Microsoft Important Lessons in Valuation: Part 1

2019-08-06

Introduction

Before I get too deep into this article, I want to start out by stating that Microsoft (MSFT) has long been one of my favorite companies.  Many years ago, I invested in Microsoft as a pure growth stock and sold it in 2000 when it became dangerous overvalued after making a very healthy long-term profit.  However, I did stay out of Microsoft until October 2011 when I then invested in it as a high-quality dividend growth stock.

Thereafter, I held the stock until January 30, 2017 where I once again sold it based on what I considered dangerous overvaluation.  Admittedly, I did leave a lot of capital gain on the table since 2017.  However, I averaged over 20% a year – including dividends – and achieved those results at what I perceived to be very low risk.  Frankly, I never regret, nor do I apologize for earning a 20% annualized rate of return over a five-year period.

This is the fourth article that I have presented on Microsoft.  My first article was written on September 26, 2010 and it was titled “After A Lost Decade, Is Microsoft A Buy?”  The comments I received on that article were quite negative regarding Microsoft, and consequently not real flattering to yours truly.

However, this was an interesting time because Microsoft grew earnings from fiscal year June 2000 to fiscal year end June 2010 at a rate exceeding 11% per annum.  Microsoft also initiated a dividend in 2003 and grew that dividend at an average growth rate of 36% from 2003 through 2011.  This was rather remarkable operating performance.  Nevertheless, in 2010 investors were sour on the company because Microsoft had only generated a total annualized rate of return of 1.4% over that timeframe which was referred to as the lost decade.

Of course, the logical question would be how investment results could be so lousy, while operating performance and dividend growth were so spectacular.  As a regular reader of my work, if you had not already guessed, the answer is simple and straightforward.  In 2000 and 2001 the market was valuing Microsoft shares at dangerous overvaluation levels.  Consequently, even though the company did well, great even, investors fared rather poorly.  Clearly, valuation matters, and it matters a lot.  Later in the following analyze out loud video I will clearly illustrate and elaborate on this.

My second Microsoft article was published on November 16, 2012 titled “Microsoft Has Been A Better Business Than It Has A Stock, But That Is About To Change.”  Once again, I received mostly negative comments suggesting that Microsoft was a dog, and valuation (undervaluation at the time) was in the eyes of the beholder, and as one comment put it “not on the balance sheet.”  What I want the reader to recognize is that from my first article in 2010 to my second article in 2012, Microsoft was trading at a normal P/E ratio of approximately 10.  The stock was undervalued on both occasions, but people hated it regardless.

Then on July 20, 2018 I published my third article on Microsoft warning investors that the stock had now become excessively valued.  This article was titled “Long-Term Microsoft Shareholders: Your Money May Be in Jeopardy.”  Once again, I was severely chastised for suggesting that Microsoft – now the superstar -was overvalued.  This criticism has continued to this day, because the stock is up approximately 34% since I published that third article warning about overvaluation.

However, I want to take this opportunity to point out that the time that has passed from my third article has not yet reached long-term status yet.  On the other hand, the time that has passed from my initial two articles have clearly passed the definition of long-term.  I feel this is important because I only present long-term ideas.  I have suggested many times in the past that neither I nor anyone else can time the market over the short run. 

Furthermore, even though my first two articles have reached long-term status, and the results have been excellent, it took my first article more than two years (which still qualifies as short term) to see any meaningful profit had you invested in Microsoft after I wrote the article.

The reason I present this is neither to brag nor to defend my past work.  My reason for bringing this up today is to attempt to illustrate just how important valuation truly is to long-term investor returns.  Ironically, in all three previous cases I was told in comments on both articles that valuation was in the eyes of the beholder.  In contrast, my stance has been, and remains today, that valuation is a mathematical principle and should never be ignored or overlooked by shareholders.  Valuation does not always have an immediate impact, but in my personal experience spanning five decades, valuation will always have a significant long-term impact – either good or bad – depending on whether valuation is low or high initially.

Microsoft Important Lessons in Valuation: Analyze Out Loud Video

The meat, and I daresay the heart and soul of this article will be presented in this video.  Consequently, I encourage the reader to please take the time to watch the video carefully, and with an open mind.  This company, Microsoft, is a very interesting case study because it teaches us very important lessons on valuation. I believe these lessons are critically important for investors to recognize and understand if they expect to be successful investing in common stocks over the long run.  Therefore, in the video, I will be evaluating Microsoft utilizing several widely-utilized and commonly-accepted valuation methodologies.

So, with all due respect, if you don’t carefully watch this video, then I would ask that you don’t bother to comment on this article.  Moreover, to soften my stance a little, I believe you will also find the video illuminating and fascinating.

Summary and Conclusions

Valuation is first and foremost a measurement of long-term risk.  Valuation is not a short-term market timing tool.  Intelligent investors understand that in the short run the market is a “voting machine” and as such likely to price stocks at ludicrous levels.  However, in the long run the market is a “weighing machine” where fundamentals inevitably rule the day.  Consequently, investors are very wise, and will be well rewarded in the long run by paying attention to fundamentals whether they are buying, holding or deciding to sell their common stock holdings.

Finally, valuation is not in the eyes of the beholder as some people believe.  Instead, valuation is a function of properly discounting money flows (earnings and/or cash flows) back to the present value.  In this regard, valuation is based on sound mathematical principles of business, economics and accounting.  In Part 2 of this miniseries I will elaborate on the mathematics underpinning valuation.

Disclosure:  No position.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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