Numbers can lie -- yet 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 expensive or 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, which 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). As with 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 11.5 and an EV/FCF ratio of 8.0 over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that Microsoft has a P/E ratio of 14.2 and a five-year EV/FCF ratio of 10.4.
A positive one-year ratio of less than 10 for both metrics is ideal (at least in my opinion). For a five-year metric, less than 20 is ideal.
Microsoft has a mixed performance in hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates.
Source: S&P Capital IQ; NM = not meaningful because of losses.
Numerically, we've seen how Microsoft's valuation rates on both an absolute and relative basis. Next, let's examine ...
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.
In the past five years, Microsoft's net income margin has ranged from 25.9% to 32%. In that same time frame, unlevered free cash flow margin has ranged from 26% to 38.1%.
How do those figures compare with those of the company's peers? See for yourself:
Source: S&P Capital IQ; margin ranges are combined.
In addition, over the past 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
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with 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 EPS growth rates of 14.5%. Meanwhile, Wall Street's analysts expect future growth rates of 9.4%.
Here's how Microsoft compares with its peers for trailing-five-year growth:
Source: S&P Capital IQ; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: S&P Capital IQ; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of Microsoft are trading at, the volatility of its operational performance, 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 an 11.5 P/E ratio, and we see cheap price multiples all around for Microsoft.
Beyond price, what's impressive is Microsoft's amazing margin range and its positive earnings growth over the past five years.
As another data point, our CAPS community rates Microsoft three stars (out of five).
I continue to hold shares and think Microsoft is worth looking into, but all this is just a start. If you find Microsoft's numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident one way or the other. As a start, add it to My Watchlist to find all of our Foolish analysis.
In our brand-new free report, "The Stocks Only the Smartest Investors Are Buying," I wrote about a stock that's flying under the radar. I invite you to take a free copy to find out the name of the company I believe Warren Buffett would be interested in if he could still invest in small companies.
Anand Chokkavelu owns shares of Apple and Microsoft, but he holds no other position in any company mentioned. The Motley Fool owns shares of IBM, Microsoft, Apple, and Google. Motley Fool newsletter services have recommended buying shares of Google, Apple, and Microsoft and creating bull call spread positions in Apple and Microsoft. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.