In November, I already published an article in which I analyzed the fundamental value of Microsoft (MSFT) in the context of such specific indicators as the free cash flow yield and the earnings yield. In this article, I will try to delve into this topic in more detail.
A bit of theory
Indicators such as the free cash flow yield or the earnings yield are kind of multiples inside out. Just if, when calculating multiples, we divide the price by the base indicator, but in this case, the base indicator is divided by the price:
Free Cash Flow Yield = Free Cash Flow TTM / Market Capitalization
Earnings Yield = EPS TTM / Market Capitalization
Thus, we get an indicator that can not only be compared, but also analyzed by itself. For example, the free cash flow yield shows how much the company generates free cash flow per dollar of its market price.
The free cash flow yield is chronically prone to decline, is this normal?
Here is the dynamics of this indicator in the case of Microsoft over the past ten years. And the main thing that catches the eye is that the indicator is chronically prone to decline:
So, if in 2013, when the current wave of growth in the company’s capitalization actually began, the indicator was almost 13%, now it is at the level of 2.6%. This means that the efficiency, in the context of the ability to generate free cash flow per one dollar of market capitalization, has decreased significantly. But if we take into account that the value of money (risk-free interest rate), in principle, also chronically decreases, this process is at least partially justified:
Therefore, in order to exclude the influence of changes in the value of money, let’s consider the spread between the free cash flow yield and the US 10-year treasury yield:
As we can see, the situation did not change significantly. If until 2018 the spread exceeded 3%, which was comparable to inflation, now the spread is already below 1%, which is significantly lower than inflation.
It is especially noteworthy that the spread value in the case of Microsoft is the lowest compared to other large technology companies that generate stable free cash flow:
What about the future?
But let’s say historical indicators do not have a big impact on the company’s capitalization, since the market evaluates the future, not the past or even the present. Therefore, in the next step, let’s consider the spread between the forward earnings yield and the US 10-year Treasury yield (there are no the forward free cash flow yield data). In this case, we will get the current value of the spread at the level of the two-year low:
And again, Microsoft’s value for this indicator is the lowest among peers:
What does it all mean
Intuitively, it is rational to assume that the price of a company should grow in harmony with its ability to generate free cash flow. And, in such case, the free cash flow yield will remain approximately at the same level.
In the case of Microsoft, this figure has been declining since 2013 and this cannot be explained simply by a decline in the cost of investment capital. Perhaps, Microsoft’s price has somewhat detached from its rational value. And in this case, the company is likely to need a correction or sideways trend in order to continue to grow in the future.