I just finished reading Buffettology, written by Warren Buffett’s daughter-in law Mary Buffett and family friend David Clark, and it’s inspired me to begin a series of articles in which I’ll take a look at a number of large cap stocks using the valuation methods outlined in the book.
My main takeaway after reading Buffettology, one that will perhaps forever change the way I value stocks, is that it’s ultimately the return on retained earnings that matters most when choosing a stock that will compound wealth for years to come. Return on equity is the key metric here.
I realize that Microsoft (NASDAQ:MSFT) is an unlikely place to start, given that Buffett doesn’t own tech, instead preferring large consumer monopolies, but I’m finding that after applying this valuation method to a number of stocks, large cap tech is offering some fantastic buying opportunities right now.
Microsoft vs. Uncle Sam
We’ll be assessing the valuation from three different angles. The first is only a comparative value look and doesn’t result in a firm price target. It pits the current earnings yield against the long-term treasury bond. Microsoft’s trailing 12-month earnings per share is $2.51. Dividing EPS by the current market price of $24.69 equates to an earnings yield of 10.1%, which stomps all over a 30-year bond yield of 4.3%. In addition, while a bond yield is static, the 10.1% yield offered by Microsoft grows along with earnings. Based on analysts’ five-year projections, the yield could grow 11.4% annually. Microsoft 1, Uncle Sam 0.
Good Ol’ Fashioned Earnings Growth
Another way to look at valuation, and the one most likely employed by a majority of investors, simply takes the current EPS of $2.51 and multiplies it by analysts’ five-year growth projection of 11.4%, which equals earnings per share in the fifth year of $4.31. Multiply this by the current P/E of 10 to get a price target of $43.10. Add in a 0.58 dividend growing an average of 11% a year and the total cash return equals 46.71 (43.10+3.61) for a CAGR of 13.6%. Not too shabby, considering this is the low end of our price target range. It also assumes a P/E of 10, which is an historically low multiple for Microsoft and greatly undervalues the earnings power, in my opinion.
The Incredible Expanding Coupon
The final and most eye-opening way Buffett values a stock is by viewing it as an equity/bond with an expanding coupon. Looking at Microsoft in this fashion, the initial investment of $24.69 a share would be seen as a bond yielding 10.1% (just like the first example above), but rather than grow at the EPS growth rate, the “coupon” would increase at the rate management is growing the per share equity base. This is where return on equity comes in. Get ready for some math.
Microsoft’s shareholders equity value, or book value, is $6.17 per share. Dividing by the EPS of $2.51 equates to a return on equity of 41%. Since Microsoft pays a dividend, all earnings are not retained for reinvestment and we must account for that. A payout ratio of 23% means that 77% of earnings are retained. An ROE of 0.41 x 0.77 = 0.33 (31%) and this is the rate at which we can expect the per share equity to grow.
It follows that five years later we can expect a book value of $23.80 (0.33 x $6.17). Multiply 23.80 by the ROE of 0.41, and you get projected earnings per share of $9.76. Multiple $9.76 by the current P/E of 10 and you obtain a five-year price target of $97.60. Add dividends of 3.61 for a total of 101.21. This would mean a CAGR of 37.4% and represents Microsoft’s true potential for building shareholder wealth.
My five-year price target for Microsoft is 46.71-101.21, representing a CAGR of 13.6% and 37.5% respectively. You might be saying, how can you miss? But that’s beside the point. This exercise is meant to show how retained earnings reinvested in profitable ways can substantially increase the value of a company over long periods of time. If you go in accepting 13.6% as a reasonable rate of return, you might be shocked by how much more Microsoft has to offer.Disclosure: I am long MSFT.