Microsoft (MSFT) shares have languished in recent times, off of their 52 week high of $32.95 and trading for a price, $28, that was first seen in November of 1998, if you can believe that. It truly has been a "lost" 15 years for Mister Softy despite unquestioned dominance in operating system software and many other arenas where the company competes. Given that shares haven't been able to get out of their own way since before the tech bubble, is that kind of non-performance warranted? We'll use Economic Value Added in order to ascertain whether or not MSFT shares deserve the no-growth multiple they currently sport.
If you are unfamiliar with EVA, the basic premise is that the company's asset base, which is defined as total assets minus current liabilities, gets "taxed" by the company's weighted average cost of capital. After-tax earnings must exceed this "taxed" amount in order to produce positive EVA. If EVA is negative, it means company management isn't producing enough income from the company's asset base to cover its economic cost of financing the assets.
In 1998, the first time MSFT saw $28 per share, the company was making $4.5 billion in annual profit. Now, with shares at the same price 15 years later, the company makes $17 billion. Obviously, there is a disconnect. The obvious reason why is due to the euphoria of the tech bubble, where stocks were bid ever higher regardless of valuation. However, there is more to MSFT's story. Microsoft was still a growth company in 1998 and it has been a long time now since that was the case. As such, MSFT's earnings multiples have collapsed. I submit now that this is completely justified based on the company's economic value added. In addition, I believe more downside is warranted.
The data for these graphs were pulled from Microsoft's 10-Ks. In addition, when computing the company's WACC for each time period, I used 11% as the equity cost of financing. All other numbers were observed or computed using observed data.
First, we see that in the late 90's, Microsoft's EVA was rising rapidly. In 2000, it was near $5 billion. However, that quickly dissipated and we saw three years of zero EVA. We are seeing a similar story now, following several years of steep EVA growth from 2004 to 2011. Last year, MSFT's EVA plummeted by 50%, from $16 billion in 2011 to $8 billion in 2012. The fact that the company's EVA is dwindling would have a major effect on the company's earnings multiple and is no doubt a contributing factor as to why the stock price is trading like its 1998.
Similarly, when we look at EVA as a percentage of total assets, we see a boom and bust cycle appear. The interesting thing about this graph is that we can see EVA start to decline as a percentage of assets before the nominal value does likewise. It occurred in the late 90s and it is occurring now.
The implication is that we should see the nominal value of EVA decline more in 2013 if history holds true for Microsoft. We see here a very steep decline in EVA as a percentage of assets for Microsoft starting in 2008, three years before the significant decline in nominal EVA.
These data do not bode well for Microsoft in the near and medium terms if history is a guide. Given that the company is so huge and has so few growth catalysts, this EVA data is definitely a reason to stay away from shares at current levels.
No company with rapidly declining EVA deserves a high multiple and we are certainly seeing that with Microsoft in recent years. Given the data I've presented, I wouldn't be surprised to see MSFT trade into the low $20s in 2013 and 2014. As a result, I will stay away for now and invest my capital in a company that is growing EVA.