Microsoft Corp. (MSFT, Financial) could be at least 20% undervalued despite the stock's recent rise. This is based on its free cash flow, which is powered by the company's focus on artificial intelligence products.
As of April 3, at $420.45 per share, the stock could be worth about 20% more at $504 over the next 12 months. This discussion will cover how this value can be seen by using a free cash flow margin analysis along with a FCF yield metric approach.
Moreover, Microsoft's upcoming release of its fiscal third-quarter results ending March 31 can show investors if it is on track to continue strong FCF growth.
Free cash flow growth
But first, let's review why FCF growth is so important with a stock like Microsoft. Free cash flow is the amount of cash flow left over after all cash operating expenses, including capex spending and net changes in working capital, that is “free” to spend on dividends, buybacks, acquisitions and debt reduction.
For example, Microsoft closed on its $75 billion all-cash acquisition of Activision Blizzard in October 2023. The company would not have been able to finance this deal if it was not producing cash that was free of any need to cover its own cash spending needs.
This year Microsoft is likely to generate about $69.9 billion in FCF based on analyst revenue estimates and using the company's guidance on its capex spending. That works out close to 29% of its revenue, which is close to its historical averages. That can be seen in the chart below.
It shows that Microsoft has been making between 28% and 33% of its sales in FCF over the past several years.
The details of the FCF growth estimates will be discussed below. But first, let's review the company's focus on AI products.
Focus on AI
Moreover, management has been benefiting from strong revenue growth based on its focus on artificial intelligence products. CEO Satya Nadella said in a Jan. 30 earnings call that “We have moved from talking about AI to applying AI at scale.”
He says that the company has been “infusing” AI across every layer of the company's tech stack. For example, AI is now part of the Azure product lineup using Microsoft's close relationship with OpenAI. He said:
“And we have great momentum with our Azure OpenAI Service. This quarter, we added support for OpenAI's latest models, including GPT-4 Turbo, GPT-4 with Vision, Dall-E 3, as well as fine-tuning.”
As a result, revenue rose 18% in its latest fiscal quarter (second-quarter 2024) ending Dec. 31, 2023. Moreover, for the six months ending Dec. 31, sales were up 15.2% year over year and for the trailing 12 months in the same period, they rose 11.5%.
FCF forecasts
This is leading to strong FCF growth as well.
For example, in the trailing 12-month periods in the last four quarters, Microsoft has shown strong FCF growth. This can be seen in the chart and table below.
This shows that in the past five quarters, as Microsoft has begun to focus on AI-driven products, its FCF margins have held up well. They have ranged from 28.1% to 29.6% on a trailing 12-month basis in the last four quarters.
This is despite higher spending on capital expenditures such as data centers to reap the benefits of generative AI products.
Moreover, based on estimates from a survey of 52 analysts, revenue for the year ending June 30, 2024 is forecast to rise by 15.2% from $211.9 billion last year to $244.3 billion.
And for the next year, these analysts forecast a rise of 14.3% in sales to $279.3 billion. As a result, using margin analysis it is possible to forecast the company's FCF going forward.
For example, look at the table below. We assume the company's capex spending will increase. This is what the CEO said in the Jan. 30 earnings call:
“We expect capital expenditures to increase materially on a sequential basis driven by investments in our cloud and AI infrastructure … there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”
As a result, we can expect that its capital expenditures as a percent of sales will increase from 13.30% last fiscal year to at least 16% this year.
The net result, despite this higher capex spending, is that FCF will still stay strong at $69.9 billion this year and $79.9 billion next year.
As a result, a price target for the stock can be set using these FCF figures.
Price target
One way to value a stock is to assume the company, assuming it generates positive FCF, was to pay out all of the FCF as a dividend. That way we can set a FCF yield metric for the stock.
In this case, Microsoft pays an annual dividend of $3 per share and there are now 7.43 billion shares outstanding. That means its dividend costs Microsoft $22.29 billion, or just 31.9% of its estimated $69.9 billion in FCF. That means if the company were to pay out 100%, it would increase the payments to shareholders by 3.10 times (i.e., 1.00/0.319 = 3.1347).
The market is presently giving the stock a 0.71 % dividend yield (i.e., $3.00/$420.45). So, theoretically, we should use an FCF yield that is 3.130 times this 0.71% dividend yield, or 2.22%.
That implies a good FCF yield metric is 2% since the stock is likely to have a lower yield with the higher dividend payment. This is also the same as multiplying the FCF estimates by 50 since the inverse of 2% is 50 (i.e., 1/0.020 = 50).
The table below shows how this works out.
Multiplying the 2024 $69.9 billion FCF estimate by 50 results in a market cap estimate of almost $3.5 trillion. And for 2025, the market cap forecast is almost $4 trillion. This implies that Microsoft's stock is worth, on average, 20% more at $3.75 trillion, or $504 per share.
The bottom line is that based on reasonable cash flow estimates and company guidance on its capex spending, Microsoft is set to produce a strong FCF result. This implies over the next 12 months it could be worth 20% more than today.
