"Can you apply the residual income model to Microsoft, forecasting book value and ROE over 5 years, calculating residual income, and deriving the justified price-to-book ratio, then compare it with the actual P/B ratio to assess valuation?"

Proxima Alpha

Can you apply the residual income model to Microsoft, forecasting book value and ROE over 5 years, calculating residual income, and deriving the justified price-to-book ratio, then compare it with the actual P/B ratio to assess valuation?

17-Sep-2025 08:45:58

The residual income model has been applied to Microsoft (ticker MSFT) using the latest financial data. Here's a summary and explanation of the results:

Step 1: Data and Assumptions

Current book value per share (BVPS): $46.2
Current return on equity (ROE): 32.44%
Cost of equity assumed: 8%
Shares outstanding: 7.43 billion
Growth rate for book value and ROE forecasted at 5% annually over 5 years

Step 2: Forecast and Calculation

Book value per share and ROE were projected to grow at 5% annually for 5 years.
Residual income was calculated each year as (ROE - cost of equity) × book value.
The present value of these residual incomes was computed using the cost of equity as the discount rate.
From these, the justified price-to-book (P/B) ratio was derived as 1 plus the present value of residual income divided by the current book value.

Results:

Justified P/B ratio	2.215
Current Market P/B ratio	11.018
Valuation Difference (Justified - Market)	-8.803

Interpretation:

The intrinsic justified P/B ratio of approximately 2.215 suggests the fair value of Microsoft stock relative to its book value based on forecasted residual income.
The current market P/B ratio is much higher at around 11.018, indicating the market is pricing in significantly higher growth, intangible assets, or expectations beyond what the residual income model projects.
The large difference (-8.803) signals a potential overvaluation by the market compared to the residual income intrinsic valuation.

Visual Summary:

The bar charts above display the present value of residual income over the five-year forecast and the comparison between the justified and market P/B ratios, clearly illustrating the valuation gap.

Recommendations and Next Steps:

Conduct sensitivity analysis on assumptions such as growth rate and cost of equity to understand their impact on the justified P/B ratio.
Investigate market factors or qualitative elements driving the high market P/B, such as intangibles, brand value, or future prospects not captured fully by the residual income model.
Complement this analysis with other valuation models like discounted cash flow or comparables for a more comprehensive picture.

All the data used here was retrieved from Microsoft’s latest financial statements and market data as of mid-2025. The residual income model applies standard valuation theory to forecast and discount residual earnings relative to the book value.

If you want, I can provide more detailed breakdowns or adjust assumptions and rerun the calculations.