Microsoft (NASDAQ:MSFT) is up 35% year-to-date and over 53% over the past year. I believe MSFT stock will likely continue to move from strength to strength over the next year. Its cash flow continues to power the stock higher.
After my last article on July 21, where I argued that MSFT stock was deeply undervalued, the company released second quarter earnings that underlined this.
On July 22, it reported that revenue rose 13% and net income was up 15%, although up just 5% on a non-GAAP basis.
Free Cash Flow Gains Over the Year
However, Microsoft’s free cash flow over the last 12 months was $45.2 billion. This grew an astounding 18.2% from $38.26 billion for the year ending June 2019.
Note also that this is four times the company’s stated net income of $11.2 billion. That means that the company’s conversion ratio is extremely high. It converted net income into free cash flow at a rate of four times.
Moreover, as a percent of its total sales, its fiscal year-end 2020 free cash flow was 31.5%. versus last year’s rate of 30.4%. That means that for every $100 in sales, $31.50 was leftover free of all major expenses other than dividends and debt reduction.
By the way, this 1.1% margin increase amounts to $1.573 billion, based on the company’s $143 billion in sales over the past year. It is probably not any coincidence that the Microsoft dividend rose by $1.33 billion over the year. In other words, the gain in margin financed the company’s dividend increase.
What to Expect Going Forward
Analysts polled by Seeking Alpha expect its Q1 earnings ending Sept. 30 to hit $1.54 per share versus $1.38 last year, or up 11.6%. For the year ending next June, analysts expect on average for EPS to reach $6.44 versus $5.76 for the year ending June 2020. This represents a similar growth rate of 11.8%.
In other words, the company will continue to power ahead from strength to strength. You can probably assume that growth will be even higher with free cash flow. That is because there tends to be an operating leverage effect with free cash flow.
For example, with net income growth of 11.5%, you can probably expect at least a third higher growth in free cash flow. That puts prospective free cash flow at $60 billion or so for next year.
Moreover, this means that MSFT stock trades now on a prospective free cash flow yield of 3.7%, given its $1.61 trillion market capitalization. That is a very attractive free cash flow yield for a company so large.
Valuing MSFT Stock
For example, by comparison, Amazon (NASDAQ:AMZN) has a similar market cap of $1.65 trillion. But it generated just $27 billion in free cash flow over the past 12 months. That gives AMZN stock a free cash flow yield of only 1.63%.
Therefore, if we valued MSFT stock on a 1.63% free cash flow yield using its prospective free cash flow this year, it would be valued much higher. By dividing $60 billion by 1.63%, we get a potential market cap of $3.68 trillion.
That would make Microsoft more valuable than even Apple (NASDAQ:AAPL), which just went over $2 trillion in market cap.
Apple generated $71.7 billion in free cash flow over the last year. If we assume that Apple’s free cash flow will grow 11% this year, that puts Apple’s prospective free cash flow at $80 billion. At today’s market cap of $2.13 trillion, its prospective free cash flow yield is 3.74%. That is the same as Microsoft’s free cash flow yield.
Using these two comps, MSFT stock should be trading at an average free cash flow yield between 1.63% and 3.74%. To be conservative, let’s call it 3%, partly because it looks like Microsoft’s free cash flow is growing faster than Apple’s.
At 3%, MSFT stock would have a market cap of $2 trillion, similar to Apple’s. That is 24.2% above today’s market cap and puts MSFT stock on a price target of $264.62.
Value investors can expect Microsoft will be one of the next company’s to hit $2 trillion in market value or $254.62 per share over the next year.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here.
