Microsoft (NASDAQ:MSFT) reported earnings on Oct. 23 and beat analysts’ expectations for both revenue and earnings per share. On the revenue front, Microsoft posted $33.06 billion well above the consensus estimate for $32.32 billion. In terms of earnings, the beat was just as impressive with Microsoft posting an EPS of $1.38. Analysts projected an EPS of $1.24.
Microsoft stock is up over 4.5% since the earnings announcement which was followed up by an even more bullish announcement. On Oct. 25, Microsoft announced that it won a $10 billion contract to provide cloud computing services for the Pentagon’s JEDI (Joint Enterprise Defense Infrastructure) system. The company beat out Amazon (NASDAQ:AMZN) in securing the bid.
Despite the positive report, I’ve seen differing opinions on whether MSFT stock is a buy. The supporters of the Microsoft stock is overvalued argument make a valid point. If the stock is overvalued, you are likely to miss out on a larger, long-term gain and there are, after all, other fish in the sea.
Is MSFT Stock Overvalued?
Caution, there will be math in this article: here is the math that shows Microsoft stock is overvalued. All data is from the market closing price on Oct. 29, 2019.
|MSFT Stock Price||PE Ratio||Dividend Yield|
Here are some additional data points:
- The historical market average price-earnings ratio is 15.
- Microsoft’s five-year average PE ratio is 34.53.
- Microsoft’s five-year average dividend yield is 2.11%
To calculate a valuation ratio, you can use several methods. One way is to divide the current PE ratio by the historical market average of 15. That gets you a valuation ratio of 1.80. Dividing that number by the current stock price produces a fair market value of $79.35 ($142.83/1.80 = $79.35). Yikes! That’s over 44% lower than the current MFST stock price.
But looked at another way, you can get a much different story. If you divide the current PE ratio by MSFT’s five-year average PE ratio provides a valuation ratio of 0.78. Dividing that number by the current MSFT stock price products a fair value of $183.11 ($142.83 /0.78 = $183.11).
Finally, you can calculate a valuation ratio by dividing the five-year average dividend yield by the current dividend yield. This produces a valuation ratio of 1.48. Dividing that number by the current MSFT stock price gives us a fair value of $96.50 ($142.83/1.48=$96.50).
The average of the three fair values comes out to $125.54. Trust me, it does. That would reflect over a 10% lower stock price than current levels.
However, if you looked at the stock price from just the day before, the same calculations would have shown the stock to be 21% overvalued. A day can make a difference.
Value Is in the Eyes of the Beholder
In Finding Nemo, a famous quote from Nemo’s traveling companion Dory was:
“Well, you can’t never let anything happen to him. Then nothing would ever happen to him.”
One of the problems with looking too closely at valuation is it can lead to analysis paralysis. Nemo had a legitimate reason to fear for his son Nemo’s safety. But he allowed that fear to paralyze him to a greater reality. Life is unpredictable. Sometimes fearing the possibility of negative consequences can lead us to not see opportunities for what they are.
The argument for not buying an overvalued stock is that it can potentially deliver a lower total return over time. It can also generate a lower dividend yield. So, income investors that were counting on quarterly dividends may find their income reduced from ideal levels.
Proponents of this theory will say that even if you intend to buy-and-hold a stock, you still should not pay more for a stock than its intrinsic value. What if you have to sell? Or what if the reasons you bought the stock no longer apply?
But if you avoid buying a stock because something bad may happen to it someday, you’ll never buy any stock. Ever. And that’s no way to invest.
Evaluate MSFT on Its Performance
Microsoft has a history of increasing revenue and earnings per share. They have made a slew of acquisitions that are positioning it for future growth. This includes a partnership with Nvidia (NASDAQ:NVDA) to provide greater integration between Microsoft’s Azure and Nvidia’s EGX Edge computer platform.
The bottom line for MSFT stock is that its products (Excel, Outlook, and Word) have a long runway. In fact, it is virtually impossible for most PCs to operate without Windows. Microsoft has products that are not commodities. They are not a brand name like Kleenex that is used by people who really mean facial tissue. They provide essential problems for which there are no substitutes.
That, in my opinion, is the value that really matters.
As of this writing, Chris Markoch did not have a position in any of the aforementioned securities.