Watch An Analyst Value Microsoft’s Shares In Five Simple Steps

You could spend months researching a stock, devouring thousands of reports and running statistical analyses that PhD candidates have never heard of. But it doesn’t have to be like that: my fellow analyst Paul recently put together a five-step template that helps you estimate any stock’s forward-looking figures in one simple process. I’m going to give it a whirl with Microsoft, given that its stock’s been on a nice run recently. If all goes well, I should come away with a decent understanding of what’s driven the second-biggest software giant’s past performance – and whether that’ll continue in the future.

Step one: Find out how sales are growing.

The first step is to look over the company’s past ten years of sales growth. This should give me a nice idea of the company’s track record, which I can then turn into a forward-looking outlook for the next ten years. Here’s Microsoft’s sales growth:

Microsoft’s annual sales growth, by year, in percentages. Source: Koyfin.

There’s no need to overthink this. Here, I notice that Microsoft’s sales performed much better in the second half of the last decade than the first, especially in the last couple of years. You could do a quick online search to see if there were any major changes around then, but I know the firm went through a cloud transition – selling its main products as cloud-hosted subscriptions rather than upfront licenses – around the middle of the last decade. That temporarily impacted the way Microsoft recorded revenue, meaning growth technically slowed down for a few years.

I also know that demand for Microsoft’s cloud-based products and services exploded after the pandemic. That work-from-home-fueled revenue growth has calmed down over the last year or so, though, meaning it’s unlikely that sales growth will stay near the 20% mark going forward. That said, Microsoft has hoisted its artificial intelligence (AI) mainsail and is in an ideal position to catch a strong tailwind should the technology take off.

Microsoft grew its annual sales by an average of 10.6% over the past ten years. And all things considered, I reckon that’s a decent estimate for the next ten – although of course, some years will be better than others.

Step two: Establish whether sales are turning into profit.

Now you want to find out how much of those sales turn into profit, and whether that conversion – known as profit margin – will get better or worse over time. If margins expand, then profit will grow faster than sales. The first step of this particular puzzle is to dig into Microsoft’s previous earnings before interest and tax (or EBIT) margins.

Microsoft’s EBIT profit margin. Source: Koyfin.

What stands out to me here is that EBIT margins have roughly traced sales. In other words, the firm’s margins have accelerated at a similar time and pace as sales growth. Microsoft’s 42% margin in 2022 means the firm’s already very profitable. The question is, though, whether it can stay that way. After all, capitalizing on the AI trend is going to cost more than a pretty penny. Still, Microsoft’s a well-oiled machine, so I can assume its head honchos will do their best to hold margins steady at a minimum.

Putting that all together, then, I believe margins will stay roughly where they are, and that means EBIT should grow along with our sales growth estimate of 10.6%.

Now I can turn that EBIT forecast into a net profit forecast. To do that, I need to take a view on interest and tax expenses – remember, EBIT is earnings before interest and tax. While interest rates have climbed higher recently, corporate tax rates haven’t shifted and Microsoft isn’t burdened by any huge amount of debt burden – more on that later. It's reasonable, then, to assume net profit will move in line with EBIT, which I’ve said is 10.6%.

Step three: See how much profit becomes actual cash.

Plenty of firms can struggle to turn their profit into cold, hard cash. That’s because they’ll splash out on, say, buying more inventory or paying suppliers before their customers cough up. And that matters: you need cash to pay dividends, repurchase shares, or buy other firms.

To figure out how much of Microsoft’s profit ends up as cash, I need to check out the firm's ratio of free cash flow to net income. Free cash is what’s left over after day-to-day expenses and project outlays. So as Paul suggested in his template, I’ve pulled Microsoft’s cash from operations figure from its cash flow statement and subtracted its capital spending (sometimes called “purchases of plant property and equipment”). That tells me the firm’s free cash flow, which I can compare to net profit.

What matters here is how Microsoft’s growing its free cash flow over time. And if Microsoft can convert more of its net income into cash flow going forward, free cash flow will grow faster than net profit.

Microsoft’s free cash flow as a percentage of net income. Sources: Finimize and Koyfin.

Looking at this chart, it’s clear that Microsoft’s turned less net income into free cash flow as time’s gone on. You’ll want to take a research break here to try and figure out why changes might be taking place. In Microsoft’s case, building data centers to ramp up its cloud services business, Azure, has been devouring mountains of capital spending (known as CapEx).

Microsoft’s CapEx as a percentage of sales. Sources: Finimize and Koyfin.

Now, this chart shows the firm’s CapEx relative to its sales. The ratio’s been climbing in support of Azure’s rampant growth, and you have to wonder whether Microsoft will need to plow even more into Azure going forward. My guess is that it will: AI’s going to need a whole load of computer power. If that’s the case, free cash flow will likely grow slower than net income over time. Honestly, there’s no quick way to quantify that, so I’m just going to take an educated guess and say this hefty CapEx requirement will lower Microsoft’s free cash flow growth by around one percentage point. So if net profit growth is 10.6%, free cash flow growth would sit at 9.6%.

Step four: Inspect the company’s overall foundations.

According to Paul’s process, I should be able to tell if Microsoft’s “built on stable foundations” by looking at its debt pile. A quick glance at the balance sheet shows the firm has around $100 billion in cash and short-term investments (shown under the assets side of the balance sheet), and roughly $50 billion in long-term debt (that’s the liabilities side). Microsoft, then, is effectively debt-free. So sure, servicing more debt could soak up cash flow in the form of interest or principal payments. But that’s clearly not an issue for Microsoft, so I can give this question a big fat “yes”.

Step five: Check the valuation.

In his Insight, Paul explained that traditional valuation multiples like price-to-earnings (P/E) ratios can be misleading when it comes to growth firms like Microsoft. That’s because most of their cash flows will materialize in the future, and P/E ratios only look at current or very near-term profit forecasts. Instead, Paul suggested taking a discounted cash flow (DCF) valuation. I don’t disagree, but I want to check the P/E anyway. (You can never have too many options, I say.) And the chart below shows that Microsoft’s P/E ratio is high compared to the past ten years, despite sitting below its 2021 peak.

Microsoft’s forward price-to-earnings ratio, using consensus earnings-per-share estimates for the next 12 months. Its long-term mean is in gray. Source: Koyfin.

With my P/E itch scratched, I can move on to a DCF valuation. I’m going to use Paul’s template for this, and you can do the same: there’s a very brief guide on how to use it right here.

After some template number-crunching, I reckon the current stock price is baking in around 9.6% free cash flow growth for the next ten years, and 2.5% after that. This is what’s known as a two-stage DCF, where I forecast for an explicit ten years, and then just assume a slower growth rate – similar to the global economy’s pace – after that. And remarkably, that’s exactly the same as my forecast.

A discounted cash flow analysis showing Microsoft’s market value is assuming 9.6% cash flow growth for ten years and 2.5% thereafter. Sources: Finimize and Koyfin.

What’s the takeaway?

Now it’s true, this is only a very rough analysis. And I might not have had a Eureka moment, but I wasn’t expecting one. Markets are pretty efficient at pricing stocks, after all, especially mega-firms like Microsoft. Plus, I could’ve dug deeper at each stage by, say, dissecting Microsoft by division in a bid to better understand the firm’s past sales and profit growth performance. But that’s the exact point of the process: it’s quick and easy for anyone to do.

I have, however, built up a decent understanding of Microsoft’s key financial metrics, and my main takeaway is that I now believe that Microsoft’s stock price – while looking quite expensive on a P/E basis – isn’t assuming overly ambitious future growth. I can use this understanding to formulate a buying strategy for Microsoft’s shares, and do the same for other firms using the same process. In this case, I’ll now seriously consider stepping in the next time Microsoft shares dip – if they ever do.