Microsoft (NASDAQ:MSFT) stock’s valuation assumes that its free cash flow machine will continue unabated. After all, the market value of MSFT stock is more than $1.1 trillion. In effect, the market value assumes the free cash flow will continue unabated for a long time.
Here is the problem. Its trailing (TTM) 12-month free cash flow (FCF) was only $38.6 billion, according to data compiled by Seeking Alpha. FCF is the amount of money left over from all spending to reduce its debt, pay dividends, buy companies, repurchase stock and add to its cash balances.
That means its free cash flow yield is 3.5%. In other words, $38.6 billion divided by $1.1 trillion is 3.5%. That is a very expensive metric for such a large stock.
Here is another way to show how expensive that measure is. Assume you were the richest person in the world several times over the richest person today. Assume also you wanted to buy 100% of Microsoft stock. Then you would have to pony up $1.1 trillion in actual cash.
But it would take 28.9 years to get your money back, assuming FCF never rose. That is because $1.1 divided by$38.6 billion is 28.9. But the market is not willing to wait 29 years for breakeven. It assumes FCF will keep growing very fast.
Market Assumes FCF Will Grow at Least 20%
For example, most people are barely willing to wait seven years for a home purchase to reach breakeven. The same applies here. What is the implied compounded growth rate of FCF for seven years breakeven at an FCF yield of 3.5%?
The number works out to be 62%. That means that the market assumes that over the next seven years FCF will grow 62% annually (i.e., proof: 1.62 to the power of 7 = 29.5, and 29.5 x $38.6 billion = $1.1 trillion).
That obviously doesn’t work. Let’s play around with waiting 15 years. If the uber-wealthy buyer is willing to wait 15 years to get their $1.1 trillion back (and no return on investment), the implied growth rate for free cash flow is 25.3%. That is assuming $38.6 billion in FCF grows 25.3% per year for 15 years, the eventual return is $1.1 trillion.
But who is willing to wait 15 years for payback? And can MSFT really grow its FCF at least 25.3% over 15 years? I don’t think so is the answer to both questions. For example, a year ago the TTM FCF for MSFT was $32 billion, according to the data. That means the TTM FCF grew only 20% by Q3 2019 to $38.6 billion.
Getting to 20% in annualized growth in FCF would mean payback would take 18.5 years or so. Come on — who is really going to wait over 18 years for payback? But that is what the market is assuming at this price for Microsoft?
Do you get my point? The FCF yield at today’s price is absurd for such a large stock. 3.5% FCF yield means the market assumes 20% FCF growth consistently over 18.5 years.
What’s a More Realistic FCF Rate for Microsoft Stock?
Let’s be realistic. Assuming a 20% growth rate is FCF is probably not sustainable for a long period of time with such a large company. The law of large numbers gets in the way.
A more realistic valuation for Microsoft stock would be a 4.5% FCF yield. That would mean that MSFT stock is overvalued by about 22%.
Here is why: At a 4.5% FCF yield, Microsoft stock would be worth $857.7 million, not $1.1 trillion (i.e., $38.6 billion divided by 4.5% = $857.7 billion). It also assumes that FCF would grow between 16% and 17% for the next 20 years. That is more realistic than the previous assumption above.
What’s This Mean for MSFT Stock Price?
Since there are 7.634 billion shares of MSFT stock outstanding, my derived $857.7 billion valuation above for Microsoft implies a stock price of $112.35 per share. Today’s price is $145 and change.
So you can see I am predicting that a realistic value for MSFT stock is $30.65 too high, or over 21% overvalued.
MSFT stock has risen over 42% so far this year. You can see with my math calculations that MSFT’s FCF yield is too expensive and the growth in FCF really can’t support this valuation. At some point, the market will likely come to terms with this analysis I believe. And then Microsoft stock will deflate to a more realistic level.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks, which includes both high dividend and buyback yields. In addition, subscribers a two-week free trial.