Running head: VALUE ANALYSIS USING EVA

Value Analysis Using EVA

Project Review

Sherin Raju

Health Care Financial Management - AH531

Dr. Keith LaPrade

August 07, 2018

VALUE ANALYSIS USING EVA

Executive Summary

This paper gives a report on an analysis and evaluation of Microsoft Corporation using

Economic Value Added (EVA), which is the primary tool of analysis used in this paper. It is

believed that a true and fair value of a company is determined by its ability to generate cash

returns that exceed the cost of capital (Rakshit, 2012). The objective of this project is to identify

a company that might be worth much more if it were broken into pieces and then valued

separately using Economic Value Added (EVA). In this paper, Microsoft Corporation has been

selected based on its strategic advantage and financial analysis as well. An Economic Value

Added (EVA) analysis of the combined company as well as its individual elements or parts (that

would be valued much higher if they were separate) has been given in this paper. In addition to

this, the paper explains the strategic advantages that could possibly be attained from a break up

that is not rationalized by Economic Value Added (EVA) analysis only.

However, there are other methods of analysis used including financial statement analysis,

ratio analysis and trend analysis over the past years of operation of the company. All calculations

and workings are clearly shown. According to the results of the Economic Value Added (EVA)

analysis, the company (Microsoft Corporation) has three main segments which can be valued

separately. These are the Intelligent Cloud segment, Productivity and Businesses Processes as

well as More Personal Computing segment (Emery, Finnerty & Stowe, 2007). Each of these

segments has been further discussed in the below sections of this paper. However, this analysis

has some limitations. The Economic Value Added (EVA) analysis is suitable for those

manufacturing companies that are asset-intensive and may not be appropriate for technology-

based organizations (Arnold, 2013).

VALUE ANALYSIS USING EVA

Introduction

Microsoft Corporation has its head offices in Redmond, Washington. It is the leading

American multinational company that develops personal computer software systems as well as

applications. It also takes part in publishing books. It produces its own tablet computers, offers

emailing services and designs electronic game systems. It also manufactures computer

peripherals including input and output devices. It has outlets and supply stores in various places

all over the world (Microsoft, 2001).

It was founded by Bill Gates and Paul G. Allen, who were two friends since their

childhood. They started by converting BASIC, a popular language in computer programing, into

a better mode that was suitable for use in the early personal computers commonly known as the

Altair (Emery, Finnerty & Stowe, 2007). Later on, the two founded Microsoft Corporation,

whose name was derived from the words “microcomputer” and “software”. They afterward

defined BASIC and created various other programming languages (Microsoft Corporation,

2009).

The International Business Machines (IBM) Corporation requested Microsoft

Corporation to design an operating system for its first personal computer in the year 1980.

Instead, Microsoft bought an operating system from another company and modified it to the

Microsoft Disk Operating System (MS-DOS). After releasing this software, most companies that

manufactured personal computers were able to license MS-DOS as their operating system. This

generated a lot of revenue to Microsoft Corporation (Pohlman & Gardiner, 2000).

In the 1990s, Microsoft Corporation became the most powerful and popular company in

the history of America. It had become a publicly owned corporation in the year 1986. It was
VALUE ANALYSIS USING EVA

consistently making profits of twenty-five percent on each sales dollar. This was really an

amazing record. During its 1956 financial year, the company its net income was topped by two

billion dollars for the first time, and its profits continued to grow during the great economic

recession (Arnold, 2013).

Analysis of Microsoft’s Shares and Stocks

Microsoft’s explosive and rapid growth in its cloud has attracted most investors to

venture in its stocks. It competes mainly with Amazon, which is categorized as retail and does

not appear in the technology stock screen. However, Microsoft has the most popular among

investment firms, having been positioned in the second place while Amazon is in the fifth.

Microsoft expects to expand and grow its cloud market by forty percent annually. It has tripled

its market share to that of Amazon, has grown to three percent, unlike Amazon which has only

one percent (Microsoft Corporation, 2009).

The performance of Microsoft Corporation in Azure has boosted its annual revenue by

twelve percent yearly to twenty-four billion dollars. Its net income increased by sixteen percent

to six billion dollars. It has used four billion dollars in repurchasing shares and dividends, thus

increasing its dividends by eight percent to forty-two cents a share. The largest investor guru is

the founder of the company, Bill Gates, with outstanding shares of 0.73%. He is followed by

Dodge and Cox, with 0.52% of Microsoft’s shareholdings, and then followed by the management

of First Eagle Investment with 0.34% shares (Trotta, 2003).

The intelligent cloud segment has realized an income of approximately seven billion

dollars, which was reported as a percentage increase of fifteen. The more personal computing

segment earned a revenue of twelve billion dollars, up two percent. This gave a total revenue of
VALUE ANALYSIS USING EVA

twenty-nine billion dollars, which was a twelve percent annual increase. This raised the gross

margin of the company to sixty-two percent, and its net operating revenue hit eight billion dollars

has increased by ten percent (Atkinson, 2016).

Individual Segments or Elements in Microsoft Corporation

Microsoft Corporation was founded as a technology-based company that develops

supports and licenses a variety of devices, software, and products. The company has three main

segments or elements including More Personal Computing, Productivity and Business Processes

and Intelligent Cloud. Its main products are operating systems, server applications, server

management tools and cross-device productivity applications among others (Microsoft, 2001).

The main devices that it manufactures include the gaming and entertainments tools,

personal computers, phones, and tablets. In addition, it offers a wide range of services which

include cloud-based solutions, consulting services and online advertising that reaches a global

audience. Each of the above product, service or device falls in one of the segments which are

further explained below (Microsoft Corporation, 2009).

a. Intelligent Cloud

The intelligent cloud segment of this company mainly consists of its private and public

services as well as hybrid server products including cloud services. It’s primarily comprised of

cloud services and server devices (Emery, Finnerty & Stowe, 2007). These comprise the servers

in the window, SQL, system center, Azure, related Client Access Licenses (CALs), enterprise

services as well as the visual studio. The enterprise services include Microsoft consulting and

premier support services. The server products are meant to increase the efficiency of the
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information technology professionals and enhance the productivity of their systems (Microsoft,

2001).

The server software integrates infrastructure and middleware and is designed for

supporting the applications of the operating system in the windows servers. The intelligent cloud

is also involved in licensing the standalone and tools for software development lifecycle, which

are used by project managers and developers. Azure is an advanced cloud computing platform

that has networking, database, and storage services. It helps customers and organizations devote

resources to developing and using applications, instead of managing the on-premises hardware or

software (Microsoft Corporation, 2009).

b. Productivity and Businesses Processes

This is a segment consisting mainly of services and products in the range of the

company’s performance, information services, and platforms. Its main elements are the Office

commercial, which includes subscriptions and volume licensing for products and services such

as SharePoint, Skype, exchange and related Client Access Licenses (CALs). Office commercial

helps manage organizational, personal or team productivity via a variety of products and

services. Skype is a service that is designed for connecting families, friends and people through

devices (Microsoft, 2001).

c. More Personal Computing

This segment of Microsoft Corporation comprises products and services that are aimed at

meeting the interests of various end users and developers. It mainly includes windows, mainly

covering the windows OEM licensing (Emery, Finnerty & Stowe, 2007). Various devices such as

Microsoft surface, personal computer accessories, gaming devices and phones are part of more
VALUE ANALYSIS USING EVA

personal Computing. These devices enable people to connect with other people and acquire

content via windows and integrated services of Microsoft. Surface helps consumers, students,

and organizations to enhance their productivity (Microsoft Corporation, 2009).

Economic Value Added (EVA) Analysis of Microsoft Corporation

According to Rakshit (2012), Economic Value Added (EVA) is an analysis method that

compares the net operating profit of an investment to its total capital cost or charge. It measures

the financial performance of a company based on remaining returns after deducting the cost of

capital from operating profits after making adjustments for income taxes on the basis of cash.

Also termed as the economic profit, this method of analysis reveals the true and fair economic

profit of a company (Trotta, 2003).

It gives the additional difference in the rate of return rate over the capital cost of the

company. It also gives the value that the business generates from funds that have been invested

into it. The analysis helps mainly in measuring the value that is generated by a company from the

funds that are shareholders invest into it. It helps in reviewing and seeing the areas of a business

that can be highly adjusted to improve the general productivity of the organization

(Rakshit, 2012).

The results of the Economic value Addition have different indications of decisions that

should be made (Schaefer, 2002). For instance, if the Economic Value Added (EVA) of a

company is negative, it implies that the company does not generate sufficient value from the

funds invested. This implies that the company is value on the funds invested. A business whose

Economic value Added remains negative should be shut down. However, if it is positive, it
VALUE ANALYSIS USING EVA

shows that the company is making value out of the funds invested in its business (Atkinson,

2016).

Economic Value Added (EVA) helps investors and management to assess the

performance of Microsoft Corporation by considering the wealth and returns created for the

shareholders, therefore raising performance above its cost of capital (Schaefer, 2002). Economic

Value added (EVA) is a key indicator of financial performance, since it shows how well the

company has utilized the assets to generate income. This helps the company management in

making the viable investment and managerial decisions (Rakshit, 2012).

By reflecting on the performance of the company management, Economic Value Added

(EVA) indicates how the projects of the company are (Issham, 2011). This analysis tool asserts

that companies ought to generate returns and profits at a rate higher than the cost of capital. It

has many advantages including giving a summary of how much wealth was generated and from

which sources. Its inclusion of balance sheet items in calculation ensures that managers consider

all assets and expenses in decision making (Atkinson, 2016).

Economic Value Added (EVA) for the Combined Company

Economic Value Added (EVA) is arrived at using the calculation below:

EVA = NOPAT – (Invested Capital * WACC) where NOPAT is the Net Operating Profit

after Tax (Rakshit, 2012).

There are three components for arriving at the EVA, that is, Net Operating Profit after

Tax (NOPAT), the Weighted Average Cost of Capital (WACC) and the capital invested. These

can easily be calculated and can be obtained from the income statement of Microsoft Corporation
VALUE ANALYSIS USING EVA

(Issham, 2011). The invested capital is the amount of cash used in funding a given project. The

WACC multiplied by the amount of invested capital arrives at the finance charge, which is the

amount needed by investors as a group to make their investment worthwhile (Atkinson, 2016).

Invested capital = Total assets – Current Liabilities

Economic Value Added (EVA) aims at quantifying the cost or charge of making a capital

investment into a particular project or company and then assessing if it creates adequate returns

for making it a viable investment (Rakshit, 2012).

NOPAT calculation for Microsoft Corporation (in million Dollars):

The year ending Fiscal year 2017 Fiscal year 2016

Net operating income $21,205 $16,797

Deferred income tax expense (benefit) -3,296 332

(Decrease) increase in allowance for doubtful accounts -21 91

Unearned revenue (Decrease) increase 10,570 8,591

Restructuring liability (Decrease) increase -277 -128

Equity equivalents (Decrease) increase 6,976 8,886

Interest expense 2,222 1,243

Lease obligations (Interest expense) 237 170

Interest expense (Adjusted) 2,459 1,413

VALUE ANALYSIS USING EVA

Interest expense (Tax benefit) -861 -495

After taxes interest expense 1,599 919

Marketable securities loss (Gain) -2,583 -668

Dividends and interest income -1,387 -903

Before taxes, investment income -3,970 -1,571

Investment income from tax expense or income 1,390 550

After taxes, investment income -2,581 -1,021

Operating profit after taxes-Net (NOPAT) 27,198 25,581

Microsoft Corp., invested capital calculation (in million Dollars):

Fiscal year 2017 Fiscal year 2016

Current Debt $9,072 $12,904

Long-term debt (Current portion) $1,049 –

Long-term debt (less current portion) $76,073 $40,783

Present Value of operating lease payments 6,980 5816

Debt & leases 93,174 59,503

Stockholders' equity 72,394 71,997

(Assets) liabilities Net deferred tax -1,883 1,256

VALUE ANALYSIS USING EVA

Provision for doubtful debts 405 426

Unearned income 44,479 33,909

Restructuring liability 432 709

Equity equivalents 43,435 36,301

Accumulated other comprehensive (income) loss -431 -1,537

Adjusted stockholders' equity 115,398 106,761

Investments -131,341 -117,161

Invested capital 77,231 49,103

The Weighted Average Cost of Capital (WACC) = 10.99%. Therefore, the Economic

Added Value (EVA) for the combined company is calculated as:

EVA = $27,198 – ($77,231 * 10.99%)

= $18,710.31

This is a positive figure, implying that the company is making good returns out of the

capital invested in its business (Rakshit, 2012).

Economic Value Added (EVA) for the Segments/Elements Valued Separately

The Net Operating Profit after Tax (NOPAT) from those three major segments was as

follows for the financial years 2017 and 2016 (Pohlman & Gardiner, 2000).

2017 2016
VALUE ANALYSIS USING EVA

Productivity and business processes $11,913 $12,418

Intelligent cloud $9,138 $9,315

More personal computing $8,288 $6,202

Total 22,326 20,182

EVA for Productivity and business processes = 11,913 – (77,231 * 10.99) = $3,425.31

EVA for Intelligent cloud = 9,138 – (77,231 * 10.99) = $650.31

EVA for more personal computing = 8,288 – (77,231 * 10.99) = ($199.69)

The two segments, intelligent cloud, and Productivity and business processes, both

have a positive figure for Economic Value Added Analysis. This is an indication that they have a

good return on the capital invested in the projects. However, the segment for more personal

computing has a negative EVA, meaning that its returns are not as good as the amount of capital

invested. The invested capitals’ return rate is lower than the capital cost (Rakshit, 2012).

In analyzing and evaluating Microsoft Corporation using Economic Value Added

analysis, it has been found that the business requires huge amounts of capital. A significant

proportion of this capital is covered by the cash flows from the more personal computing

segment, thus giving it a low EVA (Issham, 2011). The other two segments of the corporation are

the Intelligent cloud and Productivity and business processes. These need a modest amount of

capital and are able to generate amounts of cash flows, thus giving them a high valuation based

on the analysis of the Economic Value added (Microsoft Corporation, 2009).

VALUE ANALYSIS USING EVA

It is therefore very beneficial to separate the company so that the different segments

can be valued on their own without being combined. Microsoft Corporation is worth more

without the more personal computing segment than when it has it. This would help in analyzing

each segment separately as opposed to aggregately. The management will thus be able to take the

necessary measures to improve the performance of under-performing elements (Rakshit, 2012).

Strategic Advantages of Microsoft Corporation

There are other strategic advantages of breaking up a company into individual

elements (Schaefer, 2002). For instance, reinventing productivity and business processes would

help the company to create new scenarios and opportunities that accelerate digital transformation

for businesses. This would be very important in fostering employee culture and engagement by

redefining how work gets done in organizations. This would help Microsoft Corporation to reach

new potential clients while expanding usage of the company’s services and products by the

existing customers (Choi & Click, 2006).

Building the intelligent cloud computing would help transform most organizations

digitally. When these businesses transform digitally and move to the intelligent cloud, great

opportunities will be created for Microsoft Corporation. The company has made a great emphasis

on its cloud computing segment and it aims at earning twenty billion dollars annually in

commercial clouding (Dess, 2012).

Product development is another strategic advantage used by Microsoft Corporation to

increase its sales by making the necessary improvements to its present products as well as

developing new ones (Issham, 2011). The corporation is missioned to help people and

organizations and therefore designing new products is its main concern. Microsoft Corporation
VALUE ANALYSIS USING EVA

has been continually improving its existing products. For instance, Microsoft Office has existed

since the year 1992 but it has been improved very year, coming up with more useful features.

This is one of the major products of the company that help organizations and people carry out

their work (Choi & Click, 2006).

Seeking growth through mergers and acquisitions is another strategic advantage of

Microsoft Corporation. The company has acquired several technology companies to become

their own (Issham, 2011). These include Yahoo, Nokia Corporation, LinkedIn and Mojang

Synergies. This has played a major role in increasing the company’s capabilities, the range of its

products and value offering. Its acquisition of LinkedIn has particularly played an important role

in connecting the professional network to the professional cloud, thus leading to new experiences

and exciting value for all users (Rakshit, 2012).

Financial Analysis of Microsoft Corporation

According to Issham (2011), Microsoft Corporation is an organization that is

financially stable. It has diversified its technology in computing to provide services to consumer

and enterprise markets. It has achieved high gross margins due to the pricing power of its

products and services. Its gross margin is approximately sixty percent yearly. Gross profit margin

is the net of sales less the cost of sales. The gross profit margin of the company has improved

slightly from the fiscal year 2016 to the financial year 2017 (Microsoft Corporation, 2009).

Microsoft Corporation has a debt/equity ratio of only 0.4, indicating that it is free of

financial risk. This reduces its need for debt financing, which can be a great burden due to the

high cost of capital. The Return on Equity (ROE) and Return on Assets (ROA) of the company
VALUE ANALYSIS USING EVA

has improved from 2016 to 2017, indicating that it’s a good organization to invest in (Microsoft,

2001).

According to Emery, Finnerty & Stowe (2007), the stock of Microsoft Corporation

increased by four percent. This was after the company reported high revenue for its last quarter

in the financial year ended 30th June 2017. However, the stock went back to its rate after the

company announced its financial performance in the following quarter. This was followed by a

slight improvement in the pre-market trading. The company made twenty-five billion dollars

income for the whole fiscal year. LinkedIn is believed to have contributed approximately one

billion dollars to the productivity of Microsoft Corporation (Dess, 2012).

Conclusion

As discussed above, it can be adequately concluded that Microsoft Company is worth

much more if it were broken into individual elements or segments and then valued separately

using Economic Value added (EVA) analysis. According to Schaefer (2002), this gives investors

an opportunity to value the three different business units of the corporation separately. This

would enable them to come up with the best investment decisions based on the insights of

Economic Value Added (EVA) analysis. The segment for more personal computing would not

give Microsoft Corporation the desired Value Added (EVA) analysis (Rakshit, 2012).
VALUE ANALYSIS USING EVA

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