In fact, Microsoft’s balance sheet has over $22.7 billion in short-term investments listed in the most recent 10-Q. For the most part, those short-term investments are the equivalent of cash since they are primarily invested in fixed income securities that are investment grade and easily sold for cash. Taking these short-term investments into consideration, I really should have determined that net cash for Microsoft is currently $31.8 billion.

Using $31.8 billion in cash instead of $9.1 billion, my intrinsic value estimate rises to $27.39 per share versus my initial estimate of $25.  I knew something was amiss with my original estimate, but I did not see the omission until I received the comment about net cash.

Receiving comments on one’s investment analysis is one of the great benefits of posting research online for other to review and provide comment. I’m amazed at how often I receive insightful comments on my posts. Just look at the great discussion occurring on my original Microsoft Price Watch post. This is also one of the reason why I have shared my Fat Pitch Finder Spreadsheet here. 

Speaking of the Fat Pitch Finder spreadsheet, I need to update it now to better address short-term investments in determining net cash. Expect an update on this spreadsheet here at Fat Pitch Financials within the next few days.

Full Disclosure: I own shares of Microsoft

I originally determined that MSFT had an intrinsic value of at least $30. I provided my calculations along with those shared by some of my readers in a previous post about Microsoft’s value. Today, I decided to run another discounted free cash flow model to determine if I need to update my intrinsic value estimate.

I once again ran a linear regression on the past 10 years of Microsoft’s free cash flows but this time it included 2006 numbers as well as the trailing twelve month free cash flows.  Then I projected out the next ten years of free cash flows. The results are shown in the chart to the right.

I then discounted those future free cash flows using a 10% discount rate. After the tenth year, I assumed a 3% stable growth rate.  That resulted in a present value of the enterprise of $242.3 billion.  To determine the market capitalization, I added in $9 billion in cash.  Then I divided by the diluted average number of shares outstanding and determined an intrinsic value estimate of $25. Uh oh, this is significantly lower than my previous estimate of over $30.  What is going on here?

There are couple of things I noticed.  First, if you look at the graph above, the most recent year’s free cash flows and the trailing 12-month cash flows are below the trend line.  If you were to mentally draw a line, it would likely have been above this one and a bit steeper (i.e., higher growth rate). From the R-squared in the graph, you can see that only 59% of the variation in free cash flow growth is explained by the trend line.  I prefer to see at least an R-squared of 0.75 before I am comfortable with the model’s results.

I checked in with the analyst estimates for MSFT, and they forecast next years earnings to grow by 16.6% and to average 12% over the next five years.  The linear regression I ran only grows at 5% over the next five years.

I also noted that Microsoft’s business is at a major inflection point. The company has just launched several major product upgrades including Vista, Office 2007, and XBox 360. They have also launched an upgraded online presence called live.com and their own portable music and video device, Zune.  Each of these products and service have the potential to deliver significant long-term earnings.

If I substitute a 12% growth rate (a less conservative estimate) instead of using my linear regression estimate of future growth, I calculate an intrinsic value of $36.  I am not as confident in this estimate, but it is useful to create and upper bound on my estimate of Microsoft’s intrinsic value.

Given my uncertainty regarding Microsoft’s intrinsic value, I am going to stick my original estimate of at least $30 per share.  With the market’s rich valuation currently and the potential for a serious correction building, I am going to implement a stop at $30 for Microsoft. If shares drop back down to $30 or lower, especially on bad performance news, I will likely sell my shares of Microsoft. I will be closely watching Microsoft at this point and I will be updating my intrinsic value estimates as new information becomes available.

Full Disclosure: I own shares of Microsoft.

In terms of what the analysts had to say, I found it interesting that the analysts’ value targets ranged from $30 to $33. I reported back in early May that I estimated that the intrinsic value of Microsoft’s stock was about $31.  I took some heat for that estimate but it doesn’t look like I’m too far off from the professional analysts for whatever that’s worth.  Rick Sherlund of Goldman Sachs came in at the lower end with a target of $30 and the UBS analyst, Heather Bellini’s target came in at the high end of the range.

Brendan Barnicle of Pacific Crest Securities noted it looked like work on Office was going better than Windows Vista. I did not realize that another version of Office was already in the works. If it does a good job in facilitating online collaboration, I think a new version of Office could help add to revenue growth.

There is a lot of change underway at this giant wide moat tech company. I think if they can turn this ship in the right direction, there will be a lot of value generated by this stock.

[Full Disclosure: I own shares of Microsoft (MSFT).]

I discussed some of my valuation rationale for the Microsoft purchase decision in the comments section of my previous post. Let me republish it here:

I took a linear regression (i.e., a fancy way of drawing a line on a graph) of the past 10 years of Microsoft’s free cash flow. I then used that regression to project the next 11 years of free cash flow. The regression was able to explain 90 percent of the past trend in the data. I then took the present value of the first 10 years into the future and the discounted perpetual value of the 11th years estimated free cash flow estimated to maintain a sustainable growth of 3%. I selected a 10 percent discount rate for the calculations. I then added in cash to get the intrinsic enterprise value of Microsoft and then I divided by the diluted average number of shares. My final result was $31 dollars per share.

From Magic Formula Investing I found that Microsoft Corp (MSFT), Market Cap of $248,365.25 ($ Millions), pre tax earnings yield of 8% and a pre tax return on capital of greater than 100%. Microsoft was in the top 100 MFI stocks with over $1 billion market cap.

Steven of ValueBlogReview is apparently thinking along a similar line. In his comments regarding “More Microsoft”, Steven wrote:

Even assuming growth of 10-11% (which I would give a50-50 chance) you get to just about a 45% MOS with the stock at $24.50.

Another reader, Max, came to a similar finding in regards to valuation. He wrote:

Microsoft as a huge moat, but not too much growth, so I’m going to put it at 20x EBIT, which for a DCF calculation means I am assuming a 10% RROR and 5% growth in perpetuity.

Enterprise Value = 20 * 14B = $280B
$280B + $34B (cash) = $314B
$314B / 10.33B outstanding = $30.4 / share

I agree that at minimum MSFT is worth what it’s selling for today, as no matter what calculations I do the lowest # I come up with is around today’s price. So, that’s some downside protection, plus MSFT’s current moat on operating systems keeps that cash coming in.

Sam Adams had a different opinion. Sam commented:

What you have here is an investment with all themarket risk and a very limited reward. You might make some money here, you might lose some.

If you want low risk, buy a CD.

If you want to invest , find something with some mojo

Jim Chan from Collecting Wealth thinks I jumped the gun on purchasing Microsoft. He writes:

While I don’t think MSFT is a bad investment opportunity (not a particularly exciting one for me, even at this level), I think you might have jumped in a little early. Purely technical (read, short term) prospect calls for a further decline. At the very least, you probably should’ve waited till the volume has subsided. Back to the “not so exciting” part, before the slide, my calculation (there seems to be quite a few Buffett followers read your blog) showed it was trading at fair value. So the drop represents the discount that (30%) you can Steve and other have discussed. To me, that margin is still too shallow.

Looking in the rear-view mirror, I think Jim Chan makes a valid point. I don’t normally look at the technicals when buying a position in a stock. However, since reading Phil Town’s Rule #1, I’ve been considering using technical analysis in a very limited way to enter and exit positions. Maybe I should review Phil Town’s “tools” and see how they could have helped me in deciding when to buy Microsoft.

Finally, Chris from InvestorGeeks agrees with my valuation but writes:

My sticker is about $31, which gives me a MOS of 30%, however, given that the stock has traded between $24 and $29 for the last 3 years, I’m thinking the market knows something I don’t, which furthur hurts my MOS.
If you have the time to do the research, I think this is too risky for the potential reward.

In response to Chris’ comment, I don’t think that Mr. Market knows something that we don’t know about Microsoft. I just believe Mr. Market is sort sighted and gets easily depressed when major product release dates are missed. I agree with Mr. Market that Microsoft is going to have tough year, but I believe in the long run they are setting themselves up for some major improvements in the long-term.

I’m sure there are other opinions on whether Microsoft is currently a buy. Please feel free to share your thoughts and analysis either back on the original thread or down below.

I took advantage of the opportunity. I put in a limit order earlier this morning for $24.25 a share in one of my accounts and with Marketocracy. I received the following confirmation from Marketocracy:

Your ticket to buy 4120 shares of MSFT at $24.2500, created at 13:27 May 01 completed at 15:45 May 01. 4120 shares were bought at a net average price of $24.2994 including commissions and fees.

I reran my intrinsic value spreadsheet for Microsoft this morning, and I still get at least $30 per share in value. Given that finding, I decided to pull the trigger and add to my Microsoft position. I don’t normally buy a stock a second time, but I just couldn’t pass up buying some more of the widest moat stock at a discount.

A proxy statement details the corporate governance issues that are going to be discussed at a company’s annual meeting. This includes information about when and where an annual meeting is going to be held. It also lists the issues to be voted upon at the annual meeting and details what those issues are. Those issues may include:

• Capital structure
• Management compensation
• Insider ownership
• Election of the board of directors
• Conflicts of interest
• Takeover defenses
• Corporate structure

Given all these issues, proxy statements are often very long and complicated. Until I ran across an article on AAII by John Deysher entitled, “The Proxy Edge: Exercising Your Shareholder Rights “, I did not have a good systematic way to review the proxy statements that I received and those of companies I was interested in investing. I now use the shareholder scorecard at the end of that article as a framework to focusing my research efforts when reviewing a proxy. To better explain how I review a proxy, I’m going to walk you through one of my recent reviews.

Microsoft Case Study
If you are a frequent visitor to Fat Pitch Financials, you probably know that I recently purchased shares of Microsoft. As part of my decision to make that purchase, I reviewed the recent Microsoft proxy statement.

Finding the Proxy
The first step I took was to find the most recent proxy statement for Microsoft. I called on my good buddy EDGAR and I clicked on Search for Company Filings and then Companies & Other Filers. On the Companies & Other Filers page I filled in “Microsoft” in the company name box and I clicked the exclude button under “Ownership Forms 3, 4, and 5″. After clicking the Find Companies button, I scanned down the results page for form DEF 14A, which is the definitive proxy. Filings are listed in order by date with the most recent filings listed first. If I want to look at older proxies for previous years, I just continue reading down the list.

Sometime there are also amendments added to the proxy, and they are reported as from DEFA14A. You can see an example of an addition in the Microsoft filings list. It is worth the effort to quickly click on these additional proxy material filings to make sure nothing important is hiding in these additional documents. The recent Microsoft DEFA14A is just an email sent to Microsoft employees encouraging them to vote in the their proxy.

To view a form, click on the “[html]” link next to the form you are interested in viewing. When I clicked on the DEF 14A “[html]” link I get a long list of links. The important link is “1 DEF 14A ddef14a.htm“. The other links are just supporting graphics.

Annual Meeting Information
Information about Microsoft’s annual meeting is listed just below the regulatory filing information. It states:

The Annual Meeting of Shareholders of Microsoft Corporation will be held at the
MEYDENBAUER CENTER
11100 NE 6th Street
Bellevue, Washington
on November 9, 2005, at 8:00 A.M.

Voting instructions follow this information. I also noticed that Microsoft is providing live coverage of the annual meeting on their site and a transcript along with video and audio of the entire annual meeting. That type accessibility is very shareholder friendly and a plus in my book worth 2 points.

Capital Structure
Microsoft has one class of stock that has gives owners 1 vote for 1 share, so I give Microsoft a score of 10 points. The questions to ask about Microsoft’s capital structure include:

• Is there a non-transferable super-voting common class of stock? No.
• Is there a widely held class of stock that gets 0 votes? No.
• Are there any additional classes of shares owned by insiders only? No.
• Is there non-cumulative voting of directors? No. I believe you can cast your all your votes for one or two directors, but it’s not clear to me.

Management Salary Compensation
Salary information is listed in the “Summary Compensation Table” on page 5 of the proxy. Given the massive profits of Microsoft, I am impressed that none of the salaries of top management exceeds $1 million. Bill Gates and Steve Ballmer both earned $600,000 in base salary for 2005. Microsoft definitely deserves a score of 10 points in this category. The questions to ask about Microsoft’s managment salary compensation include:

• Is there minimal disclosure in the proxy statement of how salaries are determined? No. On page 7 the “Compensation Philosophy and Practice” and “Components of Executive Compensation” discuss the basis of how salaries are determined.
• Are salaries higher than for executives running similar-sized companies in similar industries? No. A good source for quick executive salary information can be found at the AFL-CIO’s Executive Paywatch. It is pretty common to find technology executives making more than $1 million in base salary in much small and less profitable companies.
• Are past increases in salary not in line with company performance? No. Salaries appear to have only increased moderately over the past three years.

Compensation: Bonuses & Cash Incentives
Ideally, a company would base its incentives on the companies return on assets or return on capital. If Microsoft had such an incentive system, I would give them a score of 10 in this category. However, Microsoft’s compensation incentives have some flaws. The questions to ask about Microsoft’s compensation incentives include:

• Are vesting periods short (less than three years)? No. The stock award and options seem to vest over five years according to the footnotes in the “SUMMARY COMPENSATION TABLE ” on page 5 and 6. In 2005, no stock options were granted to any of the executive officers. I believe Microsoft is phasing out the use of stock options.
• Are incentives based on non-return measures like earnings per share, sales levels or stock price? Yes. According to page 7 of the proxy, “The performance-based commitments used to determine bonuses will vary for each executive based on his/her responsibilities and may include financial or strategic measures, including but not limited to: revenue, contribution margin, innovation, product development and implementation, quality, customer satisfaction, or developer community satisfaction.” I’m subtracting 2 points for this vague set of measures that includes sales.
• Does the proxy lack a disclosure of how bonuses are determined? No. Page 7 and 8 give some information on how bonuses are determined. I would like to have seen more detail on exactly what metrics are used, however.
• Are there any Golden Parachute agreements? No. I did not spot any in this proxy.

Microsoft gets a total of 8 points for compensation incentives.

Compensation: Stock Options/Restricted Stock
If a company does not have a stock option or restricted stock incentive plans, I give them 10 points for this category. However, Microsoft does have a restricted stock incentive plan, so I ask the following questions:

• Are the restricted stock issued in modest quantities? Yes. However, given Microsoft’s shift from stock options to restricted stock it is a bit difficult to analyze this. Plus 2 points.
• Does the company treat option exercise as a compensation expense? Yes. Microsoft has started expensing all stock-based compensation. (I didn’t spot this in the proxy, but I found it doing a quick Internet search.) Plus two points.
• Is the option/restricted stock strike price at or above the stock’s price at the time of grant? Yes. The value is based on the closing price on the date of grant according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
• Is the vesting period greater than three years? Yes. The vesting period is over five years according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
• Are the restricted shares “funded” with shares repurchased on the open market? Not clear. I do not believe Microsoft’s proxy addresses this issue.

Given the above, I give Microsoft 8 points in this category.

Insider Ownership of Shares Outstanding
According to the table titled, “INFORMATION REGARDING BENEFICIAL OWNERSHIP OF PRINCIPAL SHAREHOLDERS, DIRECTORS, AND MANAGEMENT” on page 5, executive officers and directors own 13.79% of the outstanding shares of Microsoft. That gives Microsoft a score of 4 point out of 10 in this category. To earn ten points, insiders need to own more than 40% of outstanding shares.

Board Composition & Board Committees
I ask the following five questions regarding the Board:

• Are at least 2/3 of the board outside directors? Yes. Only Gates, Ballmer and Jon Shirley are obvious insiders. Plus 2 points.
• Is each outsider truly an outsider? Yes. According to what I read in the proxy I believe so. If I was concerned about the number of insiders, I would research each Board member more thoroughly. Plus 2 points.
• Is the Chairman of the board an outside director with no ties to management? No. Bill Gates is the Chairman.
• Are any insiders on the audit, compensation, governance, or nominating committees? No. I checked the table on page 2 of the proxy to answer this question. Plus 2 points.
• Are votes/seats held by insiders commensurate with shareholdings? No. Insiders hold three seats or 30% of the seats. Insiders only own a bit more than 13% of shares.

Microsoft gets a total score of 6 points for this category.

Conflicts of Interest & Related-Party Transactions
Page 9 of Microsoft’s proxy lists any potential conflicts of interest and related-party transactions in the section titled, “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS “. I asked the following questions regarding conflicts of interest:

• Does the company occupy a building leased from management or an affiliate? No.
• Does the company engage in business with another company owned or controlled by management? Yes. Microsoft does business with Corbis Corporation, which is solely owned by Bill Gates.
• Did the company buy real estate or businesses from management or affiliates? No.
• Did the company make loans to management on generous terms? No.
• Does management receive excessive perks? No.

I give Microsoft a score of 8 in this category.

Takeover Defenses
I do not belive Microsoft has engaged in any takeover defenses, so I give them a full score of 10. Some takeover defenses include, staggered board of directors, poison pills, restrictions to call special meetings, ability to issue unlimited preferred stock, and super-majority voting requirements.

Governance Statement
Microsoft details much of their corporate governance in their proxy and they also provide a link to a more comprehensive governance guidelines. I give Microsoft a full score of 10 in this category.

Re-Incorporation Strategies
Microsoft has no re-incorporation strategies, so I give it a full 10 points for this issue.

Conclusions

Microsoft appears to have fairly good corporate governance, which is shareholder friendly now. If I did the math right, Microsoft gets an 86 in my review.

There are a lot of details buried in these filings. If you would like to get a sampling of what can be unearthed, I recommend visiting Footnoted.org. Michelle Leder is a pro at reviewing these documents and she reports on her interesting findings daily on her site.

Like everything, it takes a bit of practice to review proxy statements efficiently and thoroughly. Start by going through all the current proxies of the companies you own. Hopefully, you won’t find anything too shocking and new to you in your search. If you do, it might save you some heartburn in the future. After you go through a few of these proxies, you will get a lot more efficient at it and you will be prepared to start reviewing proxies of companies that you are potentially interested in investing in the future.

You can follow the performance of my model portfolio (FPF Value) by visiting Marketocracy. You can review my past purchases in this long term model portfolio by visiting my FPF Value archives.