Do I like Microsoft’s business. Heck ya! I’ve used many of its products and services over the years. And the company continues to add value to society on many fronts. As a result, Microsoft continues to grow its sales…
But as an investor, I have to be conscious of the value I get relative to the share price. In the words of Warren Buffett…
Whether socks or stocks, I like buying quality merchandise when it is marked down.
When it comes to socks, it’s pretty easy to determine their value. But with multi-national corporations, on the other hand, it’s not so easy to determine what they’re worth. That’s why we see a lot of short-term volatility in the stock market. Nonetheless, there are some simple metrics we can use to get an idea of Microsoft’s current valuation.
I’m going to show you why I won’t buy Microsoft stock today. Also, the company recently announced a $60 billion stock buyback. It’s bought plenty of shares back over the years… but anywhere near its current valuation, that’s a bad move for investors.
Is Microsoft Stock a Buy?
In the past, Microsoft has shown some outstanding returns for investors. Although, its runup in price is outpacing its fundamental growth.
In the past 10 years, investors are up over 1,000%. And the bulk of that has come in the past five years. The company is now worth over $2 trillion, not far from Apple’s market cap.
Although, this size alone doesn’t tell us much. So, let’s compare Microsoft’s price relative to what the company earns…
Microsoft’s price-to-earnings (P/E) ratio has expanded by close to 400% in the past 10 years. It’s gone from below 10 to close to 40. New investors are willing to pay four times more for $1 of Microsoft’s earnings. Now, this valuation could make sense if earnings growth picks up even more in the next few years… but that’s very unlikely.
The P/E ratio is a favorite among many investors but to be honest, I’m not a big fan. Price is easy to determine… but the earnings side of the equation is easily manipulated. So, this makes it less reliable over time.
For a less manipulated valuation metric, let’s swap out earnings for topline sales. Here’s Microsoft’s price-to-sales (P/S) ratio over the past 10 years…
You can see a similar trend and valuation expansion. Investors buying Microsoft stock today are willing to pay over 300% more for every $1 in sales per share.
This is a steep valuation. Over the past few years, there’s been a lot of money sloshing around the markets. It’s helped keep interest rates low and push up valuations across the board. And I doubt this is a new normal.
The Fed – and other stimulus – has helped kick the can down the road… but my money is on mean reversion… just as we’ve seen time and time again for more than a century. Prices will likely drop, along with these valuations.
Microsoft Buybacks at a Premium
Microsoft is a mature business that’s generated more cash than it can reasonably reinvest. As a result, it’s been returning some of its earnings to investors via dividends and buybacks. And I’m a big fan of both.
Dividends put money in investors hands. They can then decide where to put it to work next. This pushes some taxes forward, which isn’t always ideal… but it can still make sense for stable businesses with big cashflows.
Buybacks, on the other hand, aren’t as straightforward. They only make sense when the company’s stock is undervalued. It’s the adage… buy low, sell high. And as you’ve seen, Microsoft is trading at a premium. This is true based on many other valuation metrics as well.
With that said, I should point out that the new share repurchase program has no expiration date. So, maybe they’ll wait to buy back shares when there’s a pullback. Although, the timing is tough to do well. Some internal incentives often lead to share buybacks at bad times.
There’s also the opportunity cost of keeping a boatload of cash on the books instead. But as mentioned, if the main goal is to reduce the low-earning cash position, increasing dividends would likely be a better route around its current valuation. Although, the dividend hike consistency and sustainability is important to consider as well.
Final Thoughts on Investing in Microsoft and Beyond
Overall, Microsoft is a solid company. But valuation-wise, I’m keeping my distance as an investor. Instead, I think there are better risk-to-reward opportunities. Alibaba for example is the newest addition to my portfolio. It’s also a tech giant and it’s down from where I bought it at… but I still like its potential over the next 10+ years.
You can check out why I bought Alibaba stock with that link.