Earnings adjustments

We avoid GAAP earnings in our valuations because accrual accounting allows an entity to record revenues before cash is collected and record expenses that do not involve payments of cash. Accrual income almost never matches the actual cash generated from operations. As investors we're primarily interested in the actual cash that a company generates from operations free of any form of manipulation.

To get there we estimate free cash flows to firm first by making a number major adjustments to earnings;
• We capitalize research and development, accrual accounting requires that R&D be expensed as it occurs, but we recognize and appreciate that results from R&D creates growth. We treat it the same as all other investments by capitalizing it.
  values in Millions

  R&D asset lifetime3 years

  R&D expense$8,164

  R&D amortized$6,630

  R&D asset value$15,106
  The R&D asset value is used to adjust the book value of equity, this in turn is used in the return on equity calculations.
• True one time charges muddle the growth picture of a stock because they tend to have a significant effect on profit but not earnings from operations. Valuations depend on our ability to predict future earnings growth, to get there we remove one time expenses from earnings.
• The marginal tax rate is used to determine the taxes that aught to have been paid. Corporations have a number of ways to defer the taxes they pay, these deferments can have a significant impact on stated earnings. Eventually though they have to be paid causing another significant impact on earnings. In order to avoid these oscillations to earnings we use the marginal tax rate to determine the amount paid for taxes.
• The other major adjustment to earnings that is made is by accounting for off-balance sheet item such as operating leases. Operating leases are treated as Operating expenses where they should be treated as financial expenses that have the same obligations as debt. Our second major adjustment therefore is in converting operating leases to their debt equivalent.
  Operating lease expenses and debt adjustment in (Millions)

  Current year$0

  Year one$0

  Year two$0

  Year three$0

  Year four$0

  Post year four$0

  Total$0

  Debt value$0

  Depreciation$0

  Debt Adjustment

  + Debt$0

  + Value of operating lease debt$0

  = Debt (Adjusted)$0

Cashflow analysis

A good estimate for future growth is derived by multiplying the estimated future reinvestment rate with the estimated future return on capital.

Operating efficiency

The balance sheet provides insight into the company's operations. It contains all it's assets and liabilities. Of particular interest are it's current assets and liabilities, these are the short term assets and liabilities generated from it's operating activities. For a company that produces a product, for example, the current assets and liabilities are the items that the company uses to build the product such as inventory and raw materials, the money owed the company after selling the product to it's customers and the money it owes to creditors such as the raw material wholesalers as well as service providers. The following metrics are estimates that define how efficient a company is at executing the sales cycle.

• Days inventory outstanding This metric measures how many days worth of inventory the company has in it's warehouse. It is measured as following DIO = (Inventory/Cost of sales) * 365.
• Days payable outstandingPayables are the moneys owed to creditors such as the providers of the raw materials or service providers. Days payable outstanding is a measure of how long the company takes to pay its creditors. it is calculated as follows: DPO = (Accounts Payable/ Cost of sales )*365.
• Days sales outstanding Sales are revenues, receivables are uncollected sales made on credit. A company has to collect sales as quickly as possible so it can use that money to create more products. This value is estimated as following: (Receivables / Revenues) * 365 or ( receivables/ Average sales per day).
• Cash conversion cycle. This metric measures how quickly in days a company can produce a product from raw materials, sell it to a customer and collect those sales, it is estimated in the following way: CCC = DIO + DSO - DPO. a good way to measure how effective management is at making money is by looking at the cash conversion cycle over time. Warning flags are an increase of Inventory (can't sell product) and Receivables (can't collect on the goods sold on credit)

Risk

• Current ratio The current ratio is a financial ratio that measures a companies ability to pay it's short term liabilities. When short term liabilities exceed short term assets the current ratio will be less than one and this indicates that a company may have problems meeting it's short-term obligations. It is calculated as follows: Current Ratio = Current Assets / Current Liabilities
• Acid test or quick ratioT he acid test measures a companies ability to pay it's short term obligations quickly using cash and near cash. It is calculated as follows: Acid Test = (Cash + Investments) / Current Liabilities
• Acid test (liberal) The more liberal version of the acid test allows a company to collect receivables and other assets except for inventory. Acid test (liberal) = (Current Assets - Inventory) / Current Liabilities
• Debt to equity ratio The debt to equity ratio shows the proportion of debt and equity used to finance a company's assets. Debt and equity are both adjusted to account for Operating leases and R&D as described above. The debt to equity ratio is calculated by dividing Debt by Equity.
• Interest coverage ratio The interest coverage ratio measures a firms ability to meet it's interest payments, it is calculated as follows: Interest coverage ratio = EBIT (adjusted) / Interest payment
• Fixed charges coverage ratio Fixed charges include interest payments and operating lease expenses for this year it is calculated as follows. EBIT (adjusted) / (interest payment + operating lease expense)

Revenue/Earnings data

Historic values

Earnings in (Millions)	2008	2007	2006	2005
Revenue	$60,420	$51,122	$44,282	$39,788
Expenses	$44,061	$38,634	$33,473	$29,601
Net income	$17,681	$14,065	$12,599	$12,254
Earnings before interest and taxes (EBIT)	$23,814	$20,101	$18,262	$16,628
Adjusted EBIT	$25,348	$20,473	$18,118	$15,977
Free cash flow to firm	$27,123	$10,502	$12,535	$12,204
Free cash flow to equity	$20,990	$11,305	$12,937	$13,193

Operating lease expenses

Historic values

Operating lease expense and debt conversion in (Millions)	2008	2007	2006	2005
Current year		$326	$276	$229
Year one		$349	$250	$230
Year two		$242	$193	$204
Year three		$202	$138	$167
Year four		$174	$105	$122
Post year four		$374	$199	$310
Total		$1,667	$1,161	$1,262
Debt value		$1,132	$755	$867
Depreciation		$226	$151	$173

Past growth rates
24 % 22 % 20 % 18 % 16 % 14 % 12 % 10 % 8 % 6 % 4 % 2 %						EBIT (adjusted) Profit Revenue
	all	4 years	3 years	2 years

Cashflow in (Millions)
$30,000 $25,000 $20,000 $15,000 $10,000 $5,000											Profit EBIT FCFE FCFF
	2000	2001	2002	2003	2004	2005	2006	2007	2008

Microsoft generates revenues by developing, manufacturing, licensing, and supporting a wide range of software products for many computing devices.

The software products include

operating systems for servers, personal computers and intelligent devices

server applications for distributed computing environments

information worker productivity applications

business solution applications

high-performance computing applications

software development tools

In addition to that they provide consulting and product support services, and train and certify computer system integrators and developers.

Microsoft also sells the Xbox 360 video game console and games, the Zune digital music and entertainment device, PC games, and peripherals.

Online offerings and information are delivered through Windows Live, Office Live, and MSN portals and channels. Microsoft also enables the delivery of online advertising through their proprietary adCenter® platform.

Executive Officers

Board of Directors

Investors

Other investors