I read something on Barron’s today that truly baffled me; the article (here) quoted an analyst note from Morgan Stanley that said the following:
“MSFT is the cheapest stock in our coverage universe with a FCF yield of 17%, and Morgan Stanley’s “what’s in the price” tool suggests MSFT is pricing in negative EPS growth in three years, which we think is unlikely. If we strip out the Windows business altogether, the FCF yield is still double digits and the remaining company would be a double digit grower with a double digit FCF yield. So, clearly MSFT is already pricing in very low expectations for Windows and the PC market in general. The stock is too cheap relative to what is likely high single digit EPS growth longer term, particularly given the 3.5% dividend yield. Further, we think there is a powerful upgrade story around the Microsoft Business Division where we are as optimistic about the product set as we have ever been, while the execution in Server & Tools has been outstanding. Longer term, we are optimistic that MSFT can leverage its synergy across tablets, phones and the corporate desktops to provide a unified platform for application and content access, bolstered by its cloud services.”
That certainly sounds pretty bullish: Microsoft (MSFT) is the cheapest stock followed by this particular analyst, followed by an expectation for high single digit EPS growth longer term – a growth rate that suggests that the current valuation is ludicrous.
Using 3% growth in perpetuity (in line with nominal GDP) and a discount rate of 12%, here’s the implied valuation at 7%, 8% and 9% annualized growth over the coming decade, along with the potential upside from the current valuation under those scenarios (this calculation assumes no value for the $50 billion in net cash in the company’s coffers):
Seeing that, you would expect this analyst to be jumping with joy (by the way, my numbers use starting FCF of $25 billion – below the numbers for the most recent fiscal year to adjust for $2 billion to $3 billion in annual M&A spend, on average); in fact, it’s quite the opposite (quoting the Barron’s article):
“Nevertheless, he thinks Microsoft faces 'a period over the next few quarters' where Windows 8 fails to 'catalyze' sales of PCs, and where corporate PC growth, which has generally been stronger than consumers, tapers off, compounding the problem. He also thinks the boost from the debut of new versions of non-PC products, such as SQL Server, had now pretty much been appreciated by investors and won’t add much in coming quarters.”
The analyst with a base case suggesting Microsoft is worth about $45 to $50 per share (basic calculations using his own numbers) considers the stock only worthy of an “equal weight” at this time, due to the fact that PC sales might be weak for the next 60, 90 or 120 days; if that doesn’t show you how useless analyst reports are to investors (meaning people who consider themselves partial owners of a business), I don’t know what will.
As always, I accept things for the way they are – and am thankful that the “smart money” is so blinded by near-term results that they can’t see an opportunity (by their own admission) when it’s staring them dead in the eyes.
About the author:I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.
I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over a period of many years.