The price-to-earnings ratio has become the go-to valuation metric for making a quick call about a stock. With that as a backdrop, when you look at Microsoft Corporation (NASDAQ:MSFT), you might ask the question: Is Microsoft stock cheap?
Well, its P/E ratio is 27.5, 40% higher than the average stock in the S&P 500, so the quick answer is: No, it’s not.
However, there’s so much more that goes into the valuation of a stock, and even then, it’s impossible to know the intrinsic value of Microsoft stock or any other for that matter.
Is Microsoft Stock Cheap?
Why bother if stock valuations are an inexact science?
Because the more you dwell on the valuation metrics of a company, which includes getting under the hood, checking out its financials, and understanding what they mean to the business, you’ll have a better understanding of why you might want to invest in a particular stock — in this case, MSFT.
It will also get you a lot closer to answering the question whether Microsoft stock is cheap, expensive or fairly valued then if you don’t carry out this research. If you’re a long-term investor, it won’t matter if your estimate is off by $5 to $10. Time heals all wounds.
Warren Buffett’s approach to buying stocks has changed over the years. When he first started investing professionally, he followed Ben Graham’s “cigar butt” approach, which meant you came up with a stock’s intrinsic value and then bought it for significantly less than that.
His partner, Charlie Munger, convinced him to forget about the bargain bin and instead focus on buying great companies at fair prices.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” said Warren Buffett in a 1989 Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) shareholders letter.
However, that doesn’t mean Buffett is prepared to pay any price for a great company: “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
Ultimately, I believe the Warren Buffett operating in 2016 would say it’s better to be wrong on price then it is to be wrong on quality. In a future article, I’ll look at the various financial model’s investors use to establish a stock’s intrinsic value.
In the meantime, let’s take a look at the various valuation metrics including P/E ratio to help us understand whether Microsoft stock is cheap.
Microsoft’s P/E Ratio
Previously, I established that MSFT’s current P/E ratio was 27.5, almost 40% higher than the S&P 500. However, that’s based on its trailing 12-month earnings.
Many investors prefer to use what’s called a “forward P/E,” which is a stock’s current price divided by the mean earnings-per-share estimate for the next fiscal year. Microsoft’s is 19.6, virtually the same as the S&P 500.
Verdict: Fairly priced
Microsoft’s P/B Ratio
The price-to-book ratio gives you a better idea of how confident investors are about a company’s net assets. The “B” stands for book value and it is calculated by subtracting a company’s liabilities from its total assets. The “P” is the company’s current stock price.
The P/B ratio is better suited for companies in asset-heavy industries but knowing MSFT’s P/B ratio, you can compare it with what investors are willing to pay for the net assets of other tech companies.
Currently, Microsoft’s P/B ratio is 6.2, which means investors are currently willing to pay $6.20 for each dollar of net assets. The industry average is a multiple of 4.9, which suggests one of two things: either investors are willing to pay more for MSFT’s net assets or it’s possibly relatively expensive relative to its peers.
Verdict: Overpriced
Microsoft’s P/S Ratio
Of the “big five” price ratios, the price-to-sales ratio is probably the one I’m most confident about. Although revenue numbers can be manipulated from quarter to quarter, there’s a lot less accounting fraud that can take place using top-line sales as opposed to bottom-line earnings.
Portfolio manager James O’Shaughnessy published “What Works on Wall Street” in 1996, a massive quantitative study of the various stock-picking approaches used by investors to predict the future success of stocks. Shaughnessy concluded that sales, not earnings, were the best way to predict a stock’s future success. Furthermore, he found that growth stocks selling for 1.5 times sales or less ultimately did better.
MSFT’s current P/S ratio is 5.4, well above O’Shaughnessy’s screening criteria and the S&P 500, who’s average stock price is a far more palatable 1.9 times average sales. However, when compared to its tech peers, whose multiple is 4.8, it doesn’t seem nearly as bad.
Verdict: Overpriced
Microsoft’s P/FCF
Like all ratios, you have to take them with a grain of salt because they’re not necessarily reflective of a stock’s true value, but rather how the market is currently valuing a certain aspect of a company’s financials.
When it comes to free cash flow, the amount of cash from operations left after a company’s capital expenditures, the number is going to be different depending on the industry. Capital-intensive businesses aren’t going to have nearly as much free cash as those who develop software and other asset-light products and services.
Take Microsoft and Apple Inc. (NASDAQ:AAPL). While they compete in certain areas of electronics hardware, MSFT is a much bigger player in software, which requires less of a capital outlay to get the job done. So, it’s only natural that Microsoft is going to have more free cash.
MSFT’s current trailing 12-month free cash flow is $25 billion or 29% of revenue. Apple’s is $50 billion or 23% of revenue. That’s pretty close. However, investors are currently willing to pay $14 per dollar of Microsoft’s free cash flow versus $10 for every dollar of Apple’s free cash flow. Apple might have the most cash, but investors don’t seem to care.
Verdict: Overpriced
Microsoft’s EV/EBITDA
This one might not be that familiar to some investors, but its importance in evaluating whether to buy a stock can’t be understated.
Enterprise value is the total price you have to pay for a company taking into consideration its debt and cash levels. EBITDA is simply a business’s operating profits before taking into consideration its financing situation as well as its tax structure and other accounting intricacies.
The downside to this particular metric is that you do want to consider a company’s taxes and debt situation before buying, whether we’re talking about an entire company or its stock.
Microsoft stock has a current enterprise value of $390.8 billion. Its trailing 12-month EBITDA is $26.8 billion. Its EV/EBITDA multiple is 17.85, which means investors are currently willing to pay $17.85 per dollar of EBITDA earnings. Apple investors, on the other hand, are only prepared to pay $8.34 for a dollar of its EBITDA earnings.
Verdict: Overpriced
Bottom Line: Is Microsoft Cheap?
The five valuation metrics I’ve highlighted all revolve around price. They’re best used as a guide rather than an absolute. I think it’s important to emphasize that the five metrics should not be enough to make a case whether to buy or sell a stock. But it’s a start.
In my opinion, Microsoft stock is NOT cheap.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
