Hey YouTube. I'm Jimmy
and this video I'm going to walk through my analysis
of Microsoft ticker symbol
MSFT.
This is the 20th video in our
series where we're analyzing all 30
stocks in the Dow Jones industrial
average. What the ultimate goal
of taking all of that analysis
and building three different portfolios
a value a growth
and a dividend you could see a link
to all of those videos in the description below.
So Microsoft is a technology company
that breaks your business into three main
segments. They have productivity
and business processes Intelligent
Cloud and more personal computing.
And as we could see they're actually fairly
spread out when it comes to a revenue perspective.
The largest is more personal computing
and that's got about 38 percent of revenue.
This segment is where they book revenue for
their Windows products.
And then they have devices like their
surface laptops Surface Pro
things like that.
They also have x box both the hardware
and the software.
Something like x box live.
Then the next largest segment
is productivity
and business processes.
That accounts for about 33 percent of revenue
in this segment Microsoft has all other office
products including Office 365.
They also have Skype one drive
all the revenue they generate from owning LinkedIn.
They also have their Dynamics Business
Solutions products
and then they have their smallest segment which
is their intelligent cloud.
This segment consists of their cloud
and server products.
The key product in this segment is Microsoft
Azure Azure is similar to Amazon's
AWS. In fact it's the second
largest public cloud service
behind only AWS.
And this brings us to an interesting point about Microsoft
and that is if you think about
it Azure is behind AWS
as Bing is behind Google.
And for me this could be both a positive
thing and a negative thing.
Microsoft has a couple big components of
their business that is second
best.
You could say on one hand that there's
plenty of upside on the other hand you could say there's an enormous
competitor in their way.
They may never get to be number one.
So it's just something to keep in the back of our minds.
Now Windows 10 is doing quite well for Microsoft.
So it's going to be tough for competitors
to knock them out of that position.
So now let's look at some numbers
and see if Microsoft is worth investing
in. So here's a chart of revenue
and the green bars are estimates.
And as we could see analysts are expecting
Microsoft revenue to grow nicely
in the next couple of years
and leading up to 2018.
Microsoft has actually done quite well
in recent years.
Now as we could see in the most recent year revenue
jumped from about ninety six billion to 110
billion. That's more than a 14 percent jump.
Now if you want to dive a bit closer
and we could see where that revenue came
from. Here's a chart of revenue going back to 2014.
This time broken out by
percentage of contribution to revenue
by segments as we could see
the cloud revenue is getting a bit bigger
each year for the past few years
at about 29 percent of revenue.
Right now.
Meanwhile personal computing
is falling.
It hit a high of about 46 percent
in 2015
and now they're down to 38 percent as
of last year.
Now this shift in revenue mix may
be a good thing because when we add
our operating margins by segment
for the end of 2018
and the end of 2018 is actually as
of their 2018 ends at the end of
June. So their fiscal year runs
June to June just there where they just finished
their first quarter recently.
But either way when we add our operating margins
we could see that more personal computing is
only 25 percent.
In fact that's the smallest of the three segments.
When we look at the other two segments Well they're
both getting larger from a percentage
basis
and their margins are better.
This should make a good case for
Microsoft margins continuing
to get stronger.
Now moving over to earnings per share we could
see that earnings per share looks very
similar to the way revenue looked.
So it seems that Microsoft is rolling
along nicely when it comes to both
revenue
and profits.
Now before we get into valuing Microsoft stock
let's look at some key points.
So recently Microsoft bought
a company called GitHub.
GitHub is a software development platform
this acquisition helps promote
Microsoft's management's
belief that over
the long term software
development will be key for the long term
success of any business.
So they hope to remain a staple
in all businesses going
forward. Now one more thing I want to point
out is when Microsoft's new
CEO took over his name is
Satya Nadella.
He took over.
If we jump back to the revenue chart we
could see he took over in 2014.
He replaced Steve Ballmer as
CEO of Microsoft.
And since then it appears that he's
been shifting the business towards
a more growth like company
and he's trying to set
up the company to dominate for
the future.
The fact that they're gradually shifting
towards better margin businesses
I think could be a very good indicator
that he seems to be doing a good job.
Plus look at the revenue chart.
Since then he's really started to pick up pace
and analysts have him expecting to
continue to do OK so now would valuation
method do we think would be best to value
Microsoft stock so
PE would probably the most popular one
and that would probably work well here
since they're a fairly stable company
and I doubt that profits
will be compromised anytime over the long
run. So my
personal favorite is of course
discounted cash flow.
So what I'm thinking is that we tried both
see how they shake out
and then try to come up
with ultimately what we believe is the best
move
with Microsoft.
Does it belong in one of our portfolios.
And if you can stick around for the discounted cash flow
valuation because I'm actually going to do something
a little different this time that I've done in some of
the other videos where we use DCF.
So let's start
with PE for me finding
peers from Microsoft might be a bit tricky
because they have so many different businesses.
Google is a good competitor when it comes to
Bing Amazon's a good competitor
with Azure.
Apple is a good competitor.
While Apple is a big competitor in a lot of different ways.
So for me it makes a lot of sense to use
Microsoft's own historical
PE averages
and then try to come up
with what we think is the best one to use
going forward.
So right now Microsoft's
current forward PE is about
21 x.
It's actually about twenty one
and a half X
but either way. Call it 21 X their
one year average is 24 x
their three year average is about 22
X and their five year average is about 19
x. So which one should we use.
Well since it seems that growth is picking
up in the past few years I think
it makes sense to use the three year average since
this would account for
the fact that things have started to pick up from
Microsoft.
If we use the five year average we might pick
up part of what we'll call the transition period
for management since they just took over in 2014.
So if we're gonna use a three year average.
Well we need a forward PE.
Let's take the 22 X we multiply
that by the expected earnings per share
and that's about four dollars
and ninety six cents according to analyst
estimates. That gives us a fair value
of about one hundred nine dollars.
Okay so we have a hundred nine dollars
with PE. Now let's look at discounted cash flow.
Okay. So now to come up the fair value using discounted cash
flow from Microsoft stock I'm going
to try to use the multi-stage
discounted cash flow valuation model.
Basically what that means is I'm going to break
their growth into different stages.
So the first stage I'm going to take
a growth rate of 14 percent
to get that number I took I simply
took the average of the past two years
and the next year projections averaged
them out came out of the simple average of 14
percent.
Now if we take that 14 percent
and we apply it to the next three years
of free cash flow.
So we have each year grow by 14 percent.
That brings us to our second
stage in that stage we're going
to assume a growth rate of 7
percent. Where did I get 7 percent.
Frankly it's half of 14.
Because ultimately what I'm trying to do
is instead of
a typical just kind of cash flow valuation
that we typically do what we do is we say
OK you have
growth rate of 14 percent
and then the next day
or the next year whenever it is it drops
immediately down to our perpetual
growth rate.
So for our case we're going to use a perpetual
growth rate of 2.5 percent.
So now we have high growth of 14
percent. Then it drops for a couple of years
at 7 percent
and then it hits our perpetual growth rate.
Now another way to do this is you can
have Phase 1
where it grows at a certain period then a transition
period and then it
tapers off into your perpetual growth rate.
But again to that another video.
So after growing free cash flow by 7
percent for a few years we end up at 2025.
Now we assume each of these
stages lasted three years
and there's no hard and fast rule for
how many years each stage should
last.
I stuck with three years because I feel like three
years is an easier number to project I could
project out three years more confidently than I could
protect our let's say five
and then after another stage would be 10 years
and 15 years that could get a bit complicated.
Now typically what we've got is
we want our research to drive
our projections
and what it might be.
So before
pretend you had a pharmaceutical
company that was going to grow
revenue by 15 percent a year
and then in year 5
they lose their patent
and you expect it to drop off quickly.
Well you could adjust this type of model would be
perfect for that you'd adjust it down
from whatever the percentages
down to whatever you believe the perpetual growth rate
is from there. Okay.
But now focusing on Microsoft now we actually
apply a perpetual growth rate
to our free cash flow.
So what that means is that from
2026 forward Microsoft
will grow forever.
In our case at 2.5 percent.
That being said this is actually
a three stage discounted cash
flow valuation method.
The yellow section is the first stage than
the bottom section is Stage 2.
Then the perpetual growth rate.
Well that's the final stage.
So now all we need to do is convert Microsoft's
free cash flow to a present value.
We do that by dividing that by
our discount factor.
In our case we're going to use a weighted
average cost of capital of eight
point five percent.
That's in blue.
And basically what do as we take
our 1 plus our eight point
five percent.
Then we raise it to the
power of whatever time period right.
So for 2019 it's one plus
eight point five percent raise to the power of
one.
And since that's only one time period way
right now you could see it as one point zero nine.
But that's only that's a rounding thing if I had Excel
round to three decimal places it would be showing
1.085.
Then in 2020 it's 1.085
raise to the power of 2.
And so on right down the right down the line
then all we have to do is we take
our projected free cash flow
divided by our discount factor
and we end up with the present value.
Add those all up we end up
with a fair value.
Today all we have to do is divide
that by the number of shares outstanding.
And that shows us that our fair value
is 80 dollars per share according
to our discounted cash flow valuation.
So this is a chart from Microsoft stock going
back over the past year.
And based on our own PE valuation
which was about one hundred nine dollars
and our discounted cash flow was
about eighty dollars.
Well we landed right
about in the middle of that right now that's about
where Microsoft is trading.
So called into our calculations
it looks at Microsoft.
Looks like Microsoft is somewhat fairly
valued.
Now personally I really like
Microsoft.
I like the growth potential of Microsoft.
I think that Microsoft likely
belongs in our growth portfolio
because it's possible
that their free cash flow ends up being
better than this over the long run.
It's also possible that they get
valued higher simply
because they become more of a growth company
and the market has a way of favoring growth companies.
So for me this is a tricky one.
I really like the company
but they seem somewhat fairly valued.
I would at the early stages before
we go ahead and build the portfolio.
I like the idea of putting them in the growth portfolio
value portfolio probably only belongs
there if it falls even more
dividend portfolio probably not they have a dividend
yield of less than 2 percent.
So I'm not sure belongs there
but what do you think.
Does Microsoft belong in any of our portfolios.
Let me know what you think of the comments below.
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with me all the way to the end of the video.
I see in the next video.