FOOL ON THE HILL
An Investment Opinion
(A little pause here to let everyone who doesn't consider valuation important to laugh, chuckle, and snort because I've let such a "useless" criteria keep me out of such a great company.)
When a couple of people started asking me about the company after its stock price started falling, I said that the stock would need to fall below $60 -- a current year Price/Earnings ratio of about 35x -- before getting my attention.
Last Friday, the stock fell down to $60 3/8, getting close to my arbitrary price threshold. I decided that it was high time to take a look at the company. Would the recent loss of over $300 billion in market capitalization whet my value-oriented heart? My current decision surprised me. I was expecting to conclude this article being prepared to buy my first Microsoft shares. Instead, I've decided to hold off unless the stock price drops significantly further.
Why am I staying away from Microsoft? The issue is still valuation. Despite being knocked down significantly, I still don't feel comfortable paying the current market price for the company. While the P/E ratio based on current-year analyst estimates of $1.77 per share is now in the high 30s, the company's P/E ratio on operating earnings is actually higher.
Adjusted Operating Earnings
From an analytical perspective, I like to break operating earnings out from investment gains and interest income to get a picture of what a company's core business is earning. Ancillary income can then be accounted for separately at its current value rather than a multiple of earnings.
Over the past 12 months, Microsoft reported after-tax operating earnings of $7.4 billion, 19% less than the $9.2 billion reported net income (the difference being investment income). Assuming that ratio will continue this year, operating net income for calendar 2000 will be $1.43 per share [$1.77 * (1- 0.19)]. This operating figure is based on reported earnings. Unfortunately, that number isn't entirely accurate since it doesn't incorporate the impact of employee stock option grants on net income (as is true for the income statements of most companies).
To get a more accurate picture of the impact of option grants, I use the methodology that is disclosed in the footnotes of 10-Ks (known technically as SFAS 123). Normally this information is only available after a company files its annual report with the SEC and inter-period results have to be estimated. Fortunately for us, however, Microsoft goes well beyond required disclosure to post this information on its website each quarter (click on earnings, the desired quarter, and then the financial highlights section).
Incorporating option expense, Microsoft would have seen after-tax operating earnings over the past 12 months nicked by nearly $1 billion to $6.5 billion. This number falls 13% shy of the $7.4 billion after-tax operating income mentioned above and a full 30% below the reported net income of $9.2 billion. Assuming once again that these ratios hold constant over the current year, that would put after-tax operating earnings for calendar 2000 at $1.24 per share.
Cash and Investment Portfolio
When calculating operating earnings, I excluded income from Microsoft's $21.2 billion cash horde and $21.3 billion investment portfolio. Obviously, these are important assets of the company that need to be taken into consideration. The $21.2 billion cash balance is worth, oh, about $21.2 billion. Some people may ascribe a premium to this cash balance since it opens up lots of opportunities with partners who want to tap into this stash, but I am leery of valuing $1 in cash at more than $1.
On to the last piece of the puzzle -- Microsoft's investment portfolio. We don't have to worry about the portfolio segment that is marked to market prices every quarter-end, since that value is pretty obvious. We do, however, need to try to figure out the worth of the portfolio that is accounted for at cost (since the value could have changed substantially from the time the investment was made).
Last June is the latest period for which semi-detailed information is available. At that point, 73% of the investment portfolio was accounted for at market prices with the remainder accounted for at original cost. I'll assume these ratios are still valid, although it is likely that the "marked to market" portfolio is a higher percentage given the strong market results over the past year.
With a $21.3 billion investment portfolio, that allocation would imply $15.6 billion valued at market and $4.7 billion at original cost. As of last June, the true market value of the securities held at cost was estimated by Microsoft to be 59% greater than their holding cost. Given the stock price runup of many tech firms, I don't mind (generously) assuming that the cost-basis portion of Microsoft's investment portfolio is now worth 150% more than original cost. That implies a current market value of $11.8 billion on an original investment of $4.7 billion. Tallying up everything as described, the cash and investment portfolio is worth $48.6 billion ($21.2+$15.6+$11.8), or $8.79 per share.
And the P/E on adjusted operating earnings is ...
To figure out how much we're paying for Microsoft's operating earnings, we need to subtract the cash and investment portfolio from the company's stock price. From that number, we can then calculate the current year earnings multiple. Taking $8.79 away from Wednesday's $62 9/16 closing price leaves a value of $53.77 for Microsoft's operating earnings. That gives a current year price/earnings ratio of 43x adjusted after-tax operating earnings.
Some people may not scoff at such a number, but it looks awfully high to me when operating earnings for the company will probably grow at no higher than 15%-20% over the next few years. I prefer putting my money into companies like dominant consumer products company Proctor & Gamble (NYSE: PG) or worldwide fast food leader Tricon Global Restaurants (NYSE: YUM), which are expected to grow earnings 10%-15% a year and are trading for less than 25x and 15x earnings, respectively.
Knowing that I'm hesitant to "pay up" for quality in hot companies, people often ask give me to choose the best company out of a given list. A sample question might be, "If you had to choose one of the following four dominant companies, which would it be: Microsoft, Cisco (Nasdaq: CSCO), General Electric (NYSE: GE), or America Online (NYSE: AOL)? Given only this list of investing options, my choice right now would be Microsoft, as it seems to offer the most attractive combination of valuation and growth opportunities.
The problem with this question, however, is that it leaves out important options that we all have as individual investors: all the other companies in the world, fixed income securities, and the choice to hold off until a truly compelling opportunity is found. This latter option is the individual investor's second-best friend (behind numero uno, compounding).
As Warren Buffett says, there are no called strikes in investing. Despite seeing an investment with lots of great characteristics, you don't have to swing at any of them unless you want to. As long as you can withstand a self-inflicted psychological flogging when you're wrong ("oh, if only I picked up Wal-Mart in 1985 after it opened in my town"), you can pass on as many investments you want without consequence. This attribute of investing provides individuals with tremendous flexibility to pick only the most succulent investing fruit.