Contents
Summary
- Following the release of MSFT’s Q3 2019 results, the share price has risen to its highest level in years.
- I view MSFT as a high quality company worthy of being a long-term investment.
- Using a couple of valuation metrics I view shares as currently being slightly overvalued.
- I present low-risk options strategies from which you can generate additional income if you are in agreement MSFT is slightly overvalued.
Introduction
When deciding upon companies in which I want to invest for the long-term I look at a host of factors which include, but are not limited to:
- the company’s competitive advantages relative to its peers;
- disruptive forces which could impact the company;
- the company’s financial strength;
- earnings growth;
- the reliability/stability of earnings;
- quality of management, and;
- the company’s valuation.
Very recently a subscriber asked me:
‘My current concern is to how to value stocks in a simple way - I'm really struggling with that. Do you have a simple way to value stocks? I find this very hard and frustrating at times and I'm afraid I'm complicating it. What would you suggest?’
I can appreciate this subscriber’s dilemma because there are multiple valuation models out there which, when used, generate very different results. Some of these models require a host of assumptions to be made to come up with the data required for input into these formulas. Amend the data ever so slightly and you get wildly different results. Furthermore, some companies are continually morphing and to predict how they will perform in the future can be a crapshoot.
If correctly valuing a company could be easily achieved through the use of some of these sophisticated valuation models then you would think that professional investors who charge exorbitant fees for their services could consistently outperform the benchmark against which their results are compared. Studies show, however, that very few active fund managers beat their benchmarks on a consistent basis.
I do not employ a department of ‘quants’ to analyze companies. My modus operandi is to use reasonably straightforward methods of determining whether a company is fairly valued, overvalued, or undervalued. I certainly am not correct all the time but for the most part my investment decisions have panned out.
This brings us to Microsoft Corporation (MSFT).
The last time I touched upon MSFT was in my FFJ Portfolio – August 2018 Dividend Income Report. In that article I wrote that on August 30, 2018 I had written November 2018 $115 covered calls and generated $3.15/share (before nominal commission).
At the time, MSFT had relatively recently released its Q4 and FY2018 results in which it reported $2.13 in EPS and $3.88 in adjusted EPS for FY2018 ($1.75 variance reflects the impact of the Tax Cut and Jobs Act (‘TCJA’)) thus giving us a PE of 52.58 and adjusted PE of 28.87 (using the ~$112 stock price at the time). I figured that if there had been no TCJA adjustment then MSFT would have generated EPS equivalent to its adjusted EPS. In essence, MSFT’s PE would have been 28.87 PE which I viewed as being somewhat high.
When the options reached their expiry date in November, MSFT was trading at ~$107.30 and the options expired worthless meaning I retained my MSFT shares.
With MSFT having released Q3 results on April 24th and now trading at $129.89 (April 26th close) I am revisiting MSFT to determine whether to employ a conservative option strategy to extract some additional income.
Q3 2019 Results and Guidance
I provide links to MSFT’s Q3 2019 10-Q, Earnings Release, and Earnings Presentation.
There is no disputing MSFT is firing on all cylinders. Although its profitability is impressive I am even more impressed by the magnitude of Free Cash Flow it continues to generate; it generated just under $11B in Q3 and in Q1 and Q2 it generated slightly in excess of $10B and $5B.
In my opinion, MSFT is the type of company that belongs in every conservative investor’s portfolio. This is certainly not a company where you have to worry about its financial stability.
Credit Ratings
MSFT has the distinction of being only 1 of 2 companies which has been accorded the coveted AAA rating from Moody’s and S&P Global; Johnson & Johnson (JNJ) is the other company.
I am not worried about MSFT’s credit risk.
Valuation
MSFT has generated $3.36 in YTD diluted EPS. If we proceed on the basis that Q4’s earnings will be comparable to the previous 3 quarters then we can reasonably expect FY2019 Diluted EPS to come in at ~$4.48. In addition, I see that Adjusted Diluted EPS guidance from multiple analysts is $4.57. Take the ~$4.53 mid-point of these two figures and the current $129.89 stock price and we get a forward PE of ~28.67.
MSFT is a great company but I view this forward PE as somewhat elevated. If MSFT’s share price were to retrace to ~$115 then the forward PE would be ~25.39 which seems more reasonable.
Let’s look at MSFT’s valuation on the basis of its dividend yield.
MSFT’s dividend and stock history can be found here.
On June 13th MSFT will pay its 3rd consecutive quarterly $0.46/share dividend and just prior to this payment date I expect MSFT to announce its 4th quarterly $0.46/share dividend which will be payable mid-September.
Within a few days of this 4th quarterly $0.46/share dividend payment I expect MSFT will announce a dividend increase of $0.03 - $0.04/share.
With MSFT trading at $129.89 the current dividend provides investors with a ~1.42% dividend yield. This is low relative to the historical dividend yield of the past several years.
If MSFT’s annual dividend were to be increased from $1.84 to $1.98 (I have used a 3.50% increase in the quarterly dividend) and the stock price were to remain at the current ~$130 level, the dividend yield would only increase to ~1.52%.
I draw your attention to this article in which A Dividend Approach to Judging the Value of Stocks is discussed. If we use this approach to determine whether MSFT is fairly valued, overvalued, or undervalued it certainly appears that MSFT’s current valuation is somewhat rich.
I certainly do not expect MSFT’s dividend yield to return to the 2.6%+ level but something closer to just below 2% would seem more reasonable to me. On this basis, a $1.98 annual dividend and a $115 stock price would provide investors with a ~1.72% dividend yield.
Investors need to keep in mind that MSFT’s Board of Directors approved a share repurchase program on September 20, 2016 in which up to $40.0B in shares can be repurchased. As of March 31, 2019, $15.6B of this $40.0B authorization remained available.
With this much share repurchase authorization remaining under the current share repurchase program, I envision MSFT’s share count will continue to slowly reduce.
The average number of shares outstanding (in billions) was 8.4 in FY2014 and 7.79 in FY2018. This continued reduction should have a positive impact on MSFT’s EPS and PE over the long-term. On a short-term basis, the repurchase of 24 – 57 million shares/quarter (this range of shares was repurchased in Q1 – Q3 of the current fiscal year) is unlikely to have a significant impact on MSFT’s EPS.
Option Strategies
Although I like MSFT as a long-term investment I am mildly bearish in the short-term given its current valuation and present the following potential option trades. They are presented separately in the event you just wish to employ just one of the option strategies.
Covered Call Option Strategy
As I compose this article I see the last price for MSFT $135 September call options is ~$4. I do not expect MSFT’s share price to rise to that level between now and expiry and am of the opinion that if you write covered calls at this level the options will expire worthless.
Your breakeven is when MSFT is trading at $139/share ($135 strike price + ~$4 premium).
Bull Put Spread Option Strategy
If you do not own the underlying shares and are in agreement that a pullback in MSFT’s share price between now and the September expiry is not out of the realm of possibility you may wish to consider the following trade.
Sell a September 2019 $125 Put and buy a September 2019 $115 Put. Selling the Put would generate ~$4.15/share and buying the Put would cost ~$1.76/share thus resulting in the receipt of ~$2.39/share at the time of the trade (excludes nominal commission).
If shares close above $125 at expiry, the holder of the right to sell MSFT shares to you at $125 would let their option expire. In addition, you would certainly not exercise your right to sell MSFT shares at $115. Your maximum profit, therefore, would be ~$2.39/share.
Your maximum risk is when MSFT is trading below $115. In this case, the purchaser of the $125 Put would sell shares to you at $125. You, however, have the right to sell MSFT at $115/share so you would be down $10/share. You, however, collected ~$2.39/share at the time of the trade so your maximum loss would be ~$7.61/share.
Combine the Covered Call AND Bull Put Spread Option Strategies
If you own the underlying MSFT shares you may wish to combine both option strategies.
As noted above, if MSFT closes below $135 you would retain 100% of the ~$4.00/share premium you collected under the Covered Call.
If MSFT is trading above $135/share, the holder of the call would have the right to acquire shares from you at $135. We saw from above that $139/share is your breakeven. Depending on your outlook, you could close out your September Covered Calls and write new Covered Calls further out on the calendar and at a higher strike price. This would generate a new premium to offset the cost of closing out your September calls.
We know your maximum potential loss under the Bull Put Spread is ~$7.61/share and this occurs when MSFT is trading below $115. The ~$4/share generated from the Covered Call would reduce your overall loss to ~$3.61/share (excludes nominal commission).
If MSFT is trading above $125, we saw from above that you would retain ~$2.39/share in premium generated from the Bull Put Spread.
If MSFT is trading between $125 - $135/share at expiry you would retain $4.00/share from the Covered Call and $2.39/share from the Bull Put Spread for a total gain of $6.39/share (excluding nominal commission). This would be your maximum profit.
Risks
I would be remiss if I did not advise you of the potential risks you need to consider. This article explains Bull Put Spreads in a bit more detail and discloses the risks associated with the use of this option strategy. This article covers Covered Calls and its risks.
Final Thoughts
I am of the opinion MSFT is a great long-term investment. On a short-term basis, however, I view MSFT’s shares as being slightly overvalued. As a result, I propose a couple of option trades from which you can benefit if the share price drops.
At the moment I intend to initiate these trades for the FFJ Portfolio on April 29th. These option positions will be included in my monthly FFJ Portfolio updates.
I hope you found this article helpful and wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long MSFT and JNJ.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
