% rate. These are simply phenomenal numbers—the result of starting from scratch and growing into a sector leader. More recently, the growth of Ebay’s free cash flow has slowed. In 2007, it grew about 23.2%, and in 2008, it grew about 5.6%.

As many know, in a NPV analysis of future cash flows, one must make a reasonable estimate of those future flows. Particularly in the case of Ebay, it is reasonable to expect those flows to be greater than today’s, given the company’s record of growing cash flows at a high rate. However, if one overestimates Ebay’s future growth, the NPV analysis will overvalue those flows. Thus, for those looking to buy a business’ future cash flows at a discount, it is very important to estimate future growth conservatively.

For today’s analysis, I will conservatively project that Ebay will grow its free cash flow at 10% over the next ten years, and then grow it at 5% for the following ten years. Given Ebay’s history of acquisitions, I expect 10% to be a reasonably conservative estimate for the next decade. 5% growth in my lights represents a business treading water—not gaining or losing market share—since 5% is a reasonable estimate of what the population growth plus the inflation rate will be for that decade.

Using these estimates, the net present value of the next two decades of Ebay’s cash flows, discounted at 15%, should be 27.6 billion. Add the 27.6 billion to Ebay’s book value, and you get a total value for Ebay of 38.68 billion. 

In other words, Ebay should throw off 119.94 billion in cash over the next two decades. However, we don’t want to pay that much solely to have it trickle back to us over twenty years; instead, we want a decent return on our capital outlay—say 15%. Thus, we should be willing to pay 38.68 billion today for 119.94 billion in cash outflows over the next two decades. Per share of Ebay, that amounts to a price of $29.47.

However, for any investment, one should only deploy cash when one has a substantial margin of safety. Estimates prove mistaken; management gets lazy; competitors spring up.  Given Ebay’s size and moat, a 25% margin of safety should be sufficient.

All told then, we should be willing to pay $22.10 per share for Ebay, expecting a 15% return on investment, with a 25% margin of safety. As of Friday, Feb. 6^th, Ebay traded at $13.63 per share.

Coming up next—Valuation (even more conservatively), continued.

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.

Ebay–What’s It Worth?

Ebay, we’ve found, operates an auction business that generates recurring sales on the widest variety of products. Its auction model renders substantial cost savings that retailers do not generally enjoy. Because it is the market-leading auction site, sellers can find the buyer willing to pay the most, and buyers find the largest selection of goods available for sale. At some level, this may all be marginally interesting, but the typical investor is most interested in what this business is worth.  Let’s get to it.

Valuations methods vary. Seth Klarman of The Baupost Group, in his Margin of Safety (Harper Collins, 1991), highlights the three methods of valuation he finds useful: a) going-concern value, which employs net present value (NPV) analysis of a business’ future cash flows, b) liquidation value, which prices the sum total of the business’ assets, as if its parts were sold and the business dissolved, and c) stock market value, which is the price at which a business and its subsidiaries would trade in the stock market (121-122). NPV analysis is best suited for evaluating profitable businesses with a consistently demonstrated earnings power; liquidation value works best for evaluating unprofitable businesses that retain assets of some value; stock market value makes sense when evaluating closed-end funds whose net asset value differs from their market value.

Given Ebay’s earnings power, NPV analysis is the best tool for determining the value of Ebay’s business. In future posts, we will offer a NPV analysis of Ebay’s cash flows.

For today, I thought it would be instructive and informative to quickly observe the portfolio of businesses that Ebay has acquired over the last decade and their acquisition prices. In itself, the price that Ebay paid for these businesses is not particularly useful for our valuation of Ebay as a whole. To tip my own hand a bit, I would argue that Ebay has overpaid for some acquisitions; thankfully though, it got a great deal on others.

Since 1999, Ebay has acquired the following businesses (and I will only list those acquisitions greater than 200 million)

Butterfield and Butterfield (1999) ~ 260 million

Half.com (2000) ~ 350 million

Paypal (2002) ~1.5 billion

Marktplaats (2004) ~ 290 million

Rent.com (2004) ~415 million

Shopping.com (2005) ~ 620 million

Skype (2005) ~2.6 billion

Stubhub (2007) ~ 310 million

BillMeLater (2008)~ 945 million

Other misc. small transactions (minimum cost of 600 million)

TOTAL COST ~ 7.89 billion

MARKET CAP of Ebay (as of 2/6/09) ~17.4 billion

In addition, another important acquisition for Ebay was a 25% stake in Craiglist in 2004 for about 13.5 million. The private market value of Craigslist could range anywhere from 2-5 billion, which would value Ebay’s stake in the range of .5 to 1.25 billion.

Most simply, we see that Ebay has a wealth of assets.  Insofar as we can break out and separately value each of these parts, we should be able to come up with a sharper and better valuation.

Coming up next—Valuation, continued.

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.