• Olympus Insights

Overview of the World's Largest Software Company

Introduction


In 2019, Microsoft’s operating earnings grew 22.5% from $35 billion in 2018 to $42 billion in 2019 and went on to obtain a market cap of over $1 trillion, one of only four companies to do so. Through continuous innovation and investment in new technology Microsoft has expanded its areas of operation to a number of different segments, each realizing massive revenue streams and further enhancing Microsoft’s competitive advantage.


Segment Overview


Microsoft’s largest segment, More Personal Computing, derives its revenue from computer manufacturers such as Dell and HP who use Microsoft's Windows operating system on the computers they sell and pay Microsoft a licensing fee in exchange for doing so. In addition, the More Personal Computing segment earns revenue from the sale of Microsoft Surface products as well as gaming revenue coming from Microsoft’s Xbox division.


Their second largest segment is their Productivity and Business Processes operations, which with an operating margin of 39% represents Microsoft’s most profitable segment. Revenues come mostly from Office 365 subscriptions that both consumer and commercial customers are becoming more reliant on for their day to day workflow. Bringing additional revenue into this segment is the advertising and subscription revenue from LinkedIn, which Microsoft purchased in 2016 for over $26 billion; one of the many important acquisitions the company has completed over the past few years.


The last segment, and smallest, is their Intelligent Cloud business, which continues to be an increasingly important segment for Microsoft. As more and more companies move their operations to the cloud, they need both technological infrastructure as well as IT assistance and a large portion of these corporations turn to Microsoft for help.


However, in each of their primary segments Microsoft has an immense level of competition with some of the largest and most innovative companies in the world, including Apple, Amazon, IBM, Google, and Oracle all competing for similar market share. Due to this increased level of competition, Microsoft has continuously poured vast sums of money into their Research and Development department as well as their Sales and Marketing division to further enhance their competitive position and maintain the profit margins they achieved in the past.


Financial Overview


With revenue of $125 billion and a net income of $39 billion Microsoft ended 2019 with a net profit margin of 31%. Naturally, Microsoft’s largest expense was their cost of sales which makes up 34% of their total revenue, with Research & Development and Sales & Marketing taking up 13% and 14% of revenue respectively. Their high margins brought in by each one of their operating segments, as well as a long-term debt to equity ratio of 65%, allowed them to achieve a return on stockholders equity of 38% in 2019, something few companies are able to do consistently.


Valuation


The key variables determining Microsoft’s valuation are as follows:


  1. Licensing of Microsoft Windows to computer OEMs

  2. Unit volume of Microsoft's Surface products

  3. Unit volume of gaming consoles and add-ons

  4. Subscriptions to the Office 365 platform

  5. Advertising and subscription revenue from LinkedIn

  6. Subscriptions to cloud offerings


In determining a valuation for Microsoft, a high level of confidence is needed in predicting what the sales volume of each one of these variables is likely to be over the coming years. Were Microsoft capable of maintaining adequate growth with each of these product and service offerings, and with interest rates at their present levels, an investor, so long as they felt they had a firm understanding of the market demand for Microsoft's products, should feel no reservation of valuing Microsoft at just over $1 trillion.


This valuation however, is based on assumptions of Microsoft’s growth, market share, competitive position, and a number of other important factors deemed essential by Olympus Wealth Management, and further explained in Guide to Olympus Insights.


To learn more about Microsoft, both their Annual Report and Form 10-K offer much more detailed information that any investor should know before making an investment decision. To read more about Microsoft's competitors see:

Please note: Olympus Wealth Management is a Tulsa based investment fund which may or may not own holdings in Microsoft and readers should not take the above article as a recommendation to buy or sell Microsoft stock but instead as an informative article meant to increase one’s knowledge of the company.


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