Evaluation of Corporate Performance - Microsoft Corporation - Research Paper Example

? Evaluation of Corporate Performance (Microsoft Corp) Introduction Microsoft Corporation (Microsoft) is in the business of developing, licensing, marketing and supporting software and hardware devices worldwide. The company began its operations a way back in 1975 as a small vendor to IBM. Since then the company has grown enormously. The company’s Windows operating system has revolutionized the ways people use the computers today. The company has several divisions that serve diverse needs of the market. Its Windows division offers, besides Windows Operating system, Windows Services suite of application and Web services and PC accessories. Its Server and Tools division offers server software, training to developers, cloud-based services. Its Business division offers Microsoft Office and related products. The company markets its products and services across most part of the world. Income Statements (all figures in millions) Year ended June 30, 2011 2012 2013 2014 (projected) Revenue $ 69,943 73,723 77,849 85,634 Cost of Revenue $ 15,577 17,530 20,249 22,274 Gross Profit $ 54,366 56,193 57,600 63,360 Total operating expense $ 27,205 34,430 30,836 33,920 Income before income tax $ 28,071 22,267 27,052 29,940 Provision for income tax $ 4,921 5,289 5,189 5,689 Net income $ 23,150 16,978 21,863 24,251 Figures for the year ended 2014 has been arrived at by projecting 10% growth on revenues and cost of revenues. Income tax provision has been made in the same percentage as made in the current year to arrive at the net income after tax. Ratio Analysis Liquidity Ratios Liquidity of the company can be denoted by several kinds such as current ratio, quick ratio, cash ratio, and cash conversion cycle. a. Current Ratio is given as Current Assets/Current Liabilities For the year ended 2013, Microsoft’s current Ratio = 101,466/37,417 = 2.71 b. Quick Ratio This is also known as the acid-test ratio. This takes into account the most liquid current assets to cover current liabilities. Inventory and less liquid current assets that cannot be converted to cash quickly are eliminated while calculating this ratio. This informs more liquid status of the company. Quick Ratio = (Cash & Equivalents + Accounts Receivable + Short-term Investments)/ Current Liabilities = (3804 + 17,486+73,218)/37,417 = 2.52 Financial Leverage c. The debt-equity ratio is one of the popular financial leverage ratios that provides information regarding the company's leverage state. This is given as = total liability/shareholder's equity = 63,487/78,944 = 0.8 This indicates that for every single dollar of share holder’s equity, there is 0.8 dollar of debt. d. Debt Ratio Debt ratio is defined as total liabilities/total assets For Microsoft, it is calculated as 63,487/142,431= 0.45 In other words, 45% of the assets of Microsoft have been created from debt funds. Asset Management The return on assets employed in the company will provide information about how assets are used to generate return for shareholders. e. Return on Total Assets It is defined as Net Profit/ total assets employed = 21,863/142,431 =15.34% However, to understand how efficiently current assets are managed in enhancing shareholder’s wealth, it would be appropriate to find return on current assets. f. Return on Current Assets It can be given as net profit/current assets = 21,863/101,466 = 21.55% Profitability There are several measures of profitability and in this paper we calculate net profit margin and profitability against shareholder’s equity. g. Net Profit Margin is given as: Net profit/ revenue = 21,863/77,849 = 28% h. Profitability on shareholders’ fund It can be given as net profit/ total equity = 21,863/78,944 = 27.7% Market Value The market value of the firm can be given by its market capitalization. i. Market Capitalization of Microsoft = No. of shares ? price/share = 8,328 ? 35.52 = $295.8 Billions j. Market Multiples (P/E) It will be interesting to understand P/E ratio in details. It is important to note that the closing price of any stock keeps fluctuating on daily basis. Trailing P/E of Microsoft as on October 30, 2013 is around 13. That means the stock price of Microsoft is 13 times the annual earnings of the company. Its importance lies in forecasting the future value of the stock based on the potential P/E and earnings per share and thereby the share price and market value of the company. DuPont Model and Return on Equity Return on equity provides a more realistic measure of firm's profitability and possibility of future growth. The crux of the thing is that two firms can have matching return on equity yet one has more chances to grow with less debt while other one has lesser possibility to grow due to higher existing debt (Kennon,2013). DuPont Model has three components to calculate return on equity and that will describe the sources of a company's return on equity: Return on equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier) Net Profit margin = Net Income/Revenue Asset Turnover = Revenue/Assets Equity multiplier = Assets/Shareholder's equity For Microsoft, Net Profit Margin = 21,863/77,849 = 28% Asset Turnover = 77, 849/142,431= 0.55 Equity Multiplier = 142,431/78,944 =1.80 Thus, return on equity = 28? 0.55?1.8 = 27.72% Microsoft’s profit margin is satisfactory but significantly high asset employment brings down return on equity considerably. If equity multiplier effect is not taken into account return gets reduced to 15.4%. Economic Value added Economic value added (EVA) provides the true economic profit generated by a company. It is a measure of economic success in a given period of time. It can be used to compare with other companies in the same industry. It differs from the market value of the company. WACC is a key while selecting stocks for investment because it is the minimum rate of return that the firm needs to earn for its survival. The difference between actual return and the WACC will be denoted as the value creation for its investors. In other words, it is an economic value addition to the shareholders kitty. Understanding WACC Capital structure of the company is made up of two components: Equity and debt. Lenders provide fund in the expectation of a certain fixed assured return on the funds provided. Similarly, equity investors too expect certain minimum return for taking certain risk in the project. In short, WACC informs about the opportunity cost of the fund. Lenders expectation will depend upon the avenues available for safe returns such as government securities. As returns from safe avenues increase, the cost of debt too increases because then debtors will expect higher returns than available to them without any risk at all. Similarly, the cost of equity depends upon the risks involved in the project. The higher the risk in the project, the higher the cost of equity will be. WACC is a key while selecting stocks for investment because it is the minimum rate of return that the firm needs to earn for its survival. The difference between actual return on the total assets employed and the WACC will be denoted as the value creation for its investors. Return on Total Assets = Earnings after tax / total assets employed = 21, 863/142,431 =15.34% Microsoft has employed total funds that represents as per the following. Shareholders’’ equity $78,944 Total liability (debt) $63,487 For the sake of simplicity, the WACC for Microsoft is taken as 10% and based on this, EVA can be calculated as (15.34% -10%) = 5.34% This means that Microsoft provides economic value addition to the tune of 5.34% to its shareholders. Findings Microsoft's current and quick ratio (2.71 and 2.52 respectively) does not pose any risk to its lenders. That means short-term debtors will not have any difficulty in receiving their dues, with interest if any, at the time of maturity. Similarly, debt-equity ratio (0.8) and debt ratio (0.45) is well within acceptable limits of the norms. Return on total assets is certainly not very encouraging when compared with Apple and SAP. So far net profit margin (28%) is considered, it goes above average when compared with many other companies in the industry. Similarly, profitability when seen in the context of shareholders' fund, it is certainly above average. If only fundamentals of the Microsoft are taken into consideration, the company seems to be an investor candidate for the coming years; however, unfortunate part is that market or stock prices do not move only on fundamentals. Critical Evaluation and Recommendations Investing in the stock of any company is a tricky issue and must be dealt with caution. Fundamentals of the company and comparative numbers do inform us whether the company is in growth path or not. It is certainly needed to delve into the fundamentals of the company but at the same time, macroeconomic parameters cannot be ignored as they influence valuation of each company to a lesser or higher degree. When general economic conditions are going downhill, GDP growth rate is stagnating, and unemployment rate is rising, then in all likelihood P/E multiples for most of the companies will also go down even though earnings remain unchanged. The point is that P/E multiple fluctuates throughout the year as future perception about the economy in general and about the company in specific keeps on changing. Future perceptions are discounted quickly to reflect in the current prices. That is why, often, the current fundaments fail to reflect fully in the current market price of the stock. On the contrary, many a times, decision taken to invest on the stock based on only fundamentals backfires terribly. The moot question then arises how to take investment decisions. The simple answer that can be given is that fundamentals can help us toward the selection of stocks but not about its timings. Fundamentally, the share may be a good buy at $35 but when it reacts to $30 on technical grounds in a few months’ time then one realizes that now, technically too, the share is a good buy. Buying a fundamentally strong share at high P/E poses a great downward risk but buying them at low P/E multiple poses a least risk and that is where the crux of investment lies for all shares. In a given year, P/E multiples are found to vary between two ranges that often show the difference of 50% or above. For example, in case of Microsoft, earnings per share in 2012 and 2013 were 2.0 and 2.58 respectively (Income Statement-Microsoft, 2013); however, Microsoft's P/E has fluctuated between 10 and 16 in 2012 and in 2013, after touching a high of 18 in the beginning of the year, it has fallen to 13 though Dow Jones index has moved up (Y Charts, 2013). The point is that macroeconomic factors and future perceptions influence the stock valuations significantly. When seen in above perspective, investment in the stock of Microsoft could be safer when it reacts further to reach P/E multiple of 11to 12. In short, the stock is not yet ripe for investment but it is better to wait until its price reaches around $30 per share. References Balance Sheet-Microsoft (2013). Investors Relations. Retrieved October 29, 2013 from https://www.microsoft.com/Investor/EarningsAndFinancials/Financials/fy13/q4/BalanceSheets.aspx Drake, P. P. (2012). Return Ratios and DuPont System. Retrieved October 29, 2013 from http://educ.jmu.edu/~drakepp/principles/module2/fin_analysis.pdf Haden, J. (2012). Should you track Economic value added? Retrieved October 29, 2013 from http://www.inc.com/jeff-haden/what-is-economic-value-added.html Income Statement-Microsoft (2013). Investors Relations. Retrieved October 29, 2013 from https://www.microsoft.com/Investor/EarningsAndFinancials/Financials/fy13/q4/Inco meStatements.aspx Kennon, J. (2013). Return on Equity- The DuPont Model. Retrieved October 30, 2013 from http://beginnersinvest.about.com/ Loth, R. (2013). Financial Ratios. Investopedia. Retrieved October 29, 2013 from http://www.investopedia.com/university/ratios/ Microsoft (2013). Company Profile. Retrieved October 29, 2013 from http://in.finance.yahoo.com/q/ks?s=MSFT Y Charts (2013). Microsoft PE Ratio. Retrieved October 31, 2013 from http://ycharts.com/companies/MSFT/pe_ratio Read More