Microsoft Stock Valuation Comparison to Baseball

Over the past few years, investors have driven the prices of some stocks to historic valuations. Many of these investors speculate on price and have little appreciation of the underlying fundamentals.

The historical valuation of Microsoft stock in the late 1990s can teach us valuable lessons about the difference between speculating and adhering to a fundamental framework.

Today we see Tesla (TSLA) shareholders, for example, believing they are entering the rookie year of the next 18-year-old Hank Aaron. Given what they see as a massive upside, they have little concern about today’s prices or valuations.

For investors blind to valuations and playing the hot hand, we wish you good luck. But, for the rest of you, we’re looking back at a young Microsoft (MSFT), the Babe Ruth of the stock market. Microsoft’s stock valuation in the late 1990s can teach us a valuable lesson about managing money in times of extreme valuations.

People who run ball clubs think in terms of buying players. Your goal is not to buy players. Your objective is to buy gains– Silver Ball

Microsoft

Bill Gates and Paul Allen founded Microsoft in a garage over 45 years ago. In 1987, the stock went public, eventually making its initial investors rich. A $1,000 investment in MSFT in 1987 is now worth over $1.5 million. Today, MSFT has a market capitalization of $2.2 trillion, making it the second largest US company.

Dreams of such huge returns lead many professionals to advocate a buy-and-hold mindset on certain stocks. Anyone who has owned MSFT for the past 35 years is brilliant. That said, a valuation-focused approach could have greatly improved their results.

Most of us don’t have the time and courage to hold a stock for decades. Plus, it’s all too easy to succumb to the temptation to take profits rather than let a stock reach its full potential. Anyway, even if we have the time, the courage and we will not give in to temptation, choosing the next MSFT, Apple or Amazon is extremely difficult.

Given the difficulties in finding and keeping the next Micky Mantle, we prefer to consider valuations to guide us. As we will show, a valuation-focused approach taken with Microsoft stocks would earn an early stage investor even greater returns than the 150,000% their stock has earned over the past 35 years.

Exponential growth

MSFT’s revenue has grown more than 40,000% since 1987, but its revenue growth rate has been declining for most of the past 30 years. This is not the fault of the management of MSFT. Almost all companies find that revenue growth declines over time for two reasons. First, desirable products tend to saturate the market, leaving fewer buyers in the future. Second, new entrants see the popularity of the product, its potential benefits, and come to market with competing products.

MSFT has a rare edge in limited competition for its core Office product. Even better, its customers are dependent on its software and must buy updates regularly.

Despite its unique advantages, MSFT’s revenue growth rate has steadily dropped despite the growing popularity of its core product. Its growth has accelerated in recent years thanks to cloud computing and games. Given the competitiveness of these efforts, we expect growth to weaken again.

Any investor who accurately predicted Microsoft’s tremendous growth was probably blindsided by how big MSFT could grow. So while the narrative of the late 1980s was compelling, the opportunities to profit from his actions fluctuated over the next forty years.

In January 1993, Microsoft stock was trading at an allocation-adjusted price of $1.73 with a price-to-earnings (P/B) valuation of 10. Despite marginal earnings growth, strong revenue growth indicated that MSFT could increase its profits in the future. Over time, that’s what happened. From 1992 to 1997, the growth of their earnings per share was nominal despite a growth in income multiplied by 5 over the period. Over the next five years, earnings per share caught up, rising 2.5 times despite a recession.

An expensive Ty Cobb

We can think of a baseball team as a portfolio of players. Given salary cap constraints, teams are limited in how much they can spend on salaries. The risk they face is paying too much for one player and not leaving enough for the rest of the team. This is often the recipe for a mediocre record.

Wealth management is similar in that we also have a limited amount of money to allocate. Although companies like MSFT may seem like good buys, we must always consider the opportunity cost. If we overpay and over-allocate for a stock, not only do we risk underperformance, but we also forego the opportunity to buy stocks at higher valuations.

The chart below shows the valuation of Microsoft’s stock price to earnings (P/E). In retrospect, the company was very cheap in 1993 and 1994 with a P/E of 10. Also, benefiting from hindsight, the company was extremely expensive with a P/E of 80 in the late 1990s.

graph of microsoft stock price valuation history to earnings

From 1993 to the eve of the dot com crash in 2000, shares of MSFT rose 1,868%. During the same period, sales growth increased by 490%. Not only has the stock price caught up to its revenue growth and profit potential, it has significantly exceeded it.

In the late 1990s, investors in MSFT were betting that the company could grow its earnings at multiple multiples of the market rate. It was an impossible feat, even for a company like MSFT.

Missed expectations

From 2000 to 2010, MSFT increased its earnings per share (EPS) by 11.7%. The rate was just over double the 5% rate of the S&P 500. Although this was a spectacular ten-year growth rate, it did not reach the stock’s high valuation premium in 1999. .

Knowing in advance that MSFT’s earnings would grow twice as fast as the market, a fair value P/E ratio on MSFT in the late 1990s was twice that of the S&P 500. The S&P 500 P/ Average E from 1980 to 1999 was 17.5. Therefore, one could argue that a fair P/E valuation for Microsoft stock was around 35, meaning that its price, on the eve of the dot com crash, was 58% overvalued. Even relative to the record S&P 500 P/E of 29 at the end of 1999, investors were still overvaluing MSFT by 30%.

As shown below, investors paid dearly for ignoring Microsoft’s high stock valuation. It took 14 years for its shares to regain the price peak of 2000.

historical microsoft stock price chart msft

Powerful stories

Unlike baseball, investors can buy and sell any stock (player) they wish at any time. They can buy a 20-year-old Willie Mays stock with great potential at a low price. They can sell Mays when he’s a star, and his value far exceeds his worth. When Mays is past his prime, they can add him back to the roster for a fair price despite his dwindling production.

In the late 1990s, the Internet and home computing were in their infancy. As a result, it was common to see massive growth projections based on the promise of these new technologies. In the late 1990s, ignoring the pie-in-the-sky narratives while heeding the message of valuations would have led a savvy investor to trim MSFT’s holdings or sell out altogether.

The stories supporting MSFT stocks and many other tech stocks were compelling. It was hard not to be greedy. The problem was that the price of MSFT was 0.600. For reference, in 1941 Ted Williams was the last player to beat above .400.

The story of two investors

Selling MSFT in 1999 was incredibly difficult, but it was smart.

Over the next 14 years, MSFT’s stock price went nowhere. A value-oriented investor could have spent the 14 years in the comfort of risk-free US Treasuries yielding around 5%. Years later, MSFT was again trading at a P/E of 10. At the time, our cautious investor, who had nearly doubled his money with bonds, could have bought back almost twice as many shares of MSFT as once held it and take it for another great ride.

The chart below compares two investors who invested $1,000 in MSFT in 1987. The first investor still owns the original shares. The second investor (MSFT trader) sold at the end of 1999 and skipped the 14 years in which MSFT shares did not come to anything. During the period, he bought bonds at 5%.

graph of historical returns of microsoft stock traders versus investors

Summary

It’s easy to sit here in 2022 and tell yourself what an investor should have done in hindsight. Unfortunately, replicating such commercial precision is impossible.

When looking to the future, and not to the past, as we have to do every day, it is extremely difficult to sell companies with great potential, even if they may have extreme valuations. Today, in many cases, valuations resemble those of the late 1990s. Once again, it feels like the good times will never end.

Twitter: @michaellebowitz

The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.

James T. Quintero