Tag: MSFT

What’s a good earnings multiple?

The traditional financial metric has the P/E ratio being some amount over the risk-free rate.

For example, if the long-term government bond yield is 5%, then the equity valuation would be a premium over this, say 8%. The spread is the risk you take for an equity investment compared to a guaranteed payout on government debt.

The above example means you’d pay 1/8% = $12.50 for each dollar of cash flow, or also a price/earnings of 12.5.

This is a gross approximation, and does not take into a myriad of factors, especially future earnings growth/decline over time and the balance sheet condition (leverage distorts the above calculations).

As a most trivial example, Microsoft, which can be reasonably anticipated to be around for the indefinite future, is estimated to earn $10.66 in their fiscal year ended June 2023. If this extrapolates forever, at the current $300 share price, you are getting a 3.6% return, or 28 times earnings.

Considering the 30-year government bond is 2.7% at present, this is not much of a premium to take risk. Obviously there is some anticipation of earnings growth at Microsoft (at a minimum, one can expect them to be able to raise prices for inflation).

Either way, investors are accustomed to buying non-high flying companies at reasonable valuations, say 9 to 30 times earnings, depending on the perceived stability and earnings power of the company.

However, in the cyclical industries, the earnings factor over time is very volatile. Nothing exhibits this better than commodities.

Canfor (TSX: CFP) is a good example of this.

We take a look at their historical earnings, which is extremely choppy:

Just on the basis of historical earnings, if you took the past four quarters, Canfor, at $22.69, is trading at 1.87 times earnings, or a 53.6% earnings yield!

Of course, things are not that easy in commodity-land. There was an obvious windfall opportunity in lumber in the aftermath of Covid-19.

Despite that, analysts are projecting a 2023 earnings of $5.08/share, which is still 22%.

The issue is that this is a stale estimate. If raw lumber prices continue to drop, this estimate will surely drop, along with the share price. Indeed, the share price itself is a reasonable signal that this estimate is likely high.

The other factor is the duration of the earnings. Cyclical companies are, by definition, ones that go through boom-bust cycles as investment kicks in and supply starts to flood the market. The lumber market in this respect is a lot quicker than some other resources that require half a decade to open up infrastructure.

If this level of earnings is projected to last further in time, then the current price will rise. Conversely, if the earnings deflate quicker than expected, the share price will drop.

Either way, it is gut-wrenching to sell a company that seemingly is trading at such a low multiple. Sometimes, selling at a low single digit multiple is a correct decision!

However, unlike the much more stable Microsoft, an investor is rewarded much more for getting the earnings picture correct for a cyclical company – correctly projecting the future in an earnings-volatile environment is much more rewarded.

Does this mean that Canfor, at 2x or 4x or whatever, is a better investment than Microsoft because it is so seemingly ‘cheap’?

This brings me to the original question on the title of this post – what is a good earnings multiple?

The answer is there is none.

High flying growth companies will badly damage new shareholders

The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.

High expectations result in high stock prices.

I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):

We will look at Zoom first.

At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.

After Covid-mania, Zoom’s income trajectory did very well:

However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!

Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.

Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.

The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.

The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.

They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.

The issue here is two-fold.

One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.

Two is that the existing company doesn’t make that much money:

Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.

Now they are trading down to US$27 billion, but this is still very high.

There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.

This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.

As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.

As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.

The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).

That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.

Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.

The end of Microsoft

Anybody using Windows 8 should realize it is a disaster for Microsoft. Possibly even worse than Windows Vista. Just ask the question of whether you will be seeing corporate clients (the major money-makers for Microsoft) upgrading to the new operating system.

The whole corporate strategy of Microsoft after they crushed IBM’s competitor, OS/2, has been to put a ringed gate around all software users and make it as difficult as possible to port outside of Microsoft DOS/Windows as possible. This worked for the most part for about 20 years before mobile and internet platforms started to become prevalent and relevant. Now, Microsoft’s strategy is simply about salvaging what is left inside the ringed gate with their Office and Exchange Server suites, where they still have a decent amount of entrenchment.

A chart is fairly instructive in terms of what the market is sensing is the reception to the Windows 8 launch:

Realize that institutional investors have much more powerful access to various data (e.g. channel sales data) than the everyday joe retail investor and you can easily see they have been betting significantly against Windows 8 being a material impact on Microsoft’s bottom line.

In terms of valuation, while Microsoft is more attractive than purchasing long term government debt, all of the growth should be discounted from the company’s valuation and instead a financial salvaging model should be applied to the company’s equity – eventually their domination of the office and exchange server market is going to erode to the point where they will completely lose pricing power.

I am not even going to get into the topic of their totally failed mobile phone market strategy, which has been even more of a disaster than Windows 8.

It is also not surprising as well to see the associated corporations, Dell and Intel being equivalent hammered by the marketplace.

All three companies will survive, but they are going to be shadows of the titans they used to be. I will give a bit of an exception for Intel, whom seem to somewhat still have their competitive act still together.

Microsoft vs. Google

I’m not interested in investing in large cap companies, but they are interesting to look at a superficial level. Sometimes this superficial analysis gets me very close to actually purchasing large cap companies (e.g. I thought Starbucks was a good purchase around $12/share back in late 2008/early 2009 when it was going through its coffee crisis during the economic crisis – I never did purchase them simply because there were so many other alluring securities trading at dirt cheap prices at this time).

Getting back to the original topic, looking at trailing 12 month P/Es (after subtracting net cash balances of both companies), Microsoft is at 12.1 and Google is at 15.9. So Microsoft is about a quarter cheaper than Google, just based on past earnings values.

Intuitively, Google looks like a much cheaper investment than Microsoft when you plug the question into your mind “Which company will be more relevant five years from now?”, or you can also use the more direct variant “Which company will grow its earnings more in five years from now?”. Both companies are in the revenue range ($74 billion for Microsoft and $43 billion for Google) where the law of large numbers is evoked – long gone are the days of 40% growth.

This is a fairly elementary analysis, but a hypothetical decision to invest a dollar in Google vs. a dollar in Microsoft is an easy decision. Google is probably the better medium term play.

However, I wouldn’t discount Microsoft’s chances too heavily – when I look at my own computing habits, I still see myself using a Microsoft operating system most of the time, and also Microsoft Office.

On this note of stickiness, as long as Yahoo doesn’t screw up their finance portal by adding in features which are utterly useless (e.g. how their news services are not filterable by content provider), I still find it to be my main “standby” webpage for just getting quick metrics on companies. I don’t know how they were able to be so sticky, but they way they present public information is a touch better than the others, including Google. If it wasn’t for Yahoo Finance, I’d find them to be completely useless.

Kevin Graham on Microsoft

Kevin Graham writes about why he is long on Microsoft (Nasdaq: MSFT) despite quoting reviewers’ ominous warnings about the usability of the new Windows 8 interface.

Certainly from historical financial measures, Microsoft is a cash machine and he does illustrate this.

Does anybody remember the release of Office 2007, with its new ribbon interface? Here is a reminder:

Almost everybody that I talk to said that this new interface required many, many painful hours of re-learning to find out where the functional equivalents were in the older pull-down menus from Office XP and before. It is one reason why I still run Office XP today – I find that the ribbon makes it about three times as difficult to remember where the function is that you are looking for and memory retention is significantly worse.

Windows 8 is going to be a similar analogy to the difference between Office 2003 to 2007. It is throwing away a lot of the “intuition” people have built up using the Windows interface, which will result in increased training time to acclimatize to the new operating system.

While the “Windows and Windows Live” division of Microsoft is responsible for about 40% of its profits, the office (business) division is just over 50%. Businesses have very little choice but to keep with office because of the fact that most staff you can hire will already know it (including the ribbon interface). Microsoft did not lose relevant business for the interface change, albeit, I do not think they were doing themselves any favours.

Windows 8 is probably going to be another incarnation of Windows Vista. With the “appletization” of computing being the new wave of software, the operating system is continuing to be less and less relevant. It is why you still have about a quarter of the population still using Windows XP, while Windows Vista users have gone below 1%. Basically people that had Vista went and upgraded to Windows 7 as soon as it was available, while those that have Windows XP machines are keeping them until they purchase new hardware with the newer version of Windows (and I am of that type – using my old and trusty Windows XP notebook that I purchased over 3 years ago).

This is the primary reason why Microsoft-centric hardware vendors like Dell (Nasdaq: DELL) are taking it in the chin.

This upgrade cycle – upgrading your software when you purchase a new computer system – is likely extending from an upgrade every two years to an upgrade every three, four, five or even more. The new features of the upgraded systems are becoming less and less relevant to actually getting work done and as a result, Microsoft’s business metrics should also slow down, albeit still gushing cash.

At a glance, if Microsoft gave out a $6 dividend tomorrow and promised not to blow money on stupid acquisitions (including their own stock, or buying out Yahoo), you still have a company that is generating roughly 15% of its value in cash a year, which is a fairly decent return when compared against the bond market. The remaining risk is how long companies and consumers will put up purchasing licenses of Windows and Office. Even if Windows 8 is a user interface disaster, I still don’t see people migrating from Office for a long time.

I do not see the stock itself, however, becoming a quick “double” or anything radical like that. If anything you will see some P/EV compression as the cash continues rolling into the bank account.