Microsoft's Trillion Dollar Question

Summary

• Evercore ISI made a very aggressive prediction.
• Microsoft's valuation is unlikely to hit $1 trillion any time soon, partially due to the impact of share repurchases.
• Microsoft nevertheless should provide solid returns going forward.
• Shares of Microsoft look attractive from a risk-reward view point.

Article thesis

Some analysts believe that Microsoft's (NASDAQ:MSFT) market capitalization could reach $1 trillion by 2020, which is far too aggressive, I think. Even without this happening Microsoft's shareholders should see solid returns over the coming years, which makes Microsoft's shares worthy of a closer look from a risk-reward view point.

Why a trillion dollar market capitalization seems unrealistic

Evercore ISI analysts have claimed that Microsoft's market capitalization could reach $1 trillion by 2020, i.e. in a little bit more than two years (they also stated that this could happen even before 2020).

MSFT Market Cap data by YCharts

In this YCharts graph we see that Microsoft is currently valued at just shy of $650 billion, which means that its market capitalization would have to rise by roughly 54% through 2020 for Evercore ISI's prediction to come true. This does not, however, mean that Microsoft's share price would have to rise by only 54%, too:

source: Microsoft's Annual Form 10-K

In Microsoft's annual report we see that the share count has dropped significantly over the last two years: from 8.25 billion in 2015 to 7.83 billion in 2017. If we assume that the pace of share repurchases remains the same over the coming years, the share count would average 7.20 billion shares in 2020.

If Microsoft's market capitalization were to hit $1 trillion in 2020, Microsoft's share price would thus have to rise to $139 ($1 trillion in market cap divided by 7.2 billion shares).

MSFT data by YCharts

We see that Microsoft's share price is around $84 right now, which means that shares would have to rally about 65% from the current level in order to hit the $139 price target that would be required in order to bring the company's market capitalization to the trillion dollar level.

Microsoft's shares have been rising substantially over the last couple of years as the company's mobile and cloud focus started to pay off and as Office 365 gained traction, but assuming that shares would rise by more than sixty percent through 2020, when we basically are entering 2018 already, seems too ambitious.

MSFT EPS LT Growth Estimates data by YCharts

Microsoft is currently trading at 24.8 times this year's expected earnings (meaning Microsoft's FY 2018, which started in July and ends June 2018), which is not a low valuation at all -- Microsoft has been trading at substantially lower multiples for many years. But even when we assume that Microsoft's valuation multiple does not contract at all over the coming years, the estimated EPS growth rates would not justify a $139 share price.

When we assume that Microsoft's EPS does indeed grow by 11.9% annually over the coming years (as analysts are forecasting right now), and that Microsoft hits the estimated $3.39 in EPS in its current financial year, then Microsoft will earn $4.24 in FY 2020 -- shares would have to trade at 32.8 times earnings by 2020 in order to get to the $139 share price that would be needed for the company's valuation to breach $1 trillion.

Microsoft is showing solid earnings growth and is a key player in the cloud market, but it seems too aggressive to assume that the company's valuation will explode to well above a thirty times earnings multiple, especially as it is questionable whether the broad bull market we have seen over the last quarters will persist through the coming years.

Even without a trillion dollar valuation Microsoft is attractive though

My belief that Microsoft will not breach the trillion dollar mark in 2020 does not mean that I believe that the company's shares are unattractive, though: Microsoft will likely deliver solid returns going forward, and that makes shares worthy of a closer look as Microsoft is a low-risk investment.

source: Microsoft's Annual Form 10-K

In its annual report Microsoft highlights some of the risks it faces, but at the same time the phrasing shows why Microsoft is in a key position to benefit in the future: Providers of successful ecosystems (such as Microsoft) have a big moat versus newcomers, as networking effects make it hard for customers to switch to a competitors' offerings -- that's why Microsoft's Windows was, is, and very likely will be the dominant leader in operating systems globally:

source: netmarketshare.com

Windows holds a 89% market share among operating systems, up slightly over the last 18 months (from 87.5% in May 2016). The same principle is true for other key cash cows of Microsoft, such as its Office products.

As stated in Microsoft's annual report other players have established successful ecosystems as well, primarily Apple (AAPL), which is integrating hardware and software/services sales in a great way, but the two are active in different markets (Apple being more focused on consumers, and Microsoft being more focused on B2B / enterprises with its offerings), and the market surely is big enough for multiple companies to earn a lot of money.

Microsoft's growth vectors are newer concepts such as Azure, but it is quite foreseeable that its cash cows Windows and Office will continue to dominate their spaces for years, thus providing a lot of visibility to earnings as well as cash flows going forward.

On top of that Microsoft has a world class balance sheet:

source: Microsoft's most recent 10-Q

Microsoft's balance sheet contains $138 billion of cash and equivalents, which is substantially more than the $77 billion of long term debt that the company owes. Microsoft not only has a $61 billion net cash position, the company's assets are also mostly of a tangible nature: Of the $249 billion in assets, just 18% are in the form of goodwill and other intangibles.

This very strong balance sheet, which is coupled with high and foreseeable cash flows, is rewarded by a AAA rating by all relevant rating agencies, making Microsoft just one of two publicly traded company to get that distinction (Johnson & Johnson (JNJ) being the other one).

Relative to other stocks Microsoft thus looks like a very low-risk investment, which is why I believe it is a viable choice for those seeking stable backbones for their portfolios, and the returns Microsoft will deliver going forward will be solid, too:

If Microsoft manages to grow its EPS by close to 12% annually going forward (as analysts are expecting), then high single-digit annual returns are possible even if the multiple shrinks going forward (which is not unlikely, as shares are trading for more than 28 times trailing earnings).

$2.96 in ttm earnings per share could turn to $5.20 in 2022 -- when we put a moderate 22 times earnings multiple on that estimate, we get to a share price of $114, which would mean an annual share price increase of 6.3% over the next five years. When we add in a dividend yielding two percent we get to high single-digit annual returns without the need for high multiples or multiple expansion, and that return comes from a low-risk investment.

Takeaway

Microsoft's shares would have to rally by well above sixty percent for the company's market cap to hit $1 trillion. I thus believe that Evercore ISI's estimates are too aggressive.

Nevertheless, Microsoft's shares have the potential to provide solid high single-digit annual returns going forward, which is a quite attractive return from a low-risk investment such as Microsoft.

Analyst’s Disclosure: I am/we are long JNJ. 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.