Microsoft Corporation: 3 Charts To Put Its Valuation Into Perspective

Summary

• Microsoft Corporation is currently priced at ~32.8x FW PE and causes concerns for some investors.
• This article examines the valuation from 3 different perspectives: dividend yield, dividend yield relative to risk-free rate, and historical PE.
• Finally, based on these examinations, an assessment of future returns will be performed.

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Thesis and Background

Microsoft Corporation (NASDAQ:MSFT) is currently priced at ~32.8x FW PE and causes concerns for some investors. To put its valuation in perspective, this article examines the valuation from 3 different angles: dividend yield, dividend yield relative to risk-free rate, and historical PE. The results show that the valuation may be a bit high in absolute terms, but certainly not in any bubble or dangerous level. Finally, based on these examinations, an assessment of future returns will be performed.

Basic information and recap

If there is a business that needs no introduction, it is probably Microsoft. Due to its scale and presence, most of us probably have used its products or services every day. It has been one of the best performing stocks over the past many decades. Take the past decade as an example. As seen from the next chart, MSFT investors have been spectacularly rewarded through a combination of earnings growth, dividend, and valuation expansion. The stock delivered more than 1,300% of total return (assuming dividend reinvestment), more than 4x of that from the S&P 500 index.

However, it is also because of such spectacular price appreciation in recent years, the stock appears to be overvalued currently and causes some concern of its valuation. And next we examine the valuation more closely from three perspectives within three charts.

Source: Seeking Alpha

Chart 1: dividend yield

As can be seen from the next chart, currently the dividend yield is at a historical low, around 0.76%. The dividend yield has been driven lower by the price appreciation. It started the decade with a dividend yield around 2.5%. And despite the continuous dividend increases, the price increased even faster and has driven down the yield to around 0.76% now. So in terms of dividend yield, the valuation has expanded by more than 3.3x.

However, do not forget that interest rates have been in steady decline also over the past decade. As you can see from the chart, over the past decade, the dividend yield of MSFT declined in tandem with interest rates (represented by the yield on IEF). Interest rates act as the gravity on all asset valuation. And when interest rates fall, the valuations for other assets such as MSFT just have to go up. So there is nothing abnormal about the valuation expansion - even if there is no profitability improvement at all.

Furthermore, as we are going to see in the next chart, the valuation of MSFT expanded no faster than the decline of the interest rates.

Source: Seeking Alpha

Chart 2: yield spread relative to risk-free rate

For a bond-like equity such as MSFT that enjoys stable profitability and pays a stable dividend, a useful indicator I rely on (and fortunately with good success so far) to gauge the risks has been the yield spread, as illustrated in the following chart. This chart shows the yield spread between MSFT and the 10-year Treasury over the past decade. The yield spread is defined as the TTM dividend yield of MSFT minus the 10-year Treasury bond rate. As can be seen, the spread is bounded and tractable. The spread has been in the range between about -1.5% and 1% the majority of the time, which makes sense for a stable and mature business like MSFT.

When the spread is near or above 1%, MSFT is significantly undervalued relative to 10-year Treasury bond (i.e., I would sell Treasury bond and buy MSFT). In this case, sellers of MSFT are willing to sell it (again an equity bond with a credit quality as good as the US government and some growth built in) to me at a yield that is 1% above a risk-free bond. So it is a good bargain for me.

And when the yield spread is near or below -1.5%, it means the opposite. Now sellers are demanding such a high price that drives yield to be 1.5% BELOW the risk free yield - which begins to make less sense to me as a buyer because the risk-free Treasury bond after all is risk-free. It is backed by the government capability to print money, a capability that MSFT does not have no matter how great its business model is.

And as of this writing, the yield spread is about -0.46%. In relative terms, it is near the middle of the historical spectrum as seen.

So the valuation of MSFT simply expanded just to keep pace with the decline of interest rate. In other words, MSFT deserves its current valuation even if there is no profitability improvement at all. And in my view, MSFT's profitability HAS improved over the past decade - but that will be a separate discussion for another day.

Source: Author based on Seeking Alpha data

Chart 3: PE history

Finally, the following chart shows the annual average PE of the stock in the past decade - the valuation metric that most of us are familiar with. As seen, the PE has expanded from less than 10x to the current ~33x, an 13% expansion rate CAGR.

However, such rapid expansion rate needs to be put into perspective too. First, the less than 10x valuation at the beginning of the decade is clearly undervalued. When you start from a really low point, the growth rate is substantially distorted.

Secondly, the current 32.8x PE is still lower than the S&P 500 index (which stands at 34.6x) by about 5%. If we are going to be worried about overvaluation, we should be more worried about the overvaluation of the overall market rather than Microsoft. In my view, compared to Microsoft, the overall market represents deworsification. The overall market is at a much weaker position compared to MSFT in terms of financial strength, profitability, moat, and scale. And yet, the overall market is valued more expensively than MSFT.

Source: Author based on Seeking Alpha data

Potential returns

Based on the above discussions, we now estimate the potential return. MSFT is a good place to apply the discounted dividend model ("DDM") due to its relatively stable income and the consistent dividend. A key variable in the DDM model is the discount rate, and this analysis uses the Weighted Average Cost of Capital ("WACC") as the discount rate due to MSFT's relatively stable earnings and capital structure. My estimation of the WACC has been around 6% to 8% in the past decade, averaging 7%. The variation was caused by the borrowing rates, and the portion of debt in the capital structure.

With the WACC, three return projections were summarized in the next chart in this section.

• As a base case, I expect the fair value to be about $315. The base case considers an average WACC of 7% and an average growth rate of ~7.75%. And if invested at the current price, the margin of safety would be 9% in this base case. And the five-year annual return is estimated to be 2% in this case.
• The bull case considers a lucky combination of higher growth rate and a lower cost of capital. The fair value in this case will be about $400. In this case, investment at the current price features a substantial margin of safety of 38%, and the five-year annual return is estimated to be 6.6%.
• The bear case represents an unlucky combination of higher cost capital and lower growth rate. And in this case, the 5-year projected return is around -4%.

Source: Author based on Seeking Alpha data

Conclusions and final thoughts

This article examines the valuation of MSFT from 3 different perspectives: dividend yield, dividend yield relative to risk-free rate, and historical PE. The results show that the valuation may be a bit high in absolute terms, but:

• The yield spread is around historical average. As of this writing, the yield spread is about -0.46%, near the middle of the historical spectrum as seen. So the current valuation of MSFT simply expanded just to keep pace with the decline of interest rate - nothing more.
• The current 32.8x PE is still lower than the S&P 500 index (which stands at 34.6x) by about 5%. If we are going to be worried about overvaluation, we should be more worried about the overvaluation of the overall market rather than Microsoft. The overall market is at a much weaker position compared to MSFT in terms of financial strength, profitability, moat, and scale. And yet, the overall market is valued more expensively than MSFT.

Based on these considerations, a "normal" scenario projection was analyzed. And the results show a reasonable risk/return profile - both in the upward and downward direction.

Thanks for reading and look forward to your thoughts and comments!

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.