Without a doubt, Microsoft (MSFT) is one of, if not, the very best company that exists on planet Earth. I continue to be amazed by the revolution that this company has experienced under the leadership of CEO Satya Nadella. MSFT has transformed itself from dead money, old tech into one of the most exciting investment opportunities in the technology sector. Furthermore, from an income-oriented perspective, MSFT's shares offer not only reliably increasing income supported by one of the largest corporate cash hoards, but also strong top-line growth prospects via its multiple leading positions in secular growth markets and sustainable bottom-line growth due to its strong cash flows, high margins, and shift towards the service space. Simply put, what's not to like about this company? Well, with shares making all-time highs and the company's market cap pushing past the $1 trillion threshold, it does have one glaring weakness: valuation.
As I write this, I'm watching Beyond Meat (BYND) spike another 20%, which is making me reconsider the premise of this piece altogether. No, Microsoft is not trading with an essentially infinite P/E ratio. This company isn't forced to be evaluated on a price to sales multiple because it's the only somewhat rational way to look at it. No, Microsoft isn't one of the highest flyers in the market, yet at the end of the day, I have a really hard time justifying the current 29x TTM P/E multiple that the market has slapped on MSFT shares.
Now, before I go any further and discuss the valuation concerns I have in more detail, I want to make it clear that I remain really bullish on MSFT long term. This paragraph is going to echo the first, but I really want to hammer home this idea before people start saying things like, "Nick's selling his MSFT!"
This article is going to come off as bearish, though as I said in the opener, I'm certain that Microsoft is one of the best companies on earth. With that in mind, I have absolutely no plans to sell my shares. To me, this is one of the best long-term, buy-and-hold investments that there is. This is a company that I am constantly wishing that I had more exposure to. Yet, even though I feel urged to add to my position on a daily basis, I'm writing this piece to say that I don't think this stock is a good buy at the moment because of its abnormally high valuation.
Source: F.A.S.T. Graphs
Looking back over the last 20 years, MSFT's average P/E ratio is 21.3x. This period of time includes the dot-com boom/bust period where we saw near triple-digit P/E multiples on the stock. It also includes the Great Recession and the Balmer eras where the stock really struggled and traded with near single-digit multiples. I think that dot-com boom has distorted the average multiple to the upside though. Looking back 10 years, we see that MSFT's average P/E ratio is just 15.1x. And, looking back five years, we see that the average P/E rises to 18.7x, but still not quite to the 20+ level. With all of these time lines in mind and factoring in MSFT's current growth prospects on a relative basis to historical prices, I think the 20x range makes sense when it comes to attempting to put a fair value multiple on these shares.
Using analyst consensus estimates, we see that MSFT is expected to post double-digit bottom-line growth in 2019, 2020, and 2021. The company also posted double-digit growth in 2017 and 2018, with EPS growth of 19% and 17%, respectively. This strong growth streak means that the stock is deserving of a premium valuation. Yet, I think the market is getting a bit ahead of itself with the current $133 price tag.
A lot of the bullish sentiment during recent years that has led to MSFT's multiple expansion from the 10x range at the start of the decade to the 30x range where the stock sits today has been due to the company's focus on its service-oriented segments and other growth markets. Before Satya Nadella took over, MSFT was thought of as a company that was tied to the PC market. That was the start of the world's shift to mobile and it's no wonder that shares were valued so cheaply. PCs haven't exactly gone the way of the dodo like I think many thought they would, though the market certainly appreciates Microsoft's focus on the cloud, A.I., security, gaming, and social media. These are all growth markets with secular tailwinds that this now transformed company has a strong position in.
Like so many other tech names, Microsoft has benefited immensely from the industry's shift from perpetual licensing to the SAAS (sales as a service) model that charges ongoing subscriptions. The stock market loves these subscription models because not only is reoccurring revenue predictable, but it's also generally very high margin. Microsoft has traditionally been a fairly high-margin company. Considered an "old-tech" name, it has been a cash cow for years. Yet, what makes MSFT fairly unique in the market today is the fact that it has been able to transform itself back into an exciting growth company without sacrificing its profitability.
MSFT has generated free cash flows of $33.6b during the trailing 12 months, and it's this profitability that has led to its enormous cash/short-term investments position(s) which totaled more than $133b at the end of the most recent quarter. This cash, alongside responsible capital allocation and capital management, allows the company to maintain one of the most attractive balance sheets in the market. Microsoft and Johnson & Johnson (NYSE:JNJ) are the only two companies in the world with AAA S&P credit ratings. For comparison's sake, the U.S. government doesn't even carry a credit rating that high after its downgrade to AA+ in 2011.
These strong cash flows (alongside the company's cash hoard) are also why I feel so comfortable owning an overweight stake coming from an income-oriented mindset. MSFT has been known for its generosity towards shareholders for a while now, with a 17-year annual dividend increase streak. This company is nearing dividend aristocracy, and while I'm not necessarily a betting man, I'd feel comfortable waging that it will get there. MSFT yields just 1.4%, due to its strong share price appreciation. Yet, this is a company that has provided a double-digit dividend growth CAGR since initiating its dividend in 2013, meaning that the relatively low yield remains attractive relative to the company's dividend growth results. The dividend growth has slowed down a bit in recent years. The company's most recent increase was just 9.5%. Granted, there is nothing wrong with a 9.5% annual raise. I don't know of many individuals who're receiving that sort of compensation boost at work. Yet, it is lower than the 15-20% increases that investors had grown used to 5-10 years ago.
Moving forward, I suspect that management will continue to reward investors with high-single-digit/low-double-digit raises. The company's current $1.84 annual dividend represents a 40% forward payout ratio and that remains fairly conservative. Earnings growth has actually outpaced dividend growth in recent years, meaning that the company's payout ratio is falling (it wasn't all that long ago that MSFT paid out more than 50% of its earnings to shareholders in the form of a dividend). It appears that Nadella is more comfortable with a lower payout ratio, and honestly, who am I to argue with that man's plans/success? Now that MSFT is operating in a variety of high growth markets, it needs to stay out from potential disruption, and that likely requires a higher degree of capital investment. At the end of the day, when you invest in a company, you're essentially investing in its management team and I trust the individuals who're currently in place to continue to generate wealth for me long term.
Before I move on to my current price target, I should probably mention that this company not only pays shareholders a growing dividend, but it also has successfully used its cash flows to reduce the outstanding share count via a shareholder buyback. MSFT isn't necessarily known for its buyback, but it has reduced its float by 6.75% over the last five years. Fewer outstanding shares means that the ones that I continue to own before are slightly more scarce, and when looking at basic supply and demand principles, that's a good thing.
So, with the company's growth potential in mind, combined with its stellar balance sheet and its generous shareholder returns, I'd say that MSFT deserves premium valuation, which is why I'd probably be willing to pay roughly 22x for shares. Typically, I look for ~10% discounts to fair value when buying equity. It's rare that I'd even consider paying a price above my fair value estimate. However, the company's unique quality, as well as the fact that the stock has traded so strongly for so long now, allows me to justify paying a premium multiple.
22x MSFT's 2019 EPS estimate of ~4.60 (yes, for a company like this, I'd even be willing to place my valuation premium on the forward multiple) is ~$101/share. This price target represents a 24% discount the stock's current price. A pretty significant sell-off would have to occur for MSFT shares to hit those levels, and I'm not going to hold my breath while I wait for the price target to hit. However, it is worth noting that MSFT traded down to the $94 level during the Christmas Eve sell-off late last year, so I don't think it's out of the realm of possibility for shares to retrace the majority of their YTD gains in the event of a strong market-wide sell-off.
Performing exercises like this periodically on the stocks that you'd most like to own help not only to avoid falling prey to the FOMO (fear of missing out) mindset and chasing the momentum alongside the rest of the herd, but also to prepare you for eventual market weakness. It's easier for most humans to chase momentum and put money to work while things are seemingly great in the markets. We all love supposed risk free environments. Humans strive for safety. We all have innate survival urges that have been passed down through the generations instinctively. But, while bullish sentiment and momentum might seem to signal an all-clear in terms of buying stocks, it's most important to continue to track the fundamentals and maintain disciplined price targets because if I know one thing about the stock markets, it's that more often than not, multiples will revert back to their means, and even though MSFT is on an absolute tear right now operationally, I don't think that this stock will be any different.
Investors are actually exposing themselves to outsized risk chasing names when they're trading at such abnormally high multiples. Sure, the opportunity cost of sitting on the sidelines with a name like this can be high. That's why I'd say that if you're hell-bent on buying MSFT shares, the safest way to do so is probably to dollar cost average over time; that way you're spreading out your risk along the time horizon while accepting today's high premiums. This approach makes sense for many investors (if not most) because attempting to time the market is generally a fool's errand. However, I don't really think that setting fundamental price targets and sticking to them in akin to market timing. An investor is actually removing speculation from the process when he or she uses fundamental data to drive decision making, and as a disciplined, long-term oriented investor, that's exactly where I want to be.
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Disclosure: I am/we are long MSFT, 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.