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What are Microsoft's shares worth, on the assumption that it is operating in a dying industry? The question is suddenly relevant, after IDC reported last week that personal computer shipments in the first quarter suffered a much worse decline than expected of 14 per cent year on year. Analysts opined that rather than boosting the market, Microsoft's latest operating system, Windows 8, actually pushed consumers away.
The simple answer to the question is: less than $29 (U.S.), their current price. To put that figure in context, consider a rough-and-ready discounted cash flow analysis. Microsoft generated $3.24 a share in unlevered free cash flow in 2012. Put the company's cost of capital between 9 and 10 per cent. Its $29 price then implies future cash flows will decline a bit less than 2 per cent a year. An analysis of this sort is inevitably sensitive to the assumed cost of capital. But Microsoft's below-average (but not rock-bottom) forward price-earnings multiple of 10 and high (but not very high) dividend yield of more than 3 per cent also paint a picture of slow but not radical decline ahead.
The problem is that the first-quarter PC shipment number is not a slow-decline kind of number. It is a market-undergoing-a-frightening-sea-change kind of number. And despite Microsoft's success in server software and gaming, the great majority of its operating profits still come directly from personal computers, in the form of Windows and Microsoft Office sales.
No one knows the future trajectory of PC sales, other than to say they will be slower than they have been. But Microsoft's price insists that the first-quarter shipment report is an outlier, or that management can find an alternative source of significant profits in the not-too-distant future. Anyone who is not confident on one of those two fronts has no business owning the stock at its current price.