How many of you have heard someone lambast Microsoft (NASDAQ:MSFT) as an investment due to the company's supposedly poor performance over the past decade? Such criticism of Microsoft ignores two very important factors: the absolutely absurd valuation of Microsoft shares ten years ago, and the contribution of dividends to Microsoft's total returns over the past ten years.
If you could turn back the clock to December 2002, you would see that shares of Microsoft traded around $29 (well, technically shares traded around $58 but there was an upcoming 2-for-1 stock split, so we'll use $29 so that our comparison to today's prices will be on an apples-to-apples basis). A cursory look at today's stock price would indicate that the stock trades at $26.50 per share, a seeming per share loss of $2.50. Considering that this is a decade later, this should prove that Microsoft has been an abysmal investment, right? Well, not quite.
The first thing that we need to take into account is Microsoft's absurd valuation way back in December 2002. The company earned $0.94 per share in 2002. Considering that the December 2002 price was $29, that means that investors were paying almost 31x earnings for Microsoft stock. That's nuts. Microsoft was already an established large-cap stock worth hundreds of billions in December 2002, and the kind of growth assumptions that are necessary for a large-cap stock with a 3% earnings yield base are speculative at best and comically unrealistic at worst. There's a reason why Benjamin Graham discouraged investors from paying over 20x earnings for an investment. It is not Microsoft's fault that investors wanted to pay almost $31 for every dollar of earnings that the company generated. It's the company'sjob to grow the business, but it is our job to determine a rational price to pay for a share of it.
Nevertheless, the underlying Microsoft Corporation performed fantastically well over the past decade, despite the unrealistic assumptions that investors priced into the stock in December 2002. Since then, Microsoft has grown earnings from $0.94 to $2.72 in 2012. I'll repeat that. In slightly over ten years, Microsoft has almost tripled earnings per share. Meanwhile, the company has also started paying out a dividend that has grown rapidly. The company initiated an annual $0.08 dividend in 2003 that has grown to $0.92 annually today. This dividend has meant the difference between a negative total return and a positive total return for Microsoft investors since December 2002. If you look at the stock price change alone, it would appear that a $10,000 investment in December 2002 would have shrunk to $9,172 over the past ten years. However, if you include the growing dividends that Microsoft has paid out since 2003, you will see that the business has grown a $10,000 investment into $13,340. That's about a 33.4% total return since 2000, as opposed to a moderate loss.
The reason why some long-term shareholders of Microsoft have not been able to participate in the returns you might expect from a company that triples earnings in a little over a decade is because the P/E ratio for the stock has fallen from 31 to about 10x earnings (Nota Bene: Many search engines may report that Microsoft has $1.85 per share in earnings, as this figure includes the effects of one-time items. I am using the Value Line figure of $2.72 that excludes non-recurring items because I am interested in the earnings power that my ownership represents. I believe this paints a more accurate portrait of the company's earnings going forward without having to make too many predictions. If you disagree about the non-recurring items or want to be extra conservative, you should use the lower figure of $1.85).
Either way you look at it, Microsoft has experienced a P/E compression from 31 to either 10x earnings or 14x earnings, depending on the current figures that you'd like to use. When you look at the past decade, the problem has not been the performance of Microsoft the business, but rather, the unrealistic assumptions of Microsoft investors. If Microsoft didn't grow over the past decade, investors would have lost over half their money due to the fact that investors are now only willing to pay $10-$14 for each dollar of earnings that Microsoft generates. But because Microsoft has managed to almost triple earnings and pay a healthily growing dividend over the period, investors have been able to eke out a positive return that has roughly kept pace with inflation. Because investors were paying way more than the company was worth in 2002, the fact that the company has still managed to give investors a positive return is a testament to the resilient strength of Microsoft's cash cow businesses. That's why you shouldn't disregard Microsoft when you hear people call it "dead money." The company is much more rationally valued at 10-14x earnings than 31x earnings, and the future performance of the stock will reflect a much better starting earnings yield than what investors started at a decade ago.