Seeking Alpha contributor Stone Fox Capital believes that Microsoft (NASDAQ:MSFT), which is trading at 30 times its forward earnings, is about to go into a lengthy stall. Stone Fox Capital believes the company’s growth doesn’t support the rich valuation of Microsoft stock.
Are they right? Let’s have a look.
Is Microsoft Stock Really Overvalued?
To make its point, Stone Fox Capital reminds readers that MSFT traded at 60 times forward earnings at its peak in 2000. It was just coming off a go-go decade in which PC sales were rocking. However, because investors spent like drunken sailors leading up to the first decade of the millennium, the stock lost almost 50% of its value.
It’s a plausible argument. However, when you consider that Worldwide PC shipments actually topped out in 2011, it’s possible that Microsoft’s stock retreated because PCs were no longer a hot commodity, not because investors overpaid in the dot.com boom.
Now consider the Microsoft of 2000 and the Microsoft of today.
In fiscal 2000, Microsoft’s revenues were $22.96 billion, 16.3% higher than a year earlier, and 153.7% higher than four years earlier in fiscal 1996. That’s decent growth for sure. As for its net income over those four years, it grew by 328.2% to $9.42 billion in 2000, from $2.20 billion in 1996.
You can’t sneeze at those numbers.
Now consider Microsoft’s growth over the past five years.
On the top line, Microsoft’s revenues grew 34.5% from $93.58 billion in 2015 to $125.84 billion in fiscal 2019 (June 30 year-end). On the bottom line, net income rose 229.1% to $39.24 in 2019 to $12.19 billion in 2015.
While revenues weren’t growing nearly as fast from 2015 to 2019 as they were from 1996 to 2000, net income still managed to grow two-thirds as fast from a much bigger base.
Interestingly, when you consider that Microsoft’s net income in fiscal 2000 was $9.42 billion, it grew just 29.4% over the next 15 years while revenues rose 307.6%. This suggests Microsoft’s share price didn’t do much in the first decade of the new millennium because of poor margins, not overzealous investors.
In 2000, Microsoft had an operating margin of 47.6%. In 2019, its operating margin was 34.1%, 13.5 percentage points less than back in 2000.
That’s bad, right? Not when you consider they were 19.9% just four years earlier. Under Satya Nadella’s leadership, the company has almost doubled its operating margins. In 1996, Microsoft had an operating margin of 35.5%, which means between 2015 and 2019, Microsoft actually did a much better job on growing its operating margin than it did between 1996 and 2000.
So, is it fair to say Microsoft stock is overvalued at 30 times forward earnings? I don’t think so. Here’s why.
The Bottom Line on Microsoft
Microsoft finished fiscal 2019 with $133.8 billion in cash and short-term investments. That’s almost six times the amount it had in 2000. Compared to Apple (NASDAQ:AAPL), Microsoft’s become the King of Cash.
In the trailing 12 months, Apple had net debt of $15.5 billion. By comparison, Microsoft had net cash of $63.8 billion, $79.3 billion higher than Apple on a relative basis.
I recently suggested that Microsoft stock would hit $200 in 2020, although I did suggest the next couple of quarters could be shaky.
The reason had a lot to do with how investors were valuing the company.
Wedbush Securities analysts Daniel Ives and Strecker Backe suggested in late April that the cloud business was worth as much as a trillion dollars. This meant that the markets were valuing the rest of its business at $360 billion. That includes Windows, Office 365, Microsoft Teams, Surface, Xbox, etc.
I find it hard to believe those pieces combined are worth just one-third of its cloud business. Either the analysts have gotten the cloud estimate wrong, or the sum of its parts is worth a heck of a lot more than $1.36 trillion.
To say Microsoft is overvalued at almost 30 times forward earnings, suggests all the great things Nadella and his management team have going right now are an optical illusion.
That’s a theory I’m just not buying.
$200, here we come.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.
