You Have to Focus on Valuation Metrics in the Stock Market!

I love Apple’s products and what Apple has accomplished over the past few years.  However, it’s been en vogue lately to compare the performance of Apple stock to the performance of Microsoft stock in a way that is highly deceptive and not at all useful to a long-term investor.  Here is an actual quote I read from a news story today:

When Steve Jobs assumed the CEO position at Apple on July 9, 1997 Apple shares cost $3.42 and the company had a market cap of around $3 billion. This week Apple shares hit $266 with a market cap of $241 billion — 80 times larger than it was 13 years ago.  Microsoft shares, in contrast, went from $17.67 to $31 in the same time frame — not even a doubling despite more than $80 billion in share buy-backs by the company.

This line of thinking is demonstrative of the lack of understanding about basic financial concepts even among journalists.  The author didn’t consider the billions upon billions of dollars that were returned to Microsoft shareholders in the form of cash dividends.  Total return was completely ignored.  Even more egregiously, they ignore valuation metrics and offer no explanation as to the reason there was a performance differential.

Had the author paid attention to the latter, it would have been clear that 13 years ago, Microsoft reached $60.00 per share, which represented a price-to-earnings ratio of 85.71.  That was an earnings yield of 1.1%.  In other words, you could have put your money in the bank and earned 6.00% on certificates of deposit at the time with no risk, or taken a lot of risk an bought Microsoft for an earnings yield of 1.1%. Today, in contrast, Microsoft has a p/e ratio of 17.01 and an earnings yield of 5.88%.

Put another way: For every $1 in profit the company earned in 1999, the market rewarded Microsoft with $85.71 in stock price.  Today, the market is valuing the firm more rationally and giving only $17.01 in stock value for every $1 in earnings. If earnings had remained consistent, the stock would have fallen by 80%, wiping out investor’s wealth.  Instead, Microsoft continued to generate unfathomable quantities of cash from operating systems, software, server licensing fees, consulting, and video games.  The software company returned almost all of this profit to stockholders in the form of cash dividends and share buybacks.

Thus, the fact that the stock has doubled, plus shareholders have received several dollars in dividends per share, over the past 13 years is a remarkable accomplishment given the completely unjustifiable and irrational valuation applied to the stock in the past.  It is far more than owners of Microsoft shares deserved given the deranged valuation awarded to their equity at the tail-end of the dot-com bubble.

I may be an Apple fan boy, but saying that Apple “beat” Microsoft is like saying the child who is a recovering heroin addict “beat” the child who is a successful Harvard-educated brain surgeon because the trajectory of the drug-addict’s life, now that he or she had achieved sobriety, was improving faster than the trajectory of the doctor’s life.  You cannot really compare the two businesses on stock price.  You can judge management on underlying operating performance.  Microsoft was priced to perfection 13 years ago.

I should point out, though, that the source article itself was an excellent analysis of the challenges faced by Microsoft.  It is definitely worth reading.

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  • Andrew

    Thank you for sharing your insight. Before reading your blog I was always somewhat flustered by stocks, as if they were an abstract cloud I could never comprehend. Now it makes much more sense to realize you are buying a real business, for real profits and profit potential, and it becomes much easier to understand these concepts.