Microsoft (MSFT) is getting pummeled today, its stock down almost 10% on earnings that missed expectations by almost five percent. Microsoft missed its revenue expectations as well, reporting $16.63 billion versus $17.08 billion. Also, the company announced that it will cut about 5,000 jobs over the next 18 months, which is better than reports of 15,000 rumored earlier in the week. The company plans to reduce operating costs by $1.5 billion through this and other cost cutting measures. Furthermore, and possibly more distressing, Microsoft management neglected to issue any guidance going forward because of market uncertainty, which has become fairly common in the current economic environment. Being a value-minded research shop with a methodology rooted in Ben Graham’s investment analysis, we believe that Microsoft is a perfect example of a stock that meets Graham’s criteria for purchase.
Before we begin, critics will be quick to point out that value-investing methodologies have been crushed in this bear market; but, it is also important to realize that a strict adherent to Graham’s value methodology would have been out of the market long before it was breaking new highs in 2007. Ben Graham-style investors would not have touched stocks at those valuation levels. However, now many stocks have fallen into a deep value margin of safety that Ben Graham would have salivated over.
Back to Microsoft, the stock set a new 52-week low today at $17.07 before the broad market began to recover. MSFT has not been this cheap in 12 years, adjusted for splits. However, Graham was careful not to recommend buying stocks just because of a low price tag; there is often a reason why a stock trades at depressed levels. The key to Graham’s investment methodology is to have a good idea of each stock’s intrinsic value, then find those that are trading well below that level. In Graham’s terminology this was a “margin of safety”. If one can find a stock selling significantly below its intrinsic value, the downside risk of the investment is reduced. Of course, the trick is establishing intrinsic value, which is a highly subjective exercise. First, first we will show Microsoft based on some of Graham’s own classic value screens, and then we will point out Ockham’s Graham-inspired valuation metrics.
First, Graham advised that value investors should never purchase a company with an earnings yield under 10% and that earnings yield should be at least twice the bond yield for long-term corporate bonds. Earnings yield is the inverse of the more commonly expressed price-earnings ratio. Microsoft reported earnings of $.47 cents this quarter, which brings its trailing twelve month earnings to $1.87 per share. As of the close of trading MSFT was $17.11, which brings its earnings yield to 10.9% ($1.87/$17.11). By comparison, AAA rated corporate bonds currently yield 4.89% for ten year maturities and 6.15% for twenty year maturities. Clearly, the 10-year bond yield fits this screen but the 20-year does not.
To screen out companies that are over-leveraged, Graham used two key techniques. First, he wanted to make sure that a company’s total assets over total shareholder equity was no more than two. Currently, Microsoft’s ratio is 1.91. Similarly, Graham liked to see the ratio of long-term debt over total equity to be less than one; MSFT’s current ratio is .22. Thus, by Graham’s time-tested and conservative assessment methods, MSFT’s debt level is not a concern.
Earnings growth for Microsoft would have passed Graham’s minimum growth threshold of greater than 3% over the last 5 years. Earnings five years ago were $.92 per share and have more than doubled to the trailing twelve month EPS of $1.87, which represents a compound annual growth rate of better than 15%. Dividend growth also stands up to Graham’s screen; he wanted to see dividend growth of at least five year’s duration. Five years ago Microsoft did not pay a dividend but since that time the company first instituted, then has consistently raised its dividend until MSFT currently yields nearly three percent.
To be fair, there are a few key Graham metrics in which Microsoft falls short. The current ratio is not more than two, which was a screen for Graham recommendations. Secondly, MSFT also fails Graham’s Net Current Asset Value (NCAV) screen. For more information on the NCAV screen, check this description.
Now to apply the Ockham methodology overlay. We study the way that the market has treated each stock based on two of Graham’s favorite ratios: price-to-sales and price-to-cash. Microsoft’s price-to-cash over the last ten years has historically ranged between 14.8x and 21.1x; the current ratio is 7.9x which is almost half of the low end of the normal range. Price-to-sales tells a similar undervalued story; this stock has normally traded between 4.7x and 6.8x with the current ratio at 2.7x. Now, we are not saying that this will happen in short order, but for the stock to return to more historically-normal price-to-cash and price-to-sales multiples, the price of MSFT would have to be in the low thirties.
Value-investing is not about figuring out where a stock’s true value is but rather is about finding stocks that are out of favor with the market to such a degree that their downside risk is minimal when compared to upside potential. We rate Microsoft as Greatly Undervalued, and we think that Ben Graham would place the company near the top of his buy list as well. MSFT is not perfect by any means, but it is still the leader industry of a very profitable and crucial industry. Its disappointing quarter brings the stock into a price range that should make value investors at least curious.