The history of Microsoft (NASDAQ:MSFT) is what I like to refer to as an "extreme ebb and flow example." Investor returns have been quite impressive over the years, but this hasn't always developed in a nice linear fashion. Here, I'll show you what I mean:
Share price appreciation tends to more or less follow business performance over the long-term, but there can be long spurts where a true disconnect occurs. Leading up to the tech bubble Microsoft the business was growing exceptionally fast, and yet the share price grew at an even quicker annual rate.
This set up a couple of periods of underperformance to come. It wasn't that Microsoft the business was now doing poorly or making less money, it was just that the previous valuation had gotten so high. From 1999 through 2005 Microsoft grew per share earnings by nearly 9% per annum, and yet investors saw a significant reduction in the price that others were willing to pay for this stake during this time.
This sort of thing carried on for years. From 2005 through 2011 Microsoft grew exceptionally well for such a large company, and yet the net result on the shareholder front was basically keeping par with inflation. In turn, this lead to the opposite effect more recently; sort of a reverse tech bubble situation.
Shares went from a sky high valuation to start the century all the way back down to "reasonable" and then further fell to near 10 times earnings a decade later. In the last few years' profits have begun to stagnant, and yet investor returns have been very solid as a result of the "snap back" in valuation.
From 2005 through 2014 company-wide earnings grew by about 6% annually and earnings-per-share increased by over 9% per year. And investors saw total returns on the magnitude of 7%+ annually. This is more or less what you might expect - investment results tracking business gains. Yet in viewing the periods above, it's clear that this was not a year-in, year-out constant process. Instead, years of stagnation were followed by exceptional returns and the relationship between business results and share price bids was not always a close one.
So when you're thinking about valuing a business, I think this sort of thing is important to keep in mind. You might be right about the business performance, but that in no way guarantees the investment will cooperate as you believe it should. Over the long-term things generally work out, but in shorter time periods (even years) there's no set mechanism that forces XYZ to trade exactly at 15 times earnings or something of the sort.
With that in mind let's try to think about how much you might be willing to pay for shares of Microsoft. Ideally I'd prefer to think in decades, but for this demonstration a five-year span will suffice.
Last fiscal year Microsoft earned $2.65 per share and the company is in the process of paying out its fourth straight $0.36 quarterly dividend. Depending on where you look, I've seen intermediate-term growth rate estimates ranging from 7% to 10%.
Let's use 6% as our guide to stay a bit conservative. If earnings-per-share were to grow by 6% per year, you might anticipate that Microsoft will be generating $3.50 or so during the next half decade. Over the past decade Microsoft's average historical earnings multiple has been in the mid-teens; which seems reasonable given that growth expectation and a very large firm generating billions in profits.
If Microsoft earned $3.50 per share and traded at say 16 times earnings, this would equate to a future share price of about $56. In addition, should the dividend increase in line with earnings, you would also anticipate collecting $8.50 or so in cash payments. Your total anticipated value for one share of Microsoft would be around $64.50 or thereabouts.
Of course this value would be in the future. Next you would have to discount that value back to today, depending on your required return in comparison to your applicable alternatives. Naturally you'd like for your potential return to be as high as possible, but being realistic is also part of the process. With an 8% annual discount rate you come to a price today of roughly $44. As we're about to see this is merely a baseline, but that's how you could begin to think about how much to pay for Microsoft.
This is a crucial first step, in my view. I'm going to let you in on interesting tidbit. I've written half an article on Microsoft - leading up to this very point - and I have no idea what the current share price is.
I did this intentionally. To look up some of the information I detailed, finance websites will obviously display the current share price quotation. Knowing this, I physically put my hand over that portion and only looked at the numbers I needed to in order to illustrate the above information to you. Other than having a rough idea of hundreds of businesses and a historical reference, I still don't know the share price.
So why did I purposely do that? That's easy: I didn't want to become anchored to the going rate as I tried to come up with a reasonable price to pay. The share price is the first thing that most people see. And once you see it, you can't forget it. It becomes anchored to your mind and everything that you do thereafter will be influenced by where shares are currently trading hands at this very moment.
If the share price were much higher than your estimation, it's reconsider: "well, the company is incredibly profitable and growing, perhaps the market is right - shares ought to trade at 18 or 20 times earnings." Conversely, should the going rate be much lower than your estimate, you might talk yourself into a lower multiple or more dismal expectations.
To be sure there is a whole lot more to valuation then what I demonstrated above, but the psychological aspect is very real. Anchoring yourself to current or past share prices can have lingering effects on how you go about the investing world. Considering the current share price first is a surefire way to follow the crowd, but not necessarily an easy path to finding investment success.
So let's continue with this example. The share price of Microsoft as I write this… wait for me to go check… is $52.29. This single observation, after first contemplating the investment without bias, allows us to think about the investment in a variety of different ways.
First we can make the easy comparison: the above baseline presumes a "fair" price near $44, whereas the actual price is closer to $52. A simple view would highlight that shares are trading above what you might consider reasonable.
Of course its paramount to remember that this is not an absolute. When you starting working through a valuation process you're going to get a very specific number - say $44.27. Yet this is certainly not to suggest that $44 is "fair" and that $44.50 would be no good. For that matter this does not indicate that $45 or $50 or $60 cannot build wealth. The idea is simply to first develop a baseline without bias.
The next step is to acknowledge just how finicky the process can be. In the above demonstration I used a discount rate of 8%. When you put that into a spreadsheet, it becomes absolute. Yet really I just picked that number out of the air - why not 7% or 9%, or 6% or 10%?
Here's the values other discount rates imply based on the exact same business and per share assumptions highlighted above:
5% = $51
6% = $48
7% = $46
8% = $44
9% = $42
10% = $40
11% = $38
Based on that information you could argue that a "fair" price to pay for Microsoft, in keeping with the above assumptions, is somewhere between $38 and $51 today. Of course this situation also highlights a secondary consideration: just like the discount rate is up for debate, so too are your assumptions. Once you model a growth rate or P/E ratio it appears cemented, but you have to be cognizant of the idea that what happens in practice can (and likely will) vary greatly.
While I created a wide range of "fair values" by changing the discount rate, there are many more variants at play. Instead of changing the discount rate (we'll leave that at 8% for the below illustration), here's how you could think about varying earnings multiples and future growth rates:
This table uses future growth rates ranging from 2% to 12% per year on the top row, along with future P/E ratios ranging from 10 to 20 down the first column. Obviously something beyond these bounds is possible, but I would contend that the above table covers a good deal of what would presently be anticipated.
The values at each intersection represent the current price that would be required in order to generate a return of 8% per annum, including dividends. So in keeping with our example, if Microsoft were to grow earnings by 6% annually and trade at 16 times earnings, you would need a share price today of around $44 to generate an 8% yearly return.
This table gives a very wide range - anywhere from $25 to $71 as a "fair" price to pay. And remember, this is only using one discount rate. You could further break out the possibilities based on varying discount rates as well.
Yet the takeaway is a bit simpler than that. The idea is that while you are going to come up with a very specific number as your baseline, that's all it is: a baseline. You have to be aware of the moving variables at play. In turn, personally I view this information as a reinforcement as to why you'd be inclined to bake in conservative rather than cheery estimates in your calculations. You want to do alright even if things don't go swimmingly.
By the way, this exact idea is highlighted when you see something like Morningstar's "fair value" estimate. The analyst there spends a great deal of time thinking about the business and security and comes up with a "fair value." I just checked for Microsoft and currently "$61" is listed. But then there's an acknowledgement of just how finicky the process can be: providing a range of "consider buy" and "consider sell" of between $42 and $82.
People like specifics. They're easy to understand. You think XYZ is worth $60, it trades at $52, so it must be good. Yet it's equally important to acknowledge the limitations involved. People don't like seeing that something might be worth between $42 and $82 (using Morningstar) or between $25 and $71 using the numbers depicted above. Yet it's a much better answer. You're dealing with unknowns and guesses about the future, no need to be precisely wrong.
Incidentally, this could be classified under the Ben Graham "fat test" whereby you don't need to know a man's exact weight to opine that he ought to lose (or gain) some pounds. It's the same reason that I believe it's ludicrous to make a buy or sell decision based on a slightly higher or lower price in comparison to your estimated value.
So, how much should you pay for Microsoft? This won't be a satisfying conclusion, but it depends greatly on your expectations about the business, how strongly you feel about those estimates and the returns that could be had with your applicable alternatives. (And "applicable" is an important side note, if something is out of your range of understanding that doesn't count as an alternative.)
The above illustration is how I'd start to think about what I might be willing to pay for Microsoft. First, I'd look at things on a high level without bias - in this case specifically that meant coming up with a "fair" price and then looking at the share price, not the other way around.
Next you want to look on a deeper level, which was not depicted here, but relates to whether or not an investment is even in your area of consideration. Thereafter, it's important to acknowledge the wide range of potential outcomes and determine on a psychological level whether that is acceptable. Luckily the investing world is filled with many more positive, wealth-creating, opportunities than negative ones so the process becomes more enjoyable as you move along.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.