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Should We Buy Microsoft Stock?
A bunch of us attending the Stampede conference sat
around talking about whether Microsoft stock would be a good investment
right now. Here is a brief summary of our discussions:
On Friday, September 20, the 2002 Microsoft Stampede
Conference concluded and Microsoft stock's price closed at $47.46 with a P/E
ratio of 33.48. Microsoft's PE ratio has climbed as high as 70 in recent
years, but this is nothing compared to the ridiculous P/E ratio levels
achieved by Yahoo! which have exceeded 2000. Based on Microsoft's P/E ratio
of 33 and the outlook for technology industry to recover, Microsoft's
entrance into many diverse markets, Microsoft's reorganization into 7
different business units, etc, I think that Microsoft's stock is a fairly
good investment right now. What do you think?
In case you do not understand P/E ratios, this
example may help:
Let us a assume that I own a company that generates
$1,000 a year in profit. To make it simple, let us further say that this
company has absolutely no expenses, each year the company simply receives
a royalty check to $1,000 - and that's it. Let us further assume that this
royalty check is based on a contract with a larger company and that I am
100% certain that I will continue to receive this $1,000 royalty check
each year. In this case, if I wanted to sell my company, how much would
you be willing to pay me? Obviously any reasonable person would pay
$1,000, after all they would receive their $1,000 back within a year and
the remaining payments would be all profit. However, would you be willing
to pay me $12,000 for this company? How about $20,000? Once again, most
reasonable investors would be willing to pay even $12,000 to $20,000 for
the right to receive $1,000 per year forever.
In each of these cases, let us compute the P/E ratio.
Assuming the company is worth just $1,000 and the earnings are $1,000 per
year, then the P/E ratio would be 1. ($1,000/$1,000). Assuming the company
is worth $12,000 and the earnings are $1,000 per year, then the P/E ratio
would be 12. ($12,000/$1,000). Assuming the company is worth $20,000 and
the earnings are $1,000 per year, then the P/E ratio would be 20.
($20,000/$1,000). In other words, the P/E ratio represents the number of
years it takes to get your money back, before the next penny is profit.
Therefore when we see that Microsoft's P/E ratio is 33.48, you must ask
yourself, are you really willing to pay a price so high that it would take
33.48 years for you to get your initial investment back? Given profits
that were not expected to rise or fall, most conservative investors draw
the line at a P/E ratio of 12 to 20. In these cases, they would be
accepting a return on their investment of 5% to 8.3% - which has been a
fairly reasonable return historically speaking. (100% / 12 = 8.3% & 100% /
20 = 5%).
However this discussion does not go far enough. The
reality is that Microsoft's profits are not fixed like the annual profits
in our example. The reality is that Microsoft's profits will either rise
or fall. If the profits were certain to rise, then a reasonable investor
should be willing to accept a higher P/E ratio than 12 to 20. For example,
let us assume that the annual royalties of our hypothetical company are
expected to increase to $5,000 per year 3 years into the future. In this
case you might be willing to pay closer to $60,000 for the company. While
this would represent a P/E ratio of 60 today, it will represent a P/E
ratio of just 20 3 years from today. In other words, no reasonable
conservative investor would ever be willing to pay a price for a company
(or stock which represents part ownership in a company) that would produce
a P/E ratio greater than 20 (or so), unless they thought that the profits
would rise. If that same reasonable investor thought that profits might
double, then a P/E ratio of 40 (or so) should be their limit, and so on.
In my opinion, we are living in depressed times -
particularly pertaining to the technology market. However, I think that part
of this depression is attributed to hysteria surrounding the Y2K bug which
accelerated spending on technology in 1998 - 1999, thus creating an
artificial change in the buying behavior pattern of the business community.
I think that ultimately, businesses across the world will return to normal
buying patterns, and that investments in technology will increase to normal
levels. Therefore I think that Microsoft's profitability will increase over
the next couple of years. Further I see Microsoft diversifying in many new
directions - making the company more stable and less prone to declines in
any one market segment. I think that Microsoft's stock is presently a good
value and I predict that Microsoft's stock price will grow to $57 to $64.00
by the end of 2003, and $80 to $94.00 by the end of 2004.
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