Since I said Mattel (MAT) was a great business – but not a great stock – let’s compare Microsoft to Mattel.
Mattel vs. Microsoft – Vital Signs
|Return on Capital||23.28%||53.29%|
|FCF Margin Variation||0.45||0.21|
|Return on Capital Variation||0.24||0.22|
|Price / 10-Year Real FCF||16.18||14.06|
|EV / 10-Year Real EBIT||12.84||11.73|
|Price / NCAV||13.86||15.55|
|Price / Tangible Book||4.53||6.98|
Microsoft is a much higher quality business. Microsoft’s free cash flow margin – that’s free cash flow divided by sales – is more than 3 times Mattel’s free cash flow margin. Microsoft’s return on capital – that’s EBIT divided by tangible assets employed – is more than double Mattel’s return on capital. And Microsoft’s free cash flow margin and return on capital both vary less – that means they’re more reliable – than Mattel’s free cash flow margin and return on capital.
In other words – Microsoft’s a better business than Mattel. Mattel is still a great business. Microsoft’s just a super great business. One of the best on planet Earth.
But Microsoft stock isn’t priced like one of the world’s best businesses. It’s priced like a run of the mill business. Like a mediocre business. Microsoft trades for just 14 times its 10-year average real free cash flow. And that doesn’t count Microsoft’s $4 in leftover cash. There’s no reason for Microsoft to keep that cash on the balance sheet. Microsoft’s EV/10-year real EBIT ratio of 11.73 is probably a better measure of Microsoft’s actual earnings multiple. Microsoft’s stock trades for about 12 times normal earnings. Certainly no more than 14 times normal earnings.
Why is one of the world’s best businesses trading for less than 15 times earnings?
Here’s Arnold Van Den Berg’s take:
“We realize that many believe Microsoft has fallen behind Apple on smart phones and tablets and that there is uncertainty surrounding the impact of cloud computing on its business. We believe that smart phones and tablets address different needs and different markets than PCs, and thus expand the computing device market. PCs are primarily input and productivity devices while smart phones and tablets are primarily output and content consumption devices, though there is overlap. In other words, Apple has been extremely successful in expanding the overall market, not only for its devices, but also for computing devices such as PCs and Internet servers sold by Microsoft, Intel, and Dell, among others. Regarding cloud computing, we believe that while there is considerable excitement surrounding it (much the same way there was excitement over the Internet 10 years ago), to the degree that it is adopted, it will make PCs more valuable and drive additional demand for PCs and laptops (as well as for other computing devices). We also believe that Microsoft is extremely well positioned to be a dominant player in cloud computing. However, Wall Street has the attitude of ‘shoot first and ask questions later’, creating opportunities for patient long‐term investors.”
Arnold Van Den Berg is saying that Wall Street is over reacting. Van Den Berg considers himself a follower of Ben Graham. And I have no doubt Graham would agree on this point. Arnold Van Den Berg has – lately at least – tended to buy higher quality businesses than Graham did. But the basic idea of buying current assets and past earnings at a deep discount when Wall Street is worried about the future – that’s Ben Graham’s bread and butter.
And that’s exactly what Arnold Van Den Berg did to value Microsoft:
“We believe Microsoft is worth a premium to the average company. Our 36 years of research shows that large quality companies like Microsoft often get a 20% to 25% premium over the average stock, and rightfully so. If we were to add a 20% premium to the median P/E of the Value Line Investment Survey® (an index of 1700 stocks) over the last two years of 15.6, it would put Microsoft’s P/E at 18.7 (15.6 2‐year median P/E plus a 20% premium = 18.7 P/E). If we were to use the 5‐year median Value Line P/E of 17.1 and add a 20% premium, it would suggest a P/E of 20.5.”
You can’t argue with Arnold Van Den Berg’s research. You can argue the future will be different from the past. Maybe just for Microsoft. Maybe for all large, quality companies. Maybe this P/E premium will disappear.
But Arnold Van Den Berg is betting it won’t. He expects to profit from Microsoft’s return to premium P/E levels:
“While it is quite possible that Microsoft will grow faster over the next five years, we are only assuming a 5% growth rate. Under this scenario, we believe it has future earning power of $3.95. If we apply the 18.7 and 20.5 P/Es just calculated, it suggests Microsoft could sell for $73 to $80 per share. If we present value this back into today’s dollars at 10%, it is equivalent to a current price of $45 to $50. If we take the average price of $24.5 over the past six months, this stock has the potential for a 5‐year annualized return of 24% to 26%.”
Arnold Van Den Berg’s approach is different from mine. I’m a big believer in the idea that no stock is worth more than its cash flows. You shouldn’t pay up for anything. Ultimately – every investment is a cash to cash transaction. The privilege of owning a great company shouldn’t factor into the analysis.
While I don’t believe in paying up for quality – I do believe in picking out the highest quality items from the bargain bin. That’s one reason why I keep showing you historical free cash flow margins, return on capital, and most importantly – variation measures. I like getting quality and reliability for free.
And while Arnold Van Den Berg’s upside argument for Microsoft comes from assuming Microsoft will one day regain its premium P/E ratio – his downside argument doesn’t:
“With a free cash flow yield of 9.1%, a dividend yield of 2.1%, plus our conservative future growth rate of 5%, we believe that Microsoft stock is a great value and a great investment. Furthermore, we do not believe the disparity between its value and price will continue for long; eventually the value will be recognized. Given the return potential of this company, along with its AAA financial security, we have to ask the following question: Why would investors buy its bonds, or for that matter U.S. Treasury bonds, instead of Microsoft stock?”
Arnold Van Den Berg is saying “heads” Microsoft regains its premium P/E and I get 20% plus annual returns; “tails” Microsoft pays out a dividend, buys back stock, muddles though with decent growth – and I do better than Treasuries without taking much risk.
Should you follow Arnold Van Den Berg into Microsoft?
Let’s start by valuing the stock. I’m not going to assume any sort of premium the way Arnold Van Den Berg does. Instead – I’m going to use my usual free cash flow approach. I’ve also thrown in EBIT for those heathens among you who still mistrust free cash flow.
|Real Free Cash Flow||Real EBIT|
Microsoft’s 10-year average real free cash flow is $1.94 per share. Microsoft’s 10-year average real EBIT is $1.99 per share. The company has $3.84 in net cash. And a stock price of $27.23. So when we back out the surplus cash we get a stock price of $23.39 a share.
It’s definitely appropriate to back out Microsoft’s surplus cash in this case. The company has shown a willingness to use that cash to buy back stock and pay out dividends very aggressively. They haven’t been willing to leverage the balance sheet. But they have been willing to pay out cash quicker than a lot of other companies.
The sheer amount of cash on Microsoft’s balance sheet makes it look like they’re hoarding cash. But that’s just the result of spewing free cash flow year in and year out. Microsoft only keeps 2 years of free cash flow on its balance sheet.
Sure. Microsoft could blow the cash on something as dumb as buying Yahoo (YHOO). Let’s hope not. And just Microsoft with the $4 in surplus cash.
So we’ve got a stock selling for $23.39 net of cash that produces $1.94 a year in free cash flow. That’s a 12 multiple. Microsoft is selling for 12 times cash earnings.
Is that too low?
15 is normal. 12 is low.
Very low for a quality, reliable business like Microsoft. Arnold Van Den Berg takes that quality into account. I want to be conservative. So we’ll value Microsoft like a run of the mill business.
A run of the mill business with Microsoft’s free cash flow record should trade at $29.10 a share. That’s 15 times $1.94. Plus the $3.84 in net cash. That gives Microsoft stock an intrinsic value of $32.94 a share.
An intrinsic value of $33 a share sounds right. Beyond that – you’re talking about the premium paid for high quality, reliable mega cap stocks like Microsoft. That premium would probably bring the stock up to $40 a share.
So Microsoft’s intrinsic value – without any quality premium – is $33 a share. The level at which companies of Microsoft’s quality normally trade is $40 a share. And the current stock price is $27.
That means you have a 20% upside in Microsoft stock if you’re just looking for Microsoft to trade at the right level compared to its free cash flow. You have a 50% upside if you’re looking for Microsoft to trade at the right level compared to both its free cash flow and its quality level.
I don’t assume a stock will ever trade at a premium to average valuation levels. And I don’t buy stocks where I don’t see at least a 30% upside. So Microsoft – at $27 a share – is too rich for me.
Microsoft will probably outperform the S&P 500. But I’m not a buyer.
Arnold Van Den Berg is. So you might want to read his full letter to investors.
You can also check out a slightly different Microsoft intrinsic value calculation I did back in February.