Friday, February 25, 2011

Why do investors hate MSFT ?

I cannot understand the market's valuation of Microsoft (MSFT). The market has consistently treated this stock badly since the collapse of it's insane overvaluation in the dotcom bubble.

But it has languished around the mid 20's for some time, even as the rest of the market has continued to climb. Management has continued a series of very shareholder friendly activities: ending equity derivative compensation, buying back large amounts of stock and raising the quarterly dividend, doing so again recently, from 13 to 16 cents. A substantial increase.

As a result, the stock yields an attractive 2.4%, with seemingly large amounts of upside potential.

I just ran the stock through my DCF model and had difficulty engineering a price below $30. Based on my forecasts for modest sales growth and continued solid margins (I find a price of $34 quite reasonable). In fact, using my operating assumptions, the discount rate required to reach the market's price is 14%, and that is too high for a business with a tremendous franchise, strong cash flows and a dividend.

I tried so assume that competition going forward would erode margins, and that tax policy would mean higher rates, but it is still hard to see how the stock does this badly, unless you assume no growth. MSFT should be able to lift volumes in it's most importnat segments in line with overall PC shipments, growing around 3% per year, and grow much faster in it's less mature product lines.

One cause for concern, though is the fact that R&D spending is currently less than depreciation, suggesting that the company may be underinvesting - in technology this means death (though software assets can be sweated more than hardware). Even so, I raised R&D spending above traditional rates of depreciation, assuming that to grow, the business will have to be a net acquirer of fixed assets. The $34 I derive already accounts for this.

So, what am I missing (other than an online order at my broker?)

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