Numbers can lie -- but they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
- The current price multiples
- The consistency of past earnings and cash flow
- How much growth we can expect
Let's see what those numbers can tell us about how cheap Microsoft
The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.
Then, we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Microsoft has a P/E ratio of 11.1 and an EV/FCF ratio of 8.1 over the trailing 12 months. If we stretch back and compare current valuations to the five-year averages for earnings and free cash flow, Microsoft has a P/E ratio of 13.4 and a 5-year EV/FCF ratio of 10.5. For both metrics, we'd like to see a one-year ratio of less than 10; for a five-year ratio, we're shooting for less than 20.
A one-year ratio under 10 for both metrics is ideal. For a 5-year metric, under 20 is ideal.
Microsoft has a mixed performance in hitting the ideal targets (for 1-year P/E, 1-year EV/FCF, 5-year P/E, and 5-year EV/FCF), but let's see how it compares against some competitors and industry mates.
To make comparison to some competitors a little bit easier, let's average Microsoft's P/E and EV/FCF ratios.
|
Company |
Average 1-Year Multiples |
Average 5-Year Multiples |
|---|---|---|
|
Microsoft |
9.6 |
12.0 |
|
Apple |
16.1 |
32.4 |
|
International Business Machines |
11.0 |
13.3 |
|
Google |
16.2 |
28.3 |
|
Average of Peers |
14.4 |
24.7 |
Source: Capital IQ, a division of Standard & Poor's.
Microsoft looks cheap on both a 1-year and 5-year basis relative to its peers.
Numerically, we've seen how cheap Microsoft is on both an absolute and relative basis. Next, let's examine...
The consistency of past earnings and cash flow
An ideal company will be steady (and growing) in its earnings and cash flow generation.
In the past five years, Microsoft's net income margin has ranged from 24.9% to 30%. In that same time frame, unlevered free cash flow margin has ranged from 27.3% to 35.5%.
How do those figures compare with those of the company's peers? See for yourself:
Source: Capital IQ, a division of Standard & Poor's; margin ranges are combined.
Additionally, over the last five years, Microsoft has tallied up five years of positive earnings and five years of positive free cash flow.
Next, let's figure out...
How much growth we can expect
Five-year analyst growth estimates tend to be comically overstated. If you accept them at face value, you will overpay for stocks. But while you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful ballpark estimate when compared to similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. In that time period, Microsoft has put up past growth rates of 13.3%. Meanwhile, Wall Street's analysts expect future growth rates of 11.8%.
Here's how Microsoft compares it its peers for trailing five-year growth:
Source: Capital IQ, a divison of Standard & Poor's; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: Capital IQ, a division of Standard & Poor's; EPS growth shown.
The bottom line
The pile of numbers we've plowed through has shown us how cheap shares of Microsoft are trading, how consistent its performance has been, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at its 11.1 P/E ratio. Still, the numbers are just a start.
If you find Microsoft's numbers compelling, continue your due diligence via earnings releases, 10-K's, company websites, Motley Fool CAPS, and more. You can also come back to Fool.com to see the analysis we're doing each day.
When you're finally confident that the numbers aren't lying to you, you'll be ready to make your own buy, sell, or hold call.
