In the history of Magic Formula Investing (MFI), there has been no more consistently screened stock than Microsoft (MSFT).
This blue chip tech stalwart has been a part of the screens almost since the day they were launched in 2006. And for good reason.
With a recent share price decline, is this great business cheap again? Let’s take a look.
By the Numbers, An Indisputably Great Business
Microsoft is undoubtedly a great business, as measured by its returns on invested capital, one of the two components used by MFI to rank stocks. According to Morningstar, Microsoft’s 10-year average returns on invested capital are an outstanding 32.2%, with returns on equity over that same period at 35.1%.
The company has also generated immense free cash flows, routinely well over 100% of net income. It has bought back a substantial number of shares (share count down 23% since 2005), and been a voluminous dividend payor (11 consecutive years of dividend raises).
Finally, Microsoft has maintained a rock solid balance sheet. The company carried no debt at all until 2009, and even today its debt-to-equity ratio is strong at just 30%, with over $100 billion in cash vs. $29 billion in long-term debt.
Despite this, The Market Remained Skeptical
Being a great business is just one half of being screened by MFI. The second half is having a quantitatively cheap stock. In this, also, Microsoft has “succeeded”. Despite the strength of the business, the company’s 5-year EBIT/Enterprise ratio (earnings yield) has averaged over 12.3%, far above the market average of about 7.5%.
Why is this?
The market, for a long time, saw Microsoft as a dinosaur, a company grasping on to its outdated business model of selling desktop software while failing abjectly while trying to enter new markets like paid search advertising, internet services, and device sales. Investors scoffed at the company’s horrifically overpriced acquisitions, like aQuantive for $6 billion, Skype for $8.5 billion, and even the failed, $45 billion bid for Yahoo!. They predicted and then boasted when PC sales flat lined and then headed south, taking a portion of Microsoft’s cash cow, Windows, with them.
