The sell-off in Microsoft (NASDAQ:MSFT) almost has to be an enormous buying opportunity. Microsoft stock has dropped 28% just since Feb. 19. And that decline seemingly makes no sense.
After all, Microsoft has little exposure to the short-term disruption the U.S. economy is going to face. Certainly, some revenue is going to be delayed. Adoption of the Azure cloud platform, for instance, is going to come to a halt. Office 365 sales are going to take a hit, and could see mid-term pressure if the short-term shutdown turns into a mid-term recession.
Indeed, in late February Microsoft already pulled its guidance for its More Personal Computing segment in the fiscal third quarter owing to the impact of the coronavirus.
Obviously, Microsoft isn’t an airline or a restaurant operator. The impact on earnings is going to be relatively modest in the grand scheme of things. It certainly doesn’t seem like enough to suggest Microsoft is worth 28% less than it was four weeks ago. With cash on the balance sheet well in excess of debt, there’s no bankruptcy risk, either.
And outside of coronavirus effects, and the resulting pulled guidance for a single segment, there’s been zero news during this sell-off. As a result, this looks like a panicked and illogical sell-off in one of the world’s best stocks.
But from another angle, the decline in MSFT stock looks much more logical than it might seem.
Microsoft Stock Is Too Cheap … Right?
Incredibly, Microsoft has lost over $400 billion in market value in less than a month. It’s impossible to argue that the coronavirus will have anywhere near the impact on the net present value of Microsoft’s future cash flows — which in theory should equal the MSFT stock price.
In fact, it’s impossible to argue that the impact will even reach $40 billion, a figure roughly equivalent to Microsoft’s adjusted net income for all of fiscal 2019 (ending June).
That is the bull case for Microsoft stock on the dip: that this sell-off is unjustified.
But the case relies on key assumption: that the Feb. 19 close of $187.28 was the ‘right’ price for Microsoft stock.
That’s far from guaranteed. At that close, MSFT traded at nearly 33x the consensus earnings per share estimate for fiscal 2020.
At least relative to the modern age, that’s a multiple that’s likely unprecedented. Mature companies don’t get that kind of multiple. The second-most valuable company in the market — behind Apple (NASDAQ:AAPL) — likely never has traded at more than 30x earnings. Rarely would the multiple get over 20x.
Go back to the middle of 2007. A multi-year bull market was set to peter out. But even then, the market’s most valuable companies looked almost cheap on an earnings basis. Exxon Mobil (NYSE:XOM) was the world’s most valuable company, and traded at 12x earnings. General Electric (NYSE:GE) was second, trading at 19x. Microsoft was fourth behind French oil giant Total S.A (NYSE:TOT), and was valued at just 21x earnings.
The issue here isn’t about the quality of Microsoft as a company. That is in little doubt. The issue comes down to valuation. At some point, even for one of the world’s best companies, the stock price has to matter.
And even after the decline, Microsoft stock still has a historically high valuation. Shares still trade at 22x next year’s consensus EPS estimate. (That estimate hasn’t moved in the last month, and so reflects expectations before the worst of coronavirus impacts became clear.)
Again, relative even to the 2007 bull market, that’s a reasonably high multiple. Against expected ~11% EPS growth, it’s not notably cheap.
That’s not to say that Microsoft stock should trade at $135. Rather, it’s to say that, even after the decline, the fundamentals, on their face, are not dramatically out of line.
Indeed, as steep as the decline has been, it’s not as if Microsoft stock is at a multi-year low. The stock only has returned to where it traded in October.
As I wrote before MSFT turned south, the stock had a historic run. The stock had a market capitalization over $700 billion and then doubled in 14 months. Even with this pullback, Microsoft still posted astounding returns for a company its size over the past few years. And that in turn suggests there’s at least a chance that run simply went too far.
The Market Battle
This debate echoes that of the market as a whole. Since Feb. 19, the S&P 500 declined nearly 30%, losing almost exactly 1,000 points.
That decline isn’t driven solely by the near-term impact of coronavirus-driven closures. It’s not necessarily driven by investor panic, either.
Rather, to at least some extent, there’s a re-rating of the entire market right now. Put another way, the spread of the coronavirus in the U.S. has been a catalyst for a sell-off that has occurred for different reasons.
To what extent that’s true will determine where the market goes from here. But at the very least, that argument is credible, both for Microsoft stock and for U.S. stocks as a whole. For both, “cheaper” doesn’t guarantee “cheap.”
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.