Microsoft (NASDAQ:MSFT) recently produced stellar earnings on Jan. 25 for its fiscal second quarter and the six months ending Dec. 31. As a result, MSFT stock looks very cheap here, even though Microsoft has a market capitalization of $2.3 trillion.
In fact, based on analyst projections and the company’s very high free cash flow (FCF) and FCF margins, MSFT stock could easily be worth more than $3 trillion. This means its value is more than 33% higher at $410 per share, based on the Jan. 28 closing price of $308.26.
The recent earnings report will also help the stock turn around from its slump. Microsoft ended last year at $336.32 and is still down about 8% year-to-date (YTD). This is after it peaked at $343.11 on Nov. 19 as well as after it hit a bottom of $288.49 in January.
Now, the tide has turned. It seems that the market is looking forward to pushing MSFT stock higher. At the very least, sentiment has been too bearish on MSFT stock. Analysts are now very positive about Microsoft’s future.
MSFT Stock: Where Things Stand
In the last three months ending Dec. 31, Microsoft produced $51.7 billion in total revenue, up 20% year-over-year (YOY). Moreover, net income was up 21% to $18.8 billion while earnings per share (EPS) rose 22% YOY to $2.48 on a diluted basis, according to its slide presentation (Page 4).
Moreover, software margins were very high in Q2. The gross margin was around 70%, as usual, and its operating margin (i.e., the percent of sales from operating income) was high at 43%. That means that 43% of every sales dollar went straight to the bottom line before taxes.
However, more importantly, Microsoft’s cash flow was very high, too (Page 6). Its free cash flow — which is operating cash flow minus capital expenditure — was $8.6 billion. That represents a very high percentage of its revenue. With $51.7 billion in sales produced during the quarter, Microsoft generated 16.65% of that in FCF.
What Microsoft Is Worth Going Forward
The easiest way to value Microsoft is to focus on its free cash flow. For example, based on analyst forecasts for revenue for its fiscal year ending June 2022, Microsoft will have close to $200 billion in sales this year. Applying a 17% FCF rate, this results in an FCF estimate of $34 billion (i.e., 0.17 x $200 billion = $34 billion).
Next, if we use a 1.0% FCF yield metric to value that FCF, it brings the potential market value for Microsoft to $3.4 trillion ($34 billion / 0.01 = $3,400 billion). This represents a potential upside of around 48% over its present market value of $2.3 trillion.
However, using the same method and applying it to the $226 billion in revenue forecast for 2023 produces an FCF estimate of $38.42 billion. That’s higher than the $34 billion for 2022. Still, since it’s further out, we should also apply a slightly worse-off FCF yield metric of 1.25%. That puts the market value of MSFT stock at $3.07 trillion, or 33% higher than today’s market value. It also represents a one-third higher price from the Jan. 28 close, or $410 per share.
What to Do with MSFT Stock
We don’t have to be quite exact when measuring the upside here. The point is that this can be forecast in the future and the market is likely to give Microsoft an FCF metric of at least 1.25%. That leads to a one-third higher price target for Microsoft.
Analysts also see upside ahead for MSFT stock. For example, Tipranks indicates that the average price target of 27 analysts who have written on the stock in the last three months is $373.92. That represents an upside of over 2o%. Many of these same analysts have yet to produce new reports and will likely raise their targets.
The bottom line? Microsoft consistently produces large amounts of free cash flow. The market will likely value that FCF very highly. The stock is worth at least 33% more at $410 per share.
On the date of publication, Mark R. Hake did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
