High-level employees in a company called "insiders" are the most connected to the business, so it often grabs investors' attention when they buy or sell stock.
Insiders buy and sell for many reasons, but large transactions like Microsoft (MSFT +2.11%) CEO Satya Nadella selling 840,000 shares, more than half of his entire stake in the company, is noteworthy. Microsoft is one of the largest companies on earth, but investors may want to use this stock sale as a reason to be cautious. Here's why.
Microsoft has become a "safety net"
While the broader stock market indexes have hovered near all-time highs for much of 2021, there has been a struggle beneath the surface; small- and mid-cap growth stocks, for example, have corrected recently.
Some individual growth stocks are currently more than 50% off of highs seen early in the year. Meanwhile, Microsoft has continued to outperform and is up about 50% over the past 12 months.
It appears that investors have retreated from a lot of smaller, more volatile companies in favor of larger, more established stocks like Microsoft. The company can certainly provide stability for investors; it's one of the few "trillion-dollar stocks," and the underlying business is very healthy. Microsoft could generate nearly $197 billion in revenue this year and is highly profitable.
The valuation has become inflated
But as more investors crave stability in larger, more established stocks like Microsoft, the valuation of these companies begins to creep higher, too. Over the past decade, Microsoft has traded at an average price-to-earnings (P/E) ratio between 25 and 26.
Image source: Getty Images.
If we look at analyst estimates for 2021, the company could earn approximately $9.20 per share. The resulting P/E ratio of 35 is 37% higher than Microsoft's historical average.
I don't pretend to be able to predict when stocks will go up or down, but I think of valuation like gravity. The higher a stock's value departs from its "norm," the stronger the forces pulling it back. If we consider what the stock has historically traded at, does it seem more likely to continue trading beyond its norms, or will it begin heading back closer to its average? In other words, with the stock dramatically higher than its historical P/E ratio, there could be more downside potential than continued upside.
It might be difficult for Microsoft to justify its valuation
Perhaps the business could justify a higher valuation with accelerated growth or something that would encourage investors to continue paying more for shares. But in Microsoft's case, it could be hard to find that reason.
The company has grown its earnings per share (EPS) at an average of 11.5% each year for the past decade. Analyst estimates call for 12% EPS growth on average over the next three to five years. It doesn't seem that a slight uptick in growth would make up for a 30%-plus premium on valuation.
Additionally, Microsoft is a much larger company now than a decade ago. As revenues keep growing, it can become increasingly harder to grow because it tends to be easier to grow from a smaller base. For example, a stock will typically have an easier time growing from $1 billion to $10 billion in value than from $10 billion to $100 billion; this is often called the "Law of Large Numbers."
Proceed with caution
Forbes reported on the stock sale, and Microsoft gave them a statement saying that, "Satya sold approximately 840,000 shares of his holdings of Microsoft stock for personal financial planning and diversification reasons."
It's worth noting that Nadella resides in the state of Washington, which will be imposing a new 7% tax on long-term capital gains, effective the first of the year. This could have had something to do with the number of shares that Nadella sold.
There is nothing wrong with Nadella selling any or all of his holdings, and these are personal decisions that everyone makes for themselves. But as investors, the news of the sale can be a reminder that Microsoft's stock is expensive, and that the company may be getting too large to overcome such a high valuation.
